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Vanguard's Computer-Powered Funds

A closer look at four quantitative funds.

The article below contains an excerpt from the January issue of our Vanguard Fund Family Report. We also provide reports for the Fidelity and American fund families. To review a risk-free trial issue of any of our Fund Family Reports, click here.

Vanguard has long been associated with index funds, but it's also home to a fine lineup of quantitative funds. These offerings, which rely on computers to pick stocks and construct portfolios, have a lot in common with index funds: All are pegged to a specific benchmark and attempt to ape its style and size characteristics as well as its sector weights. Consequently, they are broadly diversified and style pure. And like index funds, they aren't designed to blow the competition out of the water--they have rather humble goals of edging past their benchmarks by a few percentage points each year. Consequently, their rock-bottom expense ratios help them build their advantage over time.

But when it comes down to it, these are actively managed funds. The computer models consider many of the same factors that active managers do, such as valuation, balance-sheet strength, and growth potential. Plus, these funds trade more than index funds, so they are most appropriate for tax-deferred accounts.

Quantitative funds hold appeal because their strategies are consistent and repeatable. And by automating the process, the fund isn't likely to get swept up in a market mania that a human manager might fall prey to. But the real test of the potency of their approach is their ability to provide investors with attractive returns. As we shall see, all of Vanguard's quant funds have acquitted themselves well.

 Vanguard U.S. Value 
Although I think a solid case can be made for all of Vanguard's quantitative offerings, Vanguard U.S. Value is the cream of the crop, in my opinion. It's run by a team from Grantham, Mayo, Van Otterloo & Co., a firm that has an impressive resume running quant strategies for institutional clients. Their experience pays off in a number of ways. For instance, they've become careful traders through experience, and they take their time building and selling positions to minimize trading costs. Time has also helped the firm amass a sizable team of some 50 quantitative analysts. That gives the firm a real edge, in my opinion, because it has more resources to develop its models. Without enhancement, a model will gradually lose effectiveness over time, so it's imperative for quant teams to continually evaluate and adjust their models. GMO's vast resources should help extend the strategy's longevity and effectiveness.

It's also important to have a deep team in the event of a manager transition, as this fund recently illustrated. Some mistakenly assume that quant funds aren't exposed to manager risk. Even though they aren't picking stocks, managers are intimately involved in the development and evolution of the model. They decide when to add a new factor and when to eliminate one that stops working. They are also responsible for hiring and training the staff of quantitative analysts and IT professionals that supports the fund. In short, quant managers matter. So when this fund's lead manager, Robert Soucy, retired at the end of 2005, I was reassured that he was replaced by Sam Wilderman, a GMO veteran who is very familiar with the firm's quantitative models. Furthermore, Chris Darnell, who heads GMO's quant team and has been with the firm since 1979, will continue to provide oversight.

This fund has other admirable traits including a sensible price-conscious approach. The model employs two separate valuation screens--one that looks for stocks that are cheap relative to the market and one that seeks stocks trading at prices below the model's estimate of intrinsic value. It also includes a price momentum screen, which allows the fund's winners to run, and it also helps out during those times when the market prizes sentiment over fundamentals. The fund's benchmark, the Russell 3000, gives it the leeway to move up and down the market-cap ladder depending on where the model sees the most opportunities. However, the fund has always resided in the large-value segment of the style box, and management intends for it to stay there.

This approach has yielded impressive results. Since its inception in mid-2000, the fund's average annual returns best more than 75% of its rivals. Granted, this fund had a tailwind during most of its history because it held more smaller stocks than its peers. But the strategy employed in GMO's separate accounts has fared well over the long haul through a variety of market climates.

 Vanguard Growth & Income (VQNPX)
This fund, which is advised by Franklin Portfolio Associates, is the other core quantitative fund in Vanguard's lineup. It is also backed by a veteran team, led by John Cone, who has been involved with the fund for more than 20 years. Cone oversees a model that includes more than 40 individual factors that primarily fall into two buckets--valuation and growth/momentum. The aim of this fund is modest, to edge out the S&P 500 over time, and it has succeeded in that goal. Its 10-year trailing returns surpass its benchmark by 0.6 percentage points. That might not sound like much, but it's been enough to lift this fund past 83% of its large-blend rivals. Because Growth & Income is tethered to the S&P 500, it's more large-cap heavy than U.S. Value. That's why I think it's a sound choice for investors seeking a blue-chip-oriented core fund. But on the whole, I'd give the edge to U.S. Value because of its flexible mandate and GMO's extensive quantitative resources.

Vanguard Strategic Small-Cap Equity  (VSTCX)
This fund is the new kid on the block. It was introduced just last month after its mid-blend sibling  Vanguard Strategic Equity (VSEQX) was closed to new investors. Both funds are run by Vanguard's Quantitative Equity Group (QEG), which is headed by Gus Sauter and Joel Dickson. The funds employ a model that ranks stocks within industry groups based on valuation, financial health, and growth prospects. It also scouts for situations where investor sentiment (as indicated by trading momentum) doesn't square with a stock's fundamental characteristics.

That approach has yielded impressive results at Vanguard Strategic Equity, which has proven very popular with investors over the past couple of years. That fund also keeps a slice of assets in small-cap stocks, and about 40% of its holdings will overlap with the new fund. Vanguard dubbed the recent closure of Strategic Equity as a cooling-off period, but it's also likely an attempt to preserve QEG's flexibility in the small-cap space. But if the new fund proves as popular as its sibling, asset bloat will ultimately be a concern. But for now, given the limited number of good open small-cap funds, Vanguard Strategic Small-Cap Equity is a respectable option.

 Vanguard Asset Allocation 
Unlike other quantitative funds, Vanguard Asset Allocation doesn't use a computer to pick stocks. Instead, it employs a computer model to determine the optimal asset allocation between stocks and bonds, and its mandate gives it a significant amount of flexibility. In fact, at present, the fund has invested 100% of assets in stocks. That's only the sixth time in the model's 30-year history that it has signaled such a bold stance. But it's hard to argue with the fund's long-term success. Over the long haul, it has managed to beat the S&P 500 with far less volatility. Plus, it's run by an experienced team, and the model has a long, successful track record. However, it won't appeal to those who like to have firm control of their asset allocation. But for those who can accept some fluctuations in their stock/bond mix, this fund is a great choice for a core fund, particularly for those who like to keep a lid on volatility.

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