The Secret to Beating the Stock Market, According to Vanguard Experts

While surfing the web the other day I came across an article on Vanguard's website titled Beat the Market Long-Term? Yes, It Can Be Done. At first I thought I must have stumbled into some bizarre reverse universe, an upside-down world where everything you thought you knew has been turned on its head. After all, this was Vanguard, the Emperor of Index Funds, saying that investors can identify in advance actively managed funds that can outperform their benchmarks over long periods, and then suggesting ways to improve one's chances of identifying the funds that can pull off this feat.

But can individual investors apply this advice in hopes of selecting funds that can beat the market? I'm dubious.

I don't want to give the impression that Vanguard is claiming that beating the market is a walk in the proverbial park. The article notes at the very beginning that picking funds in advance that outperform their benchmarks over the long run isn't easy. But it points to Vanguard's success with its own active funds as proof that it can be done. For example, for the 30 years through the end of 2014, Vanguard calculates that its active funds outperformed their benchmarks on an asset-weighted basis by roughly half a percentage point a year.

Dan Newhall, the man who oversees the team that assesses Vanguard's active managers, goes on to cite three key factors that are crucial to identifying winning funds. Let's go over the pointers he gives one by one:

1. Focus on people rather than just performance.

The idea here is that managers who are more likely to outperform not only have a record of competitive results in a variety of market conditions; they're also smart, backed by a talented team, and have a highly disciplined investing process that they follow faithfully. In short, by identifying managers that possess these attributes plus superior performance, the more likely you'll be able to home in on funds whose outsize returns are due to skill rather than luck—and the greater the chance those market-beating returns will continue into the future.

Selecting funds on this basis sounds great in theory, but in the real world this is quite difficult to do. For example, in the more than 30 years that I've been writing about personal finance, I've met with scores of fund managers and, funnily enough, virtually every single one has claimed to have a highly disciplined investing strategy that they follow religiously. I've never had a manager tell me, "Well, we just kind of go with our gut and see what happens." So when you're talking about hundreds, or even thousands, of fund managers, trying to actually assess their procedures and how closely they follow them is a gargantuan task. And even if you somehow manage it, you would have to regularly monitor the managers you choose to make sure they don't fall down on the job.

This sort of research is difficult enough for investment firms that can devote the time, money and resources to assessing managers. I can't imagine many individual investors being able to pull it off consistently.

2. Restrict yourself to low-cost funds.

I couldn't agree more with this tip. Lots of research, including this study from Morningstar, shows that funds that are light on fees generally outperform their higher-cost counterparts. The reason is simple. The higher a fund's fees, the higher the return a manager must earn to overcome those higher costs. And when you have hundreds of thousands of people trading securities and competing against each other for the best returns, there's just very little margin for funds saddled with high costs to outperform their lower-cost peers.

But while limiting your choices to low-fee funds should increase your chances of finding funds that can exceed their benchmarks (not to mention build a bigger retirement nest egg), it's hardly a guarantee you'll end up with market beaters. Indeed, while a bar chart in the article shows that funds in the lowest 25% of expenses were about three times as likely to have beaten their benchmarks over the 10, 15, 20 and 25 years through 2015 than those in the highest-expense quartile, the percentage of low-expense funds that managed this feat wasn't particularly impressive. In fact, it never exceeded 32% (the figure for 25 years) and dipped as low as 22% for 20 years.

So while I agree with the article's statement that "sorting funds by cost is a good starting point for an active investment search," you're still going to have to weed out a heck of a lot of funds from the low-cost pool for that search to be successful.

3. Stay patient.

"Even the greatest managers aren't going to outperform year after year," Newhall told me. "So you have to expect there will be periods where good funds will underperform, and you've got to have patience during those periods when they do."

This advice makes perfect sense. After all, you don't want to bail on a fund (and miss out on its market-beating potential) before it's actually had a chance to prove itself. That said, in many cases staying the course may require the patience of Job. For example, when Vanguard looked at the 476 actively managed funds that beat the market for the 15 years through the end of 2015, it found that 98% of the outperformers lagged their benchmark in at least four out of those 15 years and 81% underperformed in at least six of those years. Nearly a third failed to beat their index in eight or more years--or more than half of the years in that 15-year stretch.

Hey, I'm all for being patient. But in a world where immediate gratification rules and the financial press focuses relentlessly on short-term performance, I think many investors might have trouble sticking with a fund that straggles behind the market for several years or more. In hindsight, we can clearly see that some long-term winners had many years of weak returns. But in real time, investors have no way of knowing whether the fund they've entrusted their money to will end up delivering market-beating performance--or turn out to be a long-term laggard.

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I wholeheartedly agree that if you're going to try to identify funds that have the potential to post market-beating returns, the process described in Vanguard's article is the sensible way to go. And I'll also allow that investment firms that have the resources and are willing and able to commit them to following such a process may be able to increase their chances of finding managers and funds that can outdistance the market over the long term.

But to me the more pertinent issue for individual investors is this: Considering how easily you can assemble a portfolio of low-cost index funds or ETFs that will give you returns that essentially match those of the market, is it really worth going to all the trouble to invest in potential market beaters, especially when you throw in the not-so-insignificant risk of ending up with funds that don't deliver market-beating gains?

Obviously, that's a decision each investor will have to make on his or her own. But after reading this Vanguard article, regularly reviewing the results of Morningstar's Active/Passive Barometer and S&P Dow Jones Indices' Persistance Scorecard and checking out Warren Buffett's paean to index funds in his latest Berkshire Hathaway shareholder letter, I'm more convinced than ever that indexing is the smarter way to go.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. Follow Walter on Twitter @RealDealRetire.