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Are These Vanguard Funds Too Hot to Handle?

Plus, T. Rowe's new fixed-income chief will have to think globally, and more.

Morningstar Analysts, 10/12/2009

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

Earlier this week, Vanguard, the more than $1 trillion asset manager, warned investors not to expect the strong domestic and international returns this year to continue forever. The MSCI US Broad Market Index is up 21.6% for 2009 through the end of September, while the MSCI EAFE Index is up an impressive 29%. Both are a far cry from the roughly 10% annualized returns these markets have traditionally returned.

This isn't the first time the firm has issues such a warning; it has issued similar notes when things were running hot in other asset classes, such as REITs, emerging markets, and precious metals.

The company went on to caution that it might be wise "to ensure that your asset allocation is in line with your long-term goals." In other words, reduce, or at least stop adding to, your allocation in the hottest asset classes. Besides closing a mutual fund for performance-related reasons, this is the closest a mutual fund manager gets to protecting investors from themselves and a contrast to other fund shops that would gleefully tout in ads the recent performance of hot funds.

Vanguard singled out four funds in its warning:

Vanguard Capital Value VCVLX
Vanguard Emerging Markets Stock Index VEIEX
Vanguard Precious Metals and Mining VGPMX
Vanguard High-Yield Corporate VWEHX

Vanguard didn't say these funds are in for an imminent fall; it is just reminding investors that hot markets eventually cool and to maintain realistic expectations.

Reversion to the Mean Alert
Some managers have argued there is still room left for the market's recent rally to run. Not so, say a number of other prominent asset managers.

Bob Doll, BlackRock's BLK global equities chief investment officer, wrote in a recent report that the S&P 500 is currently trading at a reasonable valuation based on the expectation that corporate earnings will continue to improve. However, he notes that this data points only to compound annual returns of 6% to 8% over the next several years.

John Hussman, manger of the strong performing Hussman Strategic Growth HSGFX and Hussman Strategic total Return HSTRX, agrees. He noted a few weeks ago that he expected the S&P 500 to return just 6.6% over the coming decade, "a level that except for the period since the mid-1990's has corresponded more to bull market peaks than bases for sustained advances."

Similarly, Jeremy Grantham, GMO's chief investment strategist and former chairman, wrote an article titled "Boring Fair Price!" recently. His firm estimates the S&P should return just 2.8% real over the next seven years, which translates into 5.3% if inflation averages 2.5% per year.

It's not hard to arrive at similar numbers on your own. As Hussman and other managers have noted, the S&P 500's annual peak-to-peak earnings growth has averaged 6% since 1950. Add the S&P's current dividend yield of about 2.5% and you get a prospective total return of about 8.5% assuming if, and it's a big if, the P/E ratio (which, according to various estimates, stands between 15 to 18 on a forward-looking 12-month basis) stays constant.

But even if the P/E ratio stays put, this estimate assumes similar growth in the future. PIMCO's Mohamed El-Erian argues the "new normal" will be characterized by much slower growth going forward.

So it seems Vanguard's worries are well-founded.

T. Rowe's New Fixed-Income Chief Will Have to Think Globally
T. Rowe Price's TROW chief executive officer, James Kennedy, told Morningstar that the asset manager has compiled a "short list" of internal successors for Mary Miller, its fixed-income chief, who is expected to be nominated for a U.S. Treasury post.

The post requires Senate confirmation, and in an interview earlier this week, Kennedy said that Miller will remain in her position through the confirmation hearings and that a successor wouldn't be named until she's confirmed. As was the case with Miller, Kennedy said experience throughout the fixed-income sectors is less important in a successor than an ability to maintain T. Rowe's teamwork culture. Of particular importance this time around is that the successor have a compelling vision for the expansion of T. Rowe's fixed-income business abroad. "One of the biggest challenges is expanding the division globally," Kennedy said. "There is a lot of opportunity abroad and the leader needs to keep the division ahead of the curve by expanding its expertise and breadth internationally."

Ian Kelson, British head of T. Rowe's international-bond team, may fit the bill here. He was appointed in December 2008 to T. Rowe's influential asset-allocation committee and has spent most of his investment career abroad. Before joining T. Rowe in his current position in November 2000, Kelson was head of fixed income for Morgan Grenfell/Deutsche Asset Management in London. However, given T. Rowe's deep bench of talent within senior management, we believe there are several strong candidates for fixed-income chief. T. Rowe also has a long history of successful and seamless manager transitions. There's no reason for T. Rowe investors to be concerned about Miller's possible departure.PAGEBREAK

Employment Discrimination Suit Filed against Vanguard
Vanguard Group, Inc. violated federal law when it refused to hire an African-American applicant because of her race, the Equal Employment Opportunity Commission charged in a lawsuit announced this week.

Vanguard spokesperson Rebecca Katz said in a statement that the company believes the allegations in the complaint have no merit. "Vanguard does not tolerate discrimination of any kind and we have a deep commitment to hiring and retaining a diverse workforce, believing that diversity of people, ideas and viewpoints is one of our most important assets," she said.

This is not the first time the company has been sued by the Commission. In 2008, Vanguard settled a race discrimination lawsuit with the EEOC for $500,000.

Legg Mason
LM is rebranding its mutual funds. Most Legg Mason and Legg Mason Partners retail and institutional funds will carry the Legg Mason brand followed by the name of the investment manager and fund strategy. For example, the company's most well-known fund, Legg Mason Value Trust LMVTX managed by Bill Miller, is now called Legg Mason Capital Management Value Trust to reflect the fund manager, Legg Mason Capital Management.

Marina Carlson is retiring from Artisan Small Cap ARTSX. Until this week, she ran the fund with Craigh Cepukenas. Now Andy Stephens and Jim Hamel, the team that runs Artisan Mid Cap ARTMX and Opportunistic Growth ARTRX, will join Cepukenas.

AllianceBernstein AB plans to launch a U.S. Strategic Growth fund. It will use the same investment process as Global Thematic Growth ALTFX, which was a tech fund until late 2008. As its name suggests, it will focus on domestic equities. Global Thematic manager Catherine Wood will be lead manager. She's run a separate account version of U.S. Strategic Growth since 2001. Wood previously ran the volatile AllianceBernstein Mid Cap Growth until it became AllianceBernstein Small/Mid Cap Growth CHCLX and she took over Global Thematic Growth in 2008.

The $452 million Arbitrage Fund ARBFX announced that due to continued growth in assets under management, the fund has reached advisory and administrative fee breakpoints, which will cap the fund's expense ratio at 1.69%. That's a big reduction from the 1.95% expense ratio shareholders paid last year.

Aston filed a prospectus and SAI for the Aston/Fasciano Fund, which is scheduled to launch in December. The manager, Michael Fasciano, was dismissed from Neuberger Berman last year. The fund will have a similar strategy as his old Neuberger fund, and the fund's expense ratio will be 1.42%.

Effective Nov. 1, Allianz CCM Emerging Companies PMCIX will again become available for purchase by new investors.

Thornburg announced the launch of Thornburg Developing World Fund. The fund will primarily invest in equity and debt obligations of developing country issuers. The fund's fees are expected to be 1.83% for the Class A shares.

Touchstone launched 10 new subadvised funds: four domestic equity, two international equity, two fixed income, and two alternative (global real estate and long/short). In other news, Touchstone Large Cap Value TLCAX, Touchstone JSAM Institutional Large Cap Value CIJLX, and Touchstone JSAM Institutional Value CIJVX will liquidate by Dec. 7, 2009.

Douglas Cliggott has resigned as portfolio manager of the Dover Long/Short Sector DLSAX. The fund will continue to be run by Michael G. Kassab, who rejoined the fund in October 2007.

Laudus Rosenberg International Equity RIEIX will merge into Schwab International Core Equity SICVX on Dec. 3, 2009.

FMA Small Company FMACX is merging into newly created John Hancock Small Company on Dec. 11, 2009. FMA will remain as subadvisor, while John Hancock will provide distribution and administrative services.

Fidelity Select Paper and Forest Products FSPFX is merging into Fidelity Select Materials FSDPX, and Fidelity Select Network and Infrastructure FNINX is merging into Fidelity Select Communications Equipment FSDCX.

Federated California FCMIX and Federated North Carolina NCIFX are merging into Federated Municipal Securities LMSFX.

Pioneer Mid-Cap Growth PITHX is merging into Pioneer Select Mid Cap Growth PMCTX.

There's new management at MassMutual Select Small Cap Value Equity MMQAX. Timothy McCormack and Shaun Pedersen of Wellington Management and John Harloe and James McClure of Barrow, Hanley, Mewhinney & Strauss will take over from SSgA Management as subadvisors.

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