(PUB) Vanguard Advisor

II in 1987. At the time, Barrow Hanley’s Jim Barrow was the sole manager on the fund, and Vanguard added Invesco as a second manager, putting about one-quar- ter of the fund’s assets under that firm’s aegis. Four years later, Invesco was out, and according to Jack Bogle, during that period, the performance of the two different managers was “substantially identical.” In Invesco’s place, Vanguard added three different management teams, and since then, the cast of characters has changed again and again—yet Windsor II’s performance has essentially matched the Russell 1000 Value index, once you adjust for the fund’s expenses. This has happened despite the fact that, as I’ve shown time and time again, Windsor II’s original manager, Jim Barrow, out- performs the multimanaged Windsor II. Why dilute his excellence rather than simply close the fund? One Last Exploration As I’ve said many times, there are few reasons to invest in Explorer, even if

managers who we think have the traits that can improve the odds of suc- cess.” But I question which “thoughtful investors” would go out and hire eight different small-cap growth managers. Pension funds, endowments and other large pools of capital that hire individual managers look for diversification among investment managers’ styles (e.g. growth vs. value) and the areas of the market in which those managers focus (e.g. small- caps vs. large-caps)—as I do in build- ing the team of managers in the Model Portfolios on page 2. But I don’t know of any thoughtful investors that would go out and hire eight different small- cap growth teams. It reminds me of an investor I met who owned four large-cap balanced funds. When I asked why, the investor said, “I figured if one was good, then four was even better.” It isn’t. Windsor II’s Experience As I said, Vanguard takes pains to claim a long experience with multiman- ager strategies, beginning with Windsor >

Vanguard considers it one of their “Select” funds. (That’s a story for another day.) Over the 10 years ending in December 2013, Explorer ’s average rolling one- year, three-year and five-year returns are 12.1%, 7.7% and 3.0%. Compare that to SmallCap Growth Index , with returns over the same multiple rolling periods of 13.9%, 9.7% and 5.0%. (Data on these funds and others can be found on pages 252 and 253 of the 2014 Independent Guide to the Vanguard Funds. ) Vanguard has turned a good fund into a poor index fund. It’s too bad. But in some ways, it’s no surprise Vanguard doesn’t take Explorer ’s per- formance woes seriously. Only two of its 11 directors own a stake in the fund. (Chairman Bill McNabb does not.) Meanwhile, seven directors, including McNabb, own shares in one or more of Vanguard’s three longstanding small- cap index funds. If you aren’t eating your own cooking, then I guess you don’t have to worry about how many chefs are in the kitchen. n

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terms of making that decision to go short- or long-duration relative to a benchmark.

our index-based portfolios or our actively managed portfolios, they are high-quality and broadly diversified in markets that tend to have greater liquidity than folks who are invested in the high-yield space or the bank- loan space and things of that nature. As bond dealer balance sheets shrink, can it take longer to execute a trade? Absolutely, but it also causes you to take that into consideration as you are structuring your portfolio. But on index funds you don’t have that choice. At the end of the day, it’s a high-quality benchmark. So, if you look at Total Bond Market , for example, there is only a little over 20% that’s in investment-grade corporates. The rest is in Treasurys, mortgages and agencies, which are extremely liquid. We tend to be buy-and-hold inves- tors until things drop out of the index. For Total Bond Market, that’s when stuff either gets downgraded to junk or falls inside a year to maturity, at which point you start to get a lot of interest from very short-dated funds. I have argued that bond index funds with large allocations to U.S. government-backed bonds, like Total Bond Market, now have more risk in them than most investors are expecting. Jack Bogle has expressed a similar concern. What’s your thought? We believe in market-cap weighted indices and our funds track against float-adjusted benchmarks. That means that to the extent that there are holdings that are taken out of the market by the Federal Reserve, they are out of the benchmark. It takes into consideration the extent that the Fed owns a ton of mortgages that are not readily available for purchase and get stripped out of the benchmark. If those things reverse over time, it would be reflected back in the float and represented in the benchmark.

Do you think that with the 10-year Treasury at 2.55% or even 2.65%, bond market investors have a dimmer view of the econo- my and its future prospects than stock market participants? People are pretty cautious in terms of what the economic outlook is, and that’s why you are seeing Treasurys where they are, because the market—again, with this very low-growth environment and no signs of inflation—is expecting the Fed is still going to be on hold until the middle part of next year, if not later. It is going to be very dependent upon any new economic data that we get. What about the stock market? I’m not an equity manager but if you look at equity risk premiums based upon P/Es, and where we are in terms of government yields and things of that nature, equities still look relatively attractive. So it’s not surprising that equities are still in high demand. If you look at the S&P index, not including dividends, it’s up close to 6% this year. The market still exhibits some value there. Investors have poured a ton of money into bond mutual funds over the past five years or so, and Vanguard runs some of the largest bond funds out there. What’s your sense of the liquidity in the bond market? We’ve heard that it’s become tougher to move big blocks. Is there a limit to how much Vanguard can effectively manage? It’s a function of the markets you are operating in. Our sweet spot is really in the investment-grade space. And whether you are looking at

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