Looking at Old Funds in New Ways

Below is an excerpt from the May issue of our Vanguard Fund Family Report. To view a risk-free trial issue, click here. Also note that Fund Family Reports for Fidelity and American Funds are available.

Morningstar divides the mutual fund universe into 70 distinct categories. We do so for a couple of practical reasons. First of all, it breaks down an overwhelming number of choices (there are currently more than 6,500 distinct mutual funds and exchange-traded funds) into more-manageable parts. Secondly, it helps us compare apples to apples when gauging performance and computing our Morningstar Ratings for funds.

But even though category labels are invaluable tools for navigating the vast mutual fund universe, a blind adherence to them can obscure the big picture and stifle creativity. So, in this article, I'd like to illustrate how you can "think outside the style box" by considering new ways to use two familiar funds.

 Vanguard Wellesley Income  (VWINX)
We split balanced funds into two categories--moderate allocation and conservative allocation--in order to distinguish those funds that have the bulk of assets in bonds from those that are dominated by stocks. Because Wellesley Income keeps about 60% of its portfolio in fixed-income securities, it lands in our conservative-allocation category. But for those with some risk tolerance and a long time horizon, I think this fund can serve the same function as a core bond fund.

To understand my point, think about how bond funds function in a portfolio. First of all, they add diversification because bonds don't move in tandem with stocks. Plus, their relatively mild-mannered nature helps moderate overall volatility.

If you examine how Wellesley Income has behaved over time, you'll see that it can fulfill both these purposes. Granted, because it holds a slice of stocks, it does have some correlation with the broad stock market, but it's minimal. To measure correlation, geeky financial types like me often turn to a statistical measure known as R-squared, which shows the percentage of a fund's price fluctuations can be explained by movement in the overall stock market (as measured by the S&P 500 Index). According to its R-squared, only 28% of Wellesley Income's price swings over the past decade can be explained by broad stock market fluctuations. Although that's more than a pure bond fund, which is negatively correlated with stocks, it's far less than the typical conservative-allocation fund, which has an R-squared of 68%. What's more, Vanguard's other balanced funds are much more in tune with the stock market than Wellesley Income. For example, Vanguard Wellington (VWELX) had a 10-year R-squared of 64%, and Vanguard Balanced Index's (VBINX) came in at 89.5%.

The boom-and-bust market of the late 1990s and early 2000s provides a real-world illustration of Wellesley Income's lack of correlation with the broad stock market. From the beginning of 1997 to the market peak of September 2000, Wellesley Income earned respectable average annual returns of 9.5%, but that paled in comparison to the S&P 500, which averaged returns of 21% per year during that time. But, as you might guess, the tables turned in subsequent years. During the two-year period from September 2000 through September 2002, Wellesley Income gained 15.3%, while the S&P plunged 44.7% and the average conservative-allocation fund dropped 7.3%.

That example also shows that Wellesley Income can provide some stability to a portfolio, much like a bond fund. Moreover, its five-year standard deviation (a statistical measure of volatility) is about the same as Vanguard Intermediate-Term Investment-Grade's (VFICX). Over the past 10 years, it has been slightly more volatile than most intermediate-bond funds, but it's still less turbulent than Vanguard's long-term bond funds. But such volatility is of little matter to younger investors because they have time in their favor and can afford to be more aggressive. For those with long time horizons, I think Wellesley Income is a great way to stabilize a portfolio without sacrificing much return. Its 10-year trailing returns of 8.7% are better than all of Vanguard's bond funds.

 Vanguard Asset Allocation 
This fund has taken a fair amount of criticism over the years because, unlike most balanced funds, its asset allocation changes over time. Its positioning depends on a quantitative model's (developed by the fund's advisor, Mellon Capital) assessment of the relative attractiveness of the stock and bond markets. Based on the model's signal, management divvies up the appropriate amounts to a stock portfolio that tracks the S&P 500 and a fixed-income sleeve that mimics the Lehman Brothers Long-Term Treasury Index. The allocations to these portfolios can vary widely. For instance, at present the fund has no bond exposure at all. (As an interesting side note, this is only the seventh time in 30 years that the model has signaled such a bold stance.). So, if you like to keep a tight rein on your asset allocations, steer well clear of this offering. But for those who have some flexibility, this fund becomes much easier to use if you think of it as a lower-volatility version of a large-cap core fund.

That's not too much of a stretch because Asset Allocation behaves a lot like a stock fund. To return to our old friend R-squared, about 75% of this fund's price movements over the past decade can be explained by stock market fluctuations. What's more, its returns look much more like a stock fund's than a balanced fund's. Its 10-year trailing return of 8.9% is better than Vanguard 500 Index's (VFINX) 8.2% return and is well ahead of the moderate-allocation category's average of 7.5%. In fact, if this fund were included in the large-blend category, its 10-year returns would outrank almost 80% of the competition. Yet, thanks to its fixed-income exposure, Asset Allocation has been significantly less volatile than the typical large-blend fund over that time frame. So, for those willing to tolerate fluctuations in their portfolios' stock/bond mix, this fund can ably serve the function of a core stock fund, particularly for investors who prefer a smoother ride than most pure stock funds offer.