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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.

Perennial Favorites
The next two funds have been Morningstar favorites for a long time. Vanguard Capital Opportunity VHCOX and Vanguard Primecap VPMCX are Analyst Picks in mid- and large-cap growth categories, respectively, and both are closed to new investors.

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 ADBE, while Capital Opportunity owns Symantec SYMC.PAGEBREAK

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 VPCCX, hasn't been around long enough to clear Bogle's screens, it has many of the qualities of Primecap and Capital Opportunity, and it's still accepting new money. I'd recommend it to investors in search of a core holding. Size is still an issue at Primecap Core, though. Vanguard closed the other two funds because they were reaching capacity, and while Primecap Core uses a slightly different strategy, there is still some overlap with the other funds, particularly Primecap. The firm's patient and cross-grain style lends itself well to managing large sums, but you should still watch for signs of asset bloat.

The Sector Master
Vanguard Health Care VGHCX also is one of Morningstar's perennial favorites. (It's one of my favorites, too. I own shares of this fund in my IRA.) Manager Ed Owens of Wellington Management is one of the longest-tenured managers in the health-care category with more than 22 years under his belt. The fund's expense ratio is lower than even the lowest-cost exchange-traded funds in the category (Health Care Select Sector SPDR XLV and, ironically, Vanguard Health Care ETF VHT ). And the process is rock-solid.

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 BMY and Johnson & Johnson JNJ) and hold them for years. His style and consistency (the fund has never fallen into the category's bottom quartile) sticks out in a category fraught with more frenetic managers and erratic funds.

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 VTMFX came close to meeting Bogle's criteria but was eliminated because it finished three calendar years from 2000 to 2002 in the bottom quartile of its category. It's still a superb choice for the cornerstone of a taxable account, though. (Vanguard Windsor II VWNFX also came close, but it recently raised its minimum investment and capped contributions from existing investors, so it's all but closed to many.)

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.

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