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GMO versus Vanguard: Assessing the Performance of Comparable FundsA Note Prepared for the Bogleheads 9 Meeting in Philadelphia, October 2010Edward TowerProfessor of Economics at Duke UniversityVisiting Professor at Chulalongkorn UniversityTower@econ.duke.eduOctober 2010AbstractGMO is a well known mutual fund company that serves wealthy clients. The minimum investment for a mutual fund account is 10 million dollars. GMO’s web site is a font of useful and entertaining information. Should the Vanguard investor who can’t afford to invest with GMO be envious of the wealthy who have access to GMO funds? This paper asks whether the GMO funds that have similar Vanguard counterparts over-return or under-return their Vanguard counterparts, and by how much. Some of the Vanguard counterparts are indexed. Thus, this paper also provides evidence on whether stock pickers can beat indexers.IntroductionJohn Bogle (2005), the founder of Vanguard, has argued “In investing you get what you don’t pay for.” This is part of his argument for investing in low cost index funds. Unquestionably , if managed funds charge sufficiently high expenses they will underperform indexed funds. But what of managed mutual funds with reasonably low expenses? One company that has relatively low expenses is GMO. It hosts a web site that posts useful information, including predicted real returns for various asset classes and Jeremy Grantham’s quarterly letters. However, the minimum investment for a mutual fund account is 10 million dollars ( although four of GMO’s funds are available through Schwab (2000) with a minimum investment of 1 million, and GMO is the sub-advisor for some funds issued by other companies). Tower and Zheng (2008), building on Bernstein (1999 & 2000), conclude that mutual fund families which treat their wealthiest customers to low expense ratios and do not have front-end or back-end loads and have low turnover tend to produce higher returns for clients even before expenses and loads are subtracted from mutual fund performance. They argue that these are mutual fund families which cater to richer clients, who monitor performance more closely. Therefore, competitive pressures force these companies to manage their funds to yield better returns to their clients. GMO has relatively low expenses and its mutual funds do not have loads. Thus there is a presumption that their funds will perform well relative to Vanguard’s. This is enhanced by GMO’s claims on its web page that its funds are likely to outperform indexes. For an investor what is more relevant is whether GMO’s funds perform well relative to similar funds produced by a low cost well known provider, rather than relative to indexes. Thus, it is useful to explore how well GMO’s funds perform relative to Vanguard’s funds. That is what this paper does.GMO’s ClaimsThe seven year asset class forecasts on GMO’s web site through July 2010 provide estimates of the value added by GMO’s active management for various asset classes. As of July 31, 2010 these were: US equities: 1.8%/year, international equities: 2.3%, emerging equities: 3.7%, US government bonds and inflation protected Treasuries: 0.9%, and US short term government bonds: 1.4%. Unlike all previous reports, the August 31, 2010 report does not repeat the claim of value added by GMO’s active management. The web site does not explain why GMO stopped reporting this. I wonder if it reflects a loss of confidence based on recent performance? Let’s explore whether this is a reasonable hypothesis.MethodologyMorningstar’s web page provides returns for mutual funds over 1, 3, 5 and 10 year periods. The study uses these data to compare Vanguard’s indexed mutual funds with their GMO counterparts. The comparison is shown in Table 1. The study used only those funds that judging from the name and description on the Morningstar Principia disks had a similar style to a Vanguard fund. An alternative approach would be to compare returns with Fama French constant style indexes. We leave that to a future paper. Here we ask the question “Would Vanguard investors on average have received higher returns moving from Vanguard funds to GMO funds with similar descriptions, and similar Morningstar style box descriptions. We supplement these calculations using the data on Morningstar’s Principia disk, to obtain return differentials starting at the beginning of 2003 through the end of 2009. The 2009 figures were drawn from Yahoo, since I was working from an old Principia disk. Yahoo is less reliable than Morningstar. Style adjustments were performed in an earlier study (Tower and Zheng, 2008). We looked at the equally weighted portfolio of funds investing in US assets from 1994-2004 inclusive. Using Vanguard’s minimum expense class, not adjusting for risk, we found that GMO beat its corresponding index basket by 0.74 % per year, while Vanguard beat its corresponding basket of indexes by 0.20 % per year. Risk adjusted the two numbers were 1.10 % per year and 0.37 % per year. Again GMO beat Vanguard.ResultsExhibit 1 reports that both the median and average Vanguard funds had lower returns than their GMO counterparts over the entire ten year period through September 23, 2010. The returns are annualized geometric averages. The average excess return of the GMO funds is 1.17 % per year. However, recent shorter periods are dramatically different. Over the most recent five year period, Vanguard’s average excess return is 1.81 %/year. Over the most recent 3 year period its excess return is 0.29%/year. Over the most recent year its excess return is 0.88 %/year. Median values have the same sign pattern.Thus while over ten years, GMO’s funds that correspond to Vanguard funds have out-returned Vanguard’s funds, the GMO advantage has become negative in recent years. On average GMO’s claim of the superiority of its managed funds to index performance has carried over to outperforming Vanguard funds during the first half of the most recent ten year period. Over the second half it has not. These calculations are supplemented by Exhibits 2 and 3. Exhibit 2, shows average return differentials from the start of the year indicated to the end of 2009, calculated in the same way as in Exhibit 1. Vanguard under-returned from the beginning of 2000, 2001, and 2002. It had an excess return from all other start dates, beginning in 1993. There are fewer funds in the earlier years however. The trend line shows an increase in the average differential return favoring vanguard. This slope is highly influenced by the outperformance of Vanguard in 2009.Note that Vanguard way out-returned in 1998 and 1999, when growth trounced value in the US stock market.Vanguard replaced GMO as co-manager of some of its funds with its own analysts, indicating that Vanguard feels that it can at least match GMO’s judgments after expenses.Vanguard Group, the second-biggest US mutual-fund company, dropped the Boston-based GMO LLC investment firm run by Jeremy Grantham as co-manager of three domestic stock funds that lagged behind peers in the past year.GMO was removed from the $10.5 billion Explorer, the $975 million Vanguard US Value, and the $695 million VVIF-Small Company Growth Portfolio, Vanguard said yesterday. Vanguard, based in Valley Forge, Pa., replaced the Grantham firm with its own quantitative equity group, which uses mathematical models to pick stocks. (Boston Globe, 2008).This study has not looked at GMO’s funds that are less closely matched by Vanguard’s funds. It has not examined GMO’s asset class predictions. On that see Tower (2010a). Nor has it looked at GMO’s Benchmark-Free Allocation Fund, which can substantially alter its style as different styles become over or undervalued. On that see Tower (2010b). This study should be interpreted as only comparing the stock and bond selecting prowess of GMO with the stock selection mechanism of Vanguard’s corresponding funds, be they managed or indexed. The Vanguard share class used for these comparisons is the investor class. The Admiral and Institutional share classes have lower expense ratios as do Vanguard’s ETFs. Had we used those, we would have shifted the excess return differential in favor of Vanguard. Should we be surprised at the fall in the advantage of GMO? Our result is consistent with that of Barras, Scaillet and Wermers (2008) who report a decline in the performance of stock pickers relative to indexers over time (through 2006). It is also consistent with the same result found for Vanguard’s managed versus index funds and fundamentally indexed funds versus Vanguard’s indexed funds (Tower, 2009 a &b). Perhaps the current paper’s result that GMO’s relative performance has declined reflects an increase in the efficiency of the stock market. It may reflect an increase in the efficiency of Vanguard relative to GMO. It may reflect different Fama-French styles. The sample is small and the change is not significant at conventional levels, so the change may be random.I draw two conclusions from these results. First, there is no compelling reason to be confident that GMO’s stock and bond selecting prowess will exceed Vanguard’s by enough in the future to make up for the somewhat higher expenses of GMO. This is especially true for Vanguard investors who are eligible to invest in Vanguard’s Admiral share class. Second, the high variance in the annual return differential likely reflects differences in style between funds that have similar names. An investor should investigate the composition of the corresponding funds before deciding which to hold.ReferencesBarras, L.,O. Scaillet, and R. R. Wermers. 2008: False Discoveries in Mutual Fund performance: Measuring Luck in Estimated Alphas. College Park: University of Maryland, Smith School Research Paper Series, RHS 06-043.Bernstein, W.J. 1999. The slippery slope of fund expenses. Efficient frontier: An online journal of paractical asset allocation. July. , W.J. 2000. The slippery slope of fund expenses, part II. Efficient frontier. Winter. , John C. 2005. “In Investing, You Get What You Don’t Pay For.”Keynote speech by John C. Bogle, at The World Money Show.Orlando, Florida February 2, 2005. Globe. 2008.”Vanguard drops GMO as funds co-manager.” web page. 2010. . 2010. “Investor Resources.” Schwab website. 2000. , Edward and Wei Zheng. 2008. “Ranking Mutual Fund Families: Maximum Loads and Minimum Expenses as Markers for Moral Turpitude. International Review of Economics. 55:4. pp. 315-350.Tower, Edward. 2009a. “Performance of Actively Managed Versus Index Funds: the Vanguard Case” Chapter 12 of Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship, edited by John A. Haslem. Hoboken: Wiley 2009. Pp. 211-236.Tower, Edward. 2010a. “Strategic Asset Allocation in Practice: Using Vanguard Funds to Clone GMO’s Benchmark-Free Allocation Fund.” Duke University Working Paper, October (I hope).Tower, Edward. 2010b. GMO’s Predictions as Pilots for Vanguard Portfolios: Are They a Useful Guide for Strategic Asset Allocation? Duke University “Working Paper, October (I hope).Exhibit 2. Average excess returns of Vanguard funds over their GMO counterpartsyearfrom start of year indicated to end of 2009, %/year during single year, %20095.855.8520081.030.4620071.011.9620061.662.1720051.22-1.1920040.91-0.3220030.20-3.332002-0.07-8.012001-1.67-7.292000-1.431.3219990.0312.1519980.2310.0719970.371.2419960.055.0819950.399.4519940.85-1.8019930.17-12.39 ................
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