Vanguard founder Jack Bogle's secret active-fund-picking formula.
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
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
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.
The next two funds have been Morningstar favorites for a long time. Vanguard Capital Opportunity
The redoubtable Primecap team of Howard Schow, Theo Kolokotrones, Joel Fried, and Al Modecai runs both funds in a similar style (Mitchell Milias also runs a piece of Primecap). Each of the team members runs a portion of the portfolio independently. They are all valuation-conscious growth investors who aren't afraid to pile into out-of-favor stocks and hang on no matter how bumpy the ride gets. The managers aren't always moving in the same direction, but the approach can still lead the funds to cluster their assets in sectors and industries where the managers find the most opportunities. Primecap, for example, currently has a huge helping of beaten-down software stocks, such as Adobe Systems
The team's willingness and ability to successfully invest with conviction over the long term is why I consider these funds some of the most intrepid offerings around, despite their moderate risk profiles relative to their category peers. I also like the fact that the Primecap squad has substantial sums of its own money invested in these funds.
There is an alternative for investors who don't already own these shuttered offerings. While the Primecap team's newest Vanguard fund, Vanguard Primecap Core
The Sector Master
Vanguard Health Care
Owens stays diversified across drug, services, device, biotech, and international health-care stocks and prefers to pick up shares when they are cheap (he's recently had an affinity for large-cap pharma stocks such as Bristol-Myers Squibb
This closed offering has an enormous asset base, but I still have confidence that Owens' patient, contrarian approach is compatible with running large sums. He also has more than $1 million invested here, which is comforting.
Close but No Cigar
Unfortunately, there are no close corollaries that are still open for Vanguard Health Care. It's the only place retail investors can hire Owens. Indeed, three of the four funds that cleared the screen were closed. Vanguard Tax-Managed Balanced
Overall, the Bogle formula produced good results. What this proves, besides that you don't have to be an active management partisan to know how to pick good funds, is it pays to have high standards. Doing so helps you cut quickly through the weeds to good options.
Dan Culloton is a senior analyst with Morningstar.
Get mutual fund and stock information from our analyst team delivered to your e-mailbox every Tuesday. Sign up for our free Investment Insights e-newsletter.