(PUB) Vanguard Advisor

MANAGERS Selected Value Bulks Up

VANGUARD IS AT RISK of water- ing-down the fulfilling soup that is Selected Value . As I mentioned last month, on March 31 Vanguard added a third management team to Selected Value, bringing the total number of manag- ers on the portfolio to seven. Pzena Investment Management will start off small but could become a sizable factor in the fund over time. Selected Value, with almost $9 bil- lion in assets, has seen consistent cash inflows over the last year of about $2.0 billion as many other active funds have experienced outflows. It seems that neither Barrow, Hanley, Mewhinney & Strauss nor Donald Smith & Co. (the two subadvisers that were already on the fund) were willing or able to take more of that money, so rather than close the fund to stem the inflows and keep portfo- lio management duties under control, Vanguard elected to hit the multiman- ager button yet again. Though Pzena has managed the overseas U.S. Fundamental Value since May 2005, this is the third Vanguard fund Pzena has been added to in as many years. When Emerging Markets Select Stock was launched in June 2011, they were given respon- sibility for a quarter of the assets. Then in August 2012, Pzena took over about 30% of Windsor ’s portfolio. Their responsibility at Selected Value is small to begin with, as portfo- lio managers Richard Pzena, Manoj Tandon and Eli Rabinowich are start- ing out with a piece of the fund’s cash stake. But Vanguard will also be directing “a portion of new cash flows” their way. I would venture to say they’ll be getting the lion’s share of those flows. While it will take several months (and a new semiannual report) to see how much of the portfolio Vanguard hands over to Pzena, the team’s influ- ence on the portfolio can already be

paced the benchmark, returning 122.9% versus 121.0%. This move toward benchmark-like returns demonstrates why I am skep- tical of the multimanager approach. Howard Marks, co-founder of Oaktree Capital Management (which sub- advises Convertible Securities as well as Emerging Markets Select Stock), recently wrote: “If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different . And being different is abso- lutely essential if you want a chance at being superior.” With a multimanager fund, each manager could be “different,” but it is difficult for the end result—the port- folio—to be all that different after all the managers have been accounted for. Marks also says that when you take the chance of earning superior perfor- mance, the risk of being different is that you could do very poorly. To me, that’s a given, but something that I’ve been able to avoid over the long haul by doing exhaustive research ahead of time. But it’s different for Vanguard. Adding more and more managers to a portfolio allows it to keep funds open and increase assets under man- agement—a big incentive for a com- pany whose employees and executives earn bonuses in part due to the com- plex’s size. And it lessens the risk of a fund massively underperforming. Unfortunately, it also limits our ability to earn truly superior returns. Again, that’s not Vanguard’s problem, as it simply wants to grow assets and pre- vent asset migration away from the firm by ensuring it can match its bench- marks, whether small-cap, mid-cap or large-cap. Would I have preferred thatVanguard close Selected Value rather than add a third team of managers? Yes. I believe the risk in this move is that an excep- tional fund becomes a mediocre one. Happily, I don’t think we are quite

Selected Value vs. Russell MidCap Value Index

0.90 0.95 1.00 1.05 1.10 1.15 1.20 1.25 1.30 rising line = Selected Value outperforms Donald Smith & Co. added to fund ▼ Jim Barrow takes over ▼

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seen. The number of holdings nearly doubled, from 67 in February to 120 at the end of March. Despite the increase in holdings, the percentage of assets in the 10 largest holdings remained rela- tively unchanged at 23% or so, which is to be expected, since the initial Pzena stake is small. Pzena is a deep-value manager, and like other managers that pursue that strategy, their performance can run to extremes of hot and cold. Only time will tell if Pzena’s approach comple- ments the existing managers, but I remain skeptical. Jim Barrow does a fine job by himself, and if Windsor II is a lesson in the foolishness of watering down his portfolio (see the accompanying story on page 15), then this broadening of Selected Value’s manager lineup is not a positive. The chart above plots the relative performance of Selected Value since Jim Barrow took the reins in March 1999 against the Russell MidCap Value index. Jim Barrow and his co-manager Mark Giambrone, who joined the fund in 2002, were the only managers of the fund until Vanguard added Donald Smith in May 2005. During their time as the only two chefs in SelectedValue’s kitchen, Barrow and Giambrone hand- ily outpaced their benchmark 121.7% to 98.3%. Since Donald Smith’s arrival in May 2005 through the end of March 2014, the fund has only narrowly out-

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