Living in Interesting Times with Vanguard

If you ever wished you lived in interesting times, your wish was granted in 2007. The collapse of the housing market and the subprime mortgages that fueled it blossomed into a full-blown credit crisis that reawakened volatility in the securities markets. Now that we've been reminded to be careful what we wish for, let's look back at some of more notable developments for Vanguard investors last year.

Most Promising New Funds
In 2007, the family launched 17 new traditional and exchange-traded funds (if you count the conventional and ETF share classes of the same funds as distinct entities), including a spate of mega-cap index funds for institutional and ETF investors and a first-ever long/short offering, Vanguard Market Neutral (VMNFX). Although the market neutral fund, which will be jointly run by AXA Rosenberg and Vanguard's own Quantitative Equity Group, has a lot to prove, it does offer some much-needed price competition in a pricey category of funds.

For my money, though, Vanguard's most appealing new offerings were its four new fixed-income ETFs and its two new international stock funds and ETFs. Vanguard Total Bond Market ETF (BND), Vanguard Short-Term Bond ETF (BSV), Vanguard Intermediate-Term Bond ETF (BIV), and Vanguard Long-Term Bond ETF (BLV) hit the market as the cheapest bond ETFs in their respective categories and among the most diversified. Vanguard Europe Pacific ETF (VEA) tracks the same MSCI EAFE Index as the nearly $51 billion  iShares MSCI EAFE Index (EFA), but for half the expense ratio.  Vanguard FTSE All-World ex-US Index  and  ETF (VEU) are pretty cheap, too, but they stand out as true one-stop international options because they include exposure to emerging markets and Canada, which MSCI EAFE does not.

Research and Development
Vanguard was among the first mutual fund firms to unveil vehicles designed to turn retirement nest eggs into income streams. Its three proposed managed payout funds distinguished themselves by declaring they would operate like mini-endowments for the little guy. When the funds of funds launch in 2008, they'll invest in a wide range of assets (including stocks, bonds, REITs, TIPs, commodities, and Vanguard Market Neutral Fund) to try to support a growing stream of monthly payments without dipping into shareholder capital. They are novel and unproven, but very interesting. Perhaps even more intriguing is the fact that Vanguard let slip that it may be considering starting a hedge fund for the managed payout funds to use.

Earlier in the year, Vanguard also entered the race to launch an actively managed ETF. It filed documents with the Securities and Exchange Commission seeking approval to launch an ETF share class for  Vanguard Inflation-Protected Securities (VIPSX). Shortly thereafter the firm filed similar applications for its  Vanguard Short-Term Treasury (VFISX),  Intermediate-Term U.S. Treasury (VFITX), and  Long-Term U.S. Treasury (VUSTX) funds. These funds, which keep most of their money in highly liquid U.S. Treasuries bonds, aren't the most actively managed funds around. They keep the bulk of their money in a highly efficient area of the bond market and don't make interest rate bets. But their simplicity as well as Vanguard's prowess at managing quantitative portfolios could increase their odds of approval and success.

Manager Changes
There were a number of management changes worth monitoring at Vanguard in 2007. Most notably AXA Rosenberg joined the recently struggling  Vanguard U.S. Value , which GMO had run solo since the fund's inception. I'm taking a wait-and-see attitude about this change. AXA Rosenberg is an accomplished quantitative manager. Nevertheless, it lacks a long track record in the large-cap value area, and it remains to be seen how its process will gel with GMO's. That adds a measure of uncertainty that led my colleagues to remove the fund from Morningstar's  Analyst Picks list in the large-value category.

The guard also is changing at  Vanguard Equity-Income (VEIPX) and  Vanguard Wellesley Income (VWINX). Veteran stock manager Jack Ryan of Wellington Management last year said he will step down in June 2008, making way for Michael Reckmeyer III, who has worked as an analyst and manager on this fund and other equity accounts using the same style for 13 years. I'm not worried about this change. Wellington has a track record of managing successions well, and Reckmeyer's familiarity with the fund's process should ensure a smooth transition.

I'm also not flustered about recent changes to Vanguard's tax-exempt bond funds. Reid Smith and John Carbone will replace Christopher Ryon on a number of municipal-bond funds. Ryon had been with the firm for more than 20 years, but Smith and Carbone are seasoned, too. Investors shouldn't notice a difference.

Other notable management changes included Lazard Asset Management replacing Equinox Capital Management and Tukman Capital Management and joining four remaining subadvisors on  Vanguard Windsor II (VWNFX); Jennison Associates joining three other managers on  Vanguard Morgan Growth ; and AXA Rosenberg joining six outside firms on  Vanguard Explorer (VEXPX). None of these changes rang any strong alarm bells, but they are worth watching, especially Explorer, which--with nearly $12 billion in assets--is the largest fund in the small-cap growth category.

Performance
It finally was large-cap growth's year in 2007, and no diversified fund in Vanguard's stable enjoyed it more than  Vanguard Growth Equity . Bob Turner's aggressive, momentum-oriented fund gained 22% through Dec. 31 and beat 90% of its peers. The fund definitely proved that it delivers what it promises: a pure dose of large-cap growth stocks. It's an  Analyst Pick, but due to its feast-or-famine track record, I think it's still an acquired taste for most investors.

Also right on cue,  Vanguard Small Cap Value Index (VISVX) was one of the family's worst diversified domestic-equity funds, losing 7% through Dec. 31 and trailing more than half of its peers. Small-value funds had been on a tear prior to 2007, and this fund had its share of fun. But a reversion to the mean was inevitable. This fund still has long-term utility, though. It can play a role in a diversified portfolio, and its diffuse portfolio of stocks should keep it out of serious trouble.

 Vanguard Capital Value's  2007 showing (down 7.6%) was particularly disappointing. Manager David Fassnacht entered the year talking about avoiding companies that were too reliant on the credit markets for their earnings, yet when the credit crisis hit, holdings such as  E*Trade  still hammered the large-value fund. I'm not ready to give up on the offering, though. Streaky performance comes with the territory at this eclectic contrarian, and wagers on other struggling stocks, such as cable giant  Comcast (CMCSA), seem sounder.

It was another year in which it was hard to look stupid investing overseas. Helped by strengthening currencies and excitement about rising living standards, emerging markets led the way among international stocks.  Vanguard Emerging Markets Stock Index (VEIEX) posted strong double-digit returns for the fifth year in a row. You've heard this before, but developing markets are bound to hit a significant bump eventually. It's prudent to maintain emerging-markets exposure, but trim it if it has grown into a large, unintended wager.  Vanguard International Explorer (VINEX) turned in the only really poor performance among Vanguard's foreign funds, posting a positive return but trailing more than 70% of its peers through Dec. 31. This closed fund is large and not as nimble as it used to be, but a talented and experienced team from Schroder Investment Management runs it. It should pull out of its funk.

The devil lurking in the details behind all the financial engineering that fueled the now-deflating mortgage and housing bubble reared its complicated head in 2007 and made the credit markets treacherous for bond investors. Most Vanguard bond funds fared much better than the competition, but both Vanguard Inflation-Protected Securities and Vanguard Intermediate-Term U.S. Treasury mutual funds were particularly strong due to a flight to quality. Low expenses that allow managers to take on less risk than their peers account for much of the fixed-income funds' advantages. Prudent management also was in evidence. For instance,  Vanguard Intermediate-Term Investment-Grade (VFICX) manager Bob Auwaerter and his team carefully vetted the fund's mortgage and asset-backed securities and sidestepped the subprime implosion. That was enough to make him a finalist for Morningstar's 2007 Fixed-Income Manager of the Year award.

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