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Vanguard's Huge Emer-Mkts Fund to Get Active Sibling

Family plans an actively managed alternative to Vanguard Emerging Markets Stock Index.

Dan Culloton, Morningstar Associate Director, 04/04/2011

Vanguard, home to the largest emerging-markets fund around, has decided there is room for another, actively managed, version under its own roof.

At first glance the new fund seems a bit out-of-character for Vanguard. If approved by regulators, Vanguard Emerging Markets Select Stock will join a category--diversified emerging markets--that has enjoyed strong returns both in 2010 and over the five-year trailing period and that has seen a torrent of inflows and new fund launches in the past year or so. It will be run by four subadvisors with little or no track record investing in developing markets and will charge nearly 1% in expenses, low for the category, but high for Vanguard.

The family usually avoids launching trendy funds, and its 29 actively managed stock offerings typically are staffed with personnel with long prior track records of success in the same mandate as their Vanguard funds, running money for institutions, separate accounts, or other mutual funds. (Lew Sanders, whom the family added to Vanguard Windsor II VWNFX last year, is a good example.)  Also, few Vanguard actively managed funds charge more than 0.50% expense ratios, let alone the 0.95% this one will levy, according to a prospectus filed Monday with the Securities and Exchange Commission. Is Vanguard jumping on the emerging-markets bandwagon?

Enduring Asset Class
Whether it intended to or not, the emerging-markets category has been a bandwagon. For more than a year, the emerging-markets category has been among the most popular peer groups for asset flows and fund launches. There have been 24 new emerging-markets funds (not counting all share classes) launched since January 2010, putting that category fifth for new launches behind alternatives (50), world-stock (37), target-date (31), and various small-cap funds (24). In the year ended Feb. 28, 2011, emerging-markets funds took in nearly $28 billion in new inflows, fifth best among all categories and tops among stock groups. The category's 8.6% five-year annualized return through March 30, fifth best among all peer groups, probably has something to do with its popularity.

For its part, Vanguard said recent performance, flows, and fund launches had nothing to do with its decision to roll out the fund. Such a fund had been on the drawing boards for a long time and in the earnest planning stages for about two years, said Dan Newhall, of Vanguard's portfolio review group that selects and monitors subadvisors. The family would have liked to fill this hole in its actively managed stock lineup earlier but wanted to make sure it found managers with the skill, capacity, and willingness to work for a low management fee, Newhall said.

"Emerging markets are a large and growing part of the global market and it's apparent to us that they've become very important," Newhall said. "As we look out over the next 5-, 10-, 20-years they are going to continue to be important ... it is an enduring asset class."

Vanguard hasn't just discovered emerging markets, though.  Vanguard Emerging Markets Stock Index VEIEX has been around for 17 years, and, with nearly $60 billion in assets in all its share classes (including the rapidly growing exchange-traded fund), it is the largest fund in its category by a long shot. Since its May 4, 1994, inception through Feb. 28, 2011, the fund has gained a cumulative 322% while the typical diversified emerging-markets fund has advanced 272%. Despite that investment and business success, Vanguard has decided that an actively managed fund can succeed, too. Emerging Markets Stock Index has proved that passive investing works in ostensibly less efficient areas like emerging markets, but the dispersion of returns among actively managed funds is wide enough to suggest that good active managers working for low fees can add value, Newhall said. (The returns of 15 surviving funds with records as long as Emerging Markets Stock Index range from a cumulative 98% to nearly 440%.)PAGEBREAK

Question Marks
It remains to be seen, however, if Vanguard has found managers who can deliver competitive returns over the long term for this fund. The four subadvisors who will run equal portions of the fund have prominent names and good reputations but not a lot of emerging-markets experience. M&G Investment Management runs  Vanguard Precious Metals and Mining VGPMX and 10% of  Vanguard International Growth VWIGX. Oaktree Capital Management has run Morningstar Analyst Pick  Vanguard Convertible Securities VCVSX for 15 years. Wellington Management is Vanguard's largest and oldest subadvisor with about 15 open-end fund assignments and roughly $200 billion under management for the family. And Pzena Investment Management has for six years run a U.S. value fund for Vanguard that's only available to overseas investors, as well as other offerings such as  John Hancock Classic Value PZFVX for far longer.

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