The Independent Adviser for Vanguard Investors
•
August 2014
•
15
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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-
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
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
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
...And theWinWas Earned
Incrementally
6/11
9/11
12/11
3/12
6/12
9/12
12/12
3/13
6/13
9/13
12/13
3/14
6/14
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%
1.50%
Difference in monthly returns
The Active Fund
Outperformed...
6/11
9/11
12/11
3/12
6/12
9/12
12/12
3/13
6/13
9/13
12/13
3/14
6/14
$75
$80
$85
$90
$95
$100
$105
$110
$115
Emerging Markets Index
Emerging Markets Select Stock
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
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
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
LAW AND TAXES
Vanguard Costs Under Siege in Lawsuit
>
Are four management
teams better
than one? At
Emerging Markets
Select Stock
it may be.
