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Actively Managed Vanguard Funds an Indexer Could Love

Vanguard founder Jack Bogle's secret active-fund-picking formula.

Dan Culloton, 10/03/2006

Below is an article from a recent issue of the Morningstar Fund Family Report on Vanguard, our monthly newsletter dedicated to helping Vanguard investors find superior long-term investment opportunities. To review a risk-free trial issue, click here. Fund Family Reports on Fidelity and American Funds are also available.

Besides index funds, Vanguard is known for a few actively managed funds good enough to give even inveterate passive investors second thoughts. What they may not realize, however, is that Vanguard founder and indexing evangelist John C. Bogle has a formula for picking managed funds.

The idea that Bogle would recommend funds run by securities-pickers isn't as scandalous as it sounds. Vanguard has offered actively managed funds since its beginning and even a zealot like Bogle realizes he can't win over everyone. Many investors, whether out of intellectual curiosity, hubris, or just for thrills, will always hunt for market-beating funds. So, in his classic book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, Bogle laid out some active-fund-picking rules that stress consistency, tax-efficiency, frugality, experience, and patience.

A few years ago I applied Bogle's screen to the entire mutual fund universe and came up with, for the most part, successful results. The search turned up funds, such as Excelsior Value & Restructuring UMBIX, Sound Shore SSHFX, and T. Rowe Price Mid-Cap Growth RPMGX, that drubbed their respective category averages since they appeared on the list in February 2001. (Okay, that screen also let the dismal White Oak Select Growth WOGSX, but no system is perfect).

I decided it would be instructive to turn the founder's criteria loose on his own firm's actively managed equity funds to see how the offerings stood up. I looked for actively managed Vanguard stock funds run by managers with above-category-average tenure, expense ratios in the bottom fourth of their peer groups (which, frankly, didn't eliminate many Vanguard funds, for obvious reasons), and lower turnover and tax-cost ratios than their category peers. To help gauge consistency, I also looked for funds that had finished six of the past 10 years in the top half of their categories, with no more than two appearances in the bottom fourth of their peer groups over the same time period. Just four stock funds survived--all but one of them are Morningstar Analyst Picks.

Who Invited This Fund to the Party?
Vanguard Asset Allocation VAAPX is kind of an odd duck and not one of the more popular options among Vanguard investors. Rather than offer static exposure to stocks and bonds like most peers in the moderate-allocation category, manager Tom Loeb of Mellon Capital adjusts the portfolio's portion of each asset class over time according to a quantitative model. Essentially, Loeb doesn't pick stocks or bonds, just the right mix of them based on relative valuations.

The fund builds a stock and bond portfolio tracking the S&P 500 and Lehman Brothers Long Term Treasury Index, sometimes using futures to get equity and fixed-income exposure. It has very low turnover for a vehicle that actively moves between stocks and bonds. Frankly, this wouldn't be my first choice among Vanguard's actively managed options. It's more expensive than other potential core holdings at the firm, and I'd like to see a larger investment by Loeb. (Regulatory filings say he had between $500,000 and $1 million in the fund as of September 2005.)

Still, Vanguard Asset Allocation's process is consistent, even if its portfolio isn't. The fund also has been able to edge the S&P 500 with less volatility over the last 10 years. It could appeal to someone who didn't mind giving up some control over his or her own asset allocation.

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