(PUB) Vanguard Advisor

aren’t held to the same definitions as index producers, and Emerging Markets Select Stock’s portfolio has 6.5% of its assets in South Korean stocks. Other

kets ETF, which is the third-largest holding in Emerging Markets Select Stock. The ETF serves as a cash proxy for the active fund. The deeper you dig into the portfo- lios, the greater the differences. At the end of June, for instance, the active fund held 270 different stocks versus the 963 holdings in the index fund. That relative concentration can help or hinder, but in the hands of good stock- pickers, it’s obviously a benefit. But here’s one of the more interesting differences between the index fund and the stock fund—their geographic allo- cations.You may recall that about a year ago FTSE decided that South Korea no longer qualified as an emerging market and would be moved into the developed market category. Well, active managers

Let’s take a look at how those gains were won. The second chart below shows the monthly difference between Emerging Markets Select Stock’s return and that of the index fund. Lots of regular, incremental gains over the index fund are what put the active fund ahead, as it outperformed about 75% of the time. That’s a good, solid record of performance. Digging a little deeper, while the index fund and the active fund both allocate about the same amount of assets to their 10 largest holdings (15.9% for the index fund and 16.1% for the active fund), only three of the index fund’s top 10 stocks are among the top 10 in the active fund. By the way, the top 10 Vanguard reports don’t include its own emerging mar-

Are four management teams better than one? At Emerging Markets Select Stock it may be.

big differences include Hong Kong, where the active fund has 4.5% of its assets while the index does not report any exposure, and South Africa, where fully 9.5% of the index allocates assets but the active fund has 6.5%. Also, even though the funds both have about the same allocations to Chinese companies, some of the largest Chinese firms in the index aren’t found among the top holdings at the active fund. Again, that’s a function of stock picking and whether the bogey is lousy, the stock pickers are excellent, or both. The bottom line is that the managers are winning this one over the indexers. So, are four management teams better than one? That’s a good question, and a tough one to answer. So far it looks like four management teams is better than one index. And that’s a good start. n

The Active Fund Outperformed...

...And theWinWas Earned Incrementally

$100 $105 $110 $115

1.50%

Emerging Markets Index Emerging Markets Select Stock

1.00%

0.50%

0.00%

$75 $80 $85 $90 $95

-0.50%

-1.00%

Difference in monthly returns

-1.50%

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LAW AND TAXES Vanguard Costs Under Siege in Lawsuit

on a more level playing field with Vanguard as far as costs are concerned. How so? Well, let’s look at one example. According to the complaint, Vanguard prices its services to its over- seas funds as “a 7.5% cost-plus return.” To give a sense of how this might trans- late to higher costs at home, consider the Vanguard U.S. 500 Stock Index Fund offered to overseas investors. The fund’s investor share class charges a 0.25% operating expense compared to the investor class expense of 0.17% for 500 Index here at home. That’s still >

and tax attorney who worked for Vanguard for just under five years, the suit makes some pretty major allega- tions. Let’s start by saying I’m not a tax attorney. I can’t debate the merits of the lawsuit or some of the allegations presented in it. And Vanguard says it is going to defend itself with vigor. But from a broader perspective, this assault on Vanguard’s at-cost oper- ating principle could, if successful, have seismic implications for the fund industry and possibly put competitors

A LAWSUIT, filed on May 8, 2013, and unsealed in New York in late July, claims that Vanguard has used its SEC exemptive order allowing it to operate at cost to avoid paying “approximately $1 billion of U.S. federal income tax and at least $20 million of New York tax over the last ten years.” Secondary to the at-cost arguments, the suit also alleges that Vanguard didn’t treat a $1.5 billion Contingency Reserve funded by each individual mutual fund properly from a tax perspective. Filed by a former Associate Counsel

The Independent Adviser for Vanguard Investors • August 2014 • 15

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