(PUB) Investing 2016

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4 • Fund Family Shareholder Association
VANGUARD’S HEDGE FUND turned one year old in August.
Wait. Vanguard has a hedge fund? That’s right. Alternative
Strategies is essentially a hedge fund in a mutual fund wrapper, execut-
ing a sophisticated, somewhat opaque strategy with limited access and
the aim of delivering positive returns irrespective of the stock market.
Alternative Strategies has everything but high fees, or a high profile.
You are forgiven if you’re not all that familiar with Alternative
Strategies. You can only invest directly in the fund if you are a client
of Vanguard’s Institutional Advisory Services, which means you are an
endowment, foundation or pension. You won’t even find a page for the
fund on Vanguard’s personal investor website. That said, Alternative
Strategies is a component of Managed Payout’s portfolio—so it
deserves a bit of our time and attention.
Alternative Strategies’ objective is to deliver returns that have a low
correlation to the stock and bond markets while exhibiting less volatility
than stocks. In plain English, that means the fund should behave differ-
ently than the stock and bond funds you already own, and it should land
in the middle when it comes to risk. Of course, the real aim is to do this
while also generating positive returns, regardless of what the stock or
bond markets are doing—Vanguard’s goal is to return 4% over cash—
otherwise you could just hold cash and get about the same diversifica-
tion benefits with no risk (and almost no returns).
Portfolio managers Michael Roach, Anatoly Shtekhman and Binbin
Guo try to deliver on this fairly lofty goal by investing in several differ-
ent strategies: long/short equity (which is like Market Neutral), event
driven (also known as merger arbitrage), fixed income relative value,
currencies and commodities. If that sounds a bit murky in its description,
well, that’s because it is. Vanguard could stand to improve its discussion
of how this fund actually invests.
That said, the fund’s first year has been a home run. Since its August
11, 2015 launch, Alternative Strategies’ 9.6% return is ahead of Total
Stock Market’s 5.6% gain, Total Bond Market’s 5.5% advance and
Prime Money Market’s meager 0.3% return.
Alternative Strategies has delivered those returns with low correlation to
the stock and bond markets. Remember, correlation tells us to what degree
two funds (or, say, a fund and an index) moved in the same direction at the
same time. Correlations range between -1.00 and 1.00. When two invest-
ments rise and fall in perfect unison, they are said to have a correlation of
1.00. If they always move in opposite directions, that yields a correlation
of -1.00. Since inception, Alternative Strategies and Total Stock Market
have had a correlation of 0.05, which means there was little relationship
between their ups and downs. A correlation of 0.33 between Alternative
Strategies and Total Bond Market indicates there has been a bit more of a
synchronicity, but they still moved fairly independently of each other.
ALTERNATIVES
A Strong Start, Still in the Shadows
been 11 days this year when the
10-year Treasury bond’s yield moved
5% or more from the prior day’s yield,
which is equivalent to all the 5% or
greater moves seen in 2015, and higher
than the eight such moves in 2014 and
2013 combined. With yields at such
low levels, even small absolute changes
represent big percentage moves. The
concern for investors is that low yields
mean that there isn’t much income to
cushion the blow of falling bond prices
when interest rates rise.
Which begs the question: When will
rates rise, and how fast? No one knows,
though plenty of talking heads will tell
you they do, with absolute confidence.
Those are simply guesses. What isn’t a
guess is that higher rates are likely to
be driven by faster economic growth
or higher inflation or both. Right now,
though, the economy is growing at an
uninspiring pace. Second-quarter GDP
was revised down from 1.2% growth to
1.1%. And inflation is still extremely
low. The Fed’s preferred inflation mea-
sure, core PCE, is only up 1.6% over
the past year.
Still, I think it’s likely that the Fed
will raise interest rates in September,
though we are only talking about an
incremental increase. Chair Janet Yellen
and some Fed governors have tele-
graphed to the market that they would
like to raise interest rates, though ever so
slowly. Remember, the last time the Fed
raised interest rates was in December,
so they haven’t been in a hurry. I sup-
pose it is possible, but I wouldn’t expect
a 25 basis point (0.25%) move to trigger
materially higher yields across the bond
market. Nor would it cause me to alter
the Model Portfolios—even in a period
of rising interest rates, there is a role for
bonds in keeping overall volatility under
control.
As noted earlier, there still seems
to be a good deal of negative sentiment
toward stocks, particularly U.S. stocks,
which I believe reflects the memory
of two massive bear markets over the
last two decades—the bursting of the
tech bubble, and then the credit crisis.
And while still relatively unpopular,
some of the best areas of opportunity
may be found outside our borders. Yes,
> the headlines are scary, but consider
that Emerging Markets Stock Index,
which is up 14.6% this year, is still
19.6% below its high point reached
nearly nine years ago in October 2007.
International Growth, my preferred
foreign stock fund, currently has 20.6%
of its portfolio allocated to companies in
emerging markets, a bit more than Total
International Stock Index’s 18.7%
allocation. Its 6.1% return this year is
also slightly ahead of the index fund’s
5.2% return. At some point we may
want to increase our exposure to foreign
stocks—with or without a dedicated
emerging markets holding.
On a side note, August marked the
40th birthday for 500 Index,Vanguard’s
first foray into indexing. When it was
introduced, with a 6% front-end load,
it was an abject failure, and attracted
few assets even after the load was
removed. Of course, that failure turned
into a rousing success and gave birth
to the “new” Vanguard, a no-load, low-
expense home for a slew of index and
active funds as well as ETFs. We are all
better for it. n