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Fund Family Shareholder Association
terms of making that decision to go short- or long-duration relative to a
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
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.
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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
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
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.
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