Active investing: Tilting the odds in your favor

Active investing is potentially rewarding—but challenging.

When drafting talent into a professional sports team, the front office wants to improve the team but typically has a limited salary budget. Top draft picks have the most talent, but studies show they are often overvalued given their expensive contracts. The ideal draft pick, whether taken in the first or last round, is one whose on-field production exceeds their salary.

Similarly, successful active investing is about finding a fund that can outperform the market by more than it charges in fees, leaving the end investor with attractive net-of-fee alpha. The most talented managers may not be the best investments if the price isn’t right.

Successful active management can offer significant outperformance

After costs are accounted for, most active equity funds have underperformed over time.¹ However, the rewards for selecting—and having the discipline to stick with—a successful active fund over the long term can be significant. For example, Vanguard PRIMECAP Fund has outperformed its benchmark, the S&P 500, by a cumulative 159%, or 1.05% annualized, over the 20 years ended May 31, 2025. See the fund’s most recent standardized performance.

Investors and researchers have long sought active fund characteristics that have a reliable relationship with outperformance. Research from Vanguard’s Investment Strategy Group and the long experience of our Oversight & Manager Search team in selecting active equity managers for our funds highlight several quantitative and qualitative characteristics that can increase the likelihood of selecting an outperforming manager.

Quantitatively, investors should avoid simply anchoring to past performance, particularly over the short term.² Instead, investors should seek to understand the drivers of past performance and to compare managers to appropriate benchmarks and peer groups to determine if performance stemmed from luck or skill.³

A fresh assessment of active fund characteristics and performance

Using a sample of 1,600 U.S.-domiciled active equity funds, we evaluated four characteristics previously identified by researchers as being reliably connected with outperformance.⁴ We looked at data over the 33-year period from January 1990 through December 2022, calculating the characteristics over distinct three-year periods starting with 1990–1992, and then assessed their ability to explain excess returns in the subsequent three-year period (1993-1995). We then repeated this process in subsequent three-year periods (1993–1995 to calculate characteristics and assess their ability to explain excess returns from 1996–1998) for the rest of the period. The adjacent figure shows the characteristics that displayed economically meaningful and statistically significant relationships with future performance.⁵

As previous Vanguard research suggests, cost is paramount in selecting a fund: The higher the costs, the higher the hurdle to outperforming a given benchmark net of fees.⁶

Fund size is another key and interrelated consideration. While larger funds generally are lower cost and more likely to survive over time than their smaller counterparts, funds that grow too large relative to their investment universe or investment process can incur higher trading costs and find it difficult to take meaningful positions in less liquid stocks that may be mispriced.

Turnover reflects the extent to which a manager trades; all else equal, higher turnover translates into higher trading costs, such as commissions and market impact, which reduce returns. Like fund operating costs (expense ratios), the costs associated with higher turnover present a larger hurdle to outperformance. High-turnover funds can and do still outperform, particularly in more liquid market segments or with more diversified strategies, but the odds are lower.

Capture ratio is proxied by upside capture ratio divided by downside capture ratio, where upside (downside) capture ratio is the net return for a fund in the months during periods when the market, proxied by the S&P 500 Index, rose (fell) divided by the prospectus benchmark return in those same months (3-year average). This can be thought of as the ability of a manager to outperform in both up and down markets. A fund’s capture ratio tends to be more predictive of future performance than prior absolute returns alone. For example, a fund with 120% upside capture and 130% downside capture—a negative capture ratio—could have strong results amid a steady bull market but be less likely to succeed over a full market cycle, with the risk of significant underperformance in a bear market.

Quantitative characteristics are just the starting point

This group of four quantitative characteristics accounts for less than 20% of the variability in future relative performance. That still leaves more than 80% of the volatility in performance relative to a manager’s benchmark unexplained. That suggests that qualitative factors are also important to consider when selecting an active manager.

With 50 years of experience searching for and overseeing active managers, we believe that investors should consider the firm, the fund strategy, the investment team, their investment philosophy, and their investment process.

People are paramount. Investors should seek portfolio management teams that are well credentialed in terms of educational backgrounds and formal training (e.g., CFA/MBA), experienced, and cohesive. Diversity within investment teams is also important. Vanguard research has shown that teams with strong credentials and teams that are diverse have tended to outperform.⁷ On the firm side, investors should consider resources, reputation, and incentive structures—factors that ultimately serve to attract, retain, and develop talented investors.

Philosophy and process are intertwined.⁸ Investors should think of a fund’s philosophy as what the managers look for in a stock—the market inefficiency they seek to exploit—and the investment process as how they go about exploiting it. Investors should seek to understand both the economic rationale and historical risk and return characteristics of a given philosophy.

A fund’s investment process spans idea generation, research, portfolio construction, and trading. Investors should focus on whether those elements are clear, disciplined, and repeatable. The research aspect is particularly important. Active investing is a highly competitive endeavor—company information is widely available and there are hundreds of smart, well-trained analysts following most larger-capitalization stocks. Consistently deriving an edge against this competition and developing a differentiated view on a company’s future requires thorough, proprietary research that goes well beyond simple headlines, publicly available financial ratios, or catchy themes.

An active fund investor must answer two questions, “Has this investment strategy worked in the past, and will it continue to work in the future?” There is meaningful risk of investors failing to appreciate the cyclicality that besets even the most successful active managers over the long term, exposing them to underperformance if they buy near the peak of a strategy’s success or sell near its trough. Active fund investing requires discipline to realize its benefits.²

To succeed as an active fund investor, focus on the key characteristics

Because active equity fund investing remains challenging, investors should consider the potential benefits of working with a financial advisor with the resources and time to devote to the search and selection process. For all advisors and investors, including the self-directed, focusing on these quantitative and qualitative criteria can improve the odds of selecting above-average active equity funds that can deliver more than they cost—like the general managers of sports teams drafting future all-stars in the latter rounds of a draft.

The authors would like to thank Doug Grim and Ning Yan for their invaluable quantitative and qualitative contributions to this commentary.

1 S&P Dow Jones Indices LLC, SPIVA® U.S. Scorecard, mid‑year 2025.

2 See Tidmore, Chris, and Andrew Hon, 2021. Patience With Active Performance Cyclicality: It’s Harder Than You Think. The Journal of Investing 30(4): 622.

3 See Fama, Eugene F., and Kenneth R. French, 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics 33(1): 3–56. See also Berk, Jonathan B., and Richard C. Green, 2004. Mutual Fund Flows and Performance in Rational Markets. Journal of Political Economy 112(6): 1269–1295.

4 We use a pooled regression approach to determine the association between equity funds’ future excess returns (average excess return relative to their Morningstar-assigned benchmarks over the subsequent 3-year period, starting with 1993–1995) and the prior period characteristics. The model included 10,354 monthly observations.

5 The results shown in the figure are from a pooled sample. We performed a similar analysis using a balanced panel approach and found similar results. In addition to the four charted characteristics, we tested the information ratio, the peer-adjusted information ratio, number of holdings, cash weight, excess return, tracking error, fund r-squared, fund age, systematic activeness, and log of firm AUM. Information ratio, peer-adjusted information ratio, cash weight, tracking error, and fund age were not statistically significant.  Average turnover was statistically significant at the 5% level. All others were statistically significant at the 1% level.

6 See Considerations for active fund investing, Vanguard, 2024; See also Are Investors Paying Too Much for their Risk Exposure, Vanguard, 2025; available at https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/are-investors-paying-too-much-risk-exposure.html.

7 Diversity Matters: The Role of Gender Diversity on US Active Equity Fund Performance; available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4081494

8 For more detail on philosophy and process, please see Active edge: Winning the zero-sum game; available at https://corporate.vanguard.com/content/dam/corp/research/pdf/active_edge_winning_the_zero_sum_game.pdf

Notes:

For more information about Vanguard funds, visit advisors.vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.