Vanguard Alludes to Absolute Return Fund in Managed Payout Fund Prospectus

A trio of funds of funds from Vanguard are designed to grow shareholders' capital while making regular monthly distributions. A revised prospectus was recently released, and it clarifies a number of issues. It gives the offerings formal names, sets their minimum investments and expense ratios, and further explains their strategies and risks. The most intriguing tidbit in the filing, however, is a reference to a fund that doesn't exist, which the new funds don't plan to invest in yet, but that Vanguard saw fit to mention in the document anyway.

A section devoted to "investments in a prospective absolute return fund" (a fund that tries to achieve positive returns no matter the market climate) piqued my interest because it read like Vanguard was contemplating launching a hedge fund for the managed payout funds to use. Granted, the filing goes out of its way to say the family has not decided to and may never create an absolute-return fund. Clearly, though, the firm wanted to ensure it had the flexibility to do so.

If It Walks Like a Hedge Fund ...
Whether or not the fund ever comes to fruition, its prospectus description has hedge fund written all over it. The offering would be "a private investment fund" that uses multiple strategies to seek capital appreciation with a low correlation to the stock market, according to the filing. It would seek out opportunities emanating from market structure, pricing, liquidity and volatility, and the relative value of various markets, according to the prospectus. It would have stocks, bonds, commodities, currencies, derivatives, short sales, leverage, and other asset classes and tactics in its tool kit and would not be organized as a mutual fund or "registered under any federal or state securities laws, including the Investment Company Act of 1940," the filing said.

If It Talks Like a Hedge Fund ...
Vanguard says it's premature to talk about the mystery fund. But if that's not a hedge fund, which is often defined as an unregistered private investment vehicle with a lot of flexibility to seek profit in all market environments, then I'm a dart-throwing monkey. It sounds to me, and others I've consulted, like Vanguard's pretty far along in designing the fund.

Running a hedge fund is a long way from managing a low-cost index fund. And establishing an unregistered absolute-return fund is sure to add new fuel to the debate over how far Vanguard has evolved (some would say strayed) from its roots. But it actually makes some sense within the context of what the family is trying to achieve with the managed-payout funds. The offerings, like others recently launched by the likes of Fidelity, hope to help investors convert their nest eggs into streams of income that will grow and last throughout their retirement years. Only Vanguard's funds will use complex asset-allocation strategies--similar to those employed by many endowments--to achieve their goals, investing in domestic stocks, international equities, bonds, REITs, and market-neutral strategies via Vanguard funds (including the newly launched Vanguard Market Neutral Fund (VMNFX)). They'll also use derivatives to get exposure to commodities.

Endowments, however, often throw hedge funds into the mix, too. Vanguard doesn't yet have that strategy in its arsenal, and outside hedge funds are probably too expensive for its tastes. If it could figure out a way to effectively run a low-cost hedge fund, it could add to the managed-payout funds diversification and shake up the hedge fund world with some price competition, too. That is a whopper of an if, though, even though the family has taken a step in the hedge fund direction with the new Vanguard Market Neutral Fund. It will be interesting to watch this develop.

Nuts and Bolts
Before I sign off, here are the other highlights from the latest Managed Payout Fund prospectus.

The funds will be named, respectively, Vanguard Managed Payout Growth Focus Fund, Growth and Distribution Fund, and Distribution Focus Fund. The Growth Focus Fund will be the most aggressive (with the smallest initial payout but best chance for growth) and Distribution Focus the least aggressive (with the largest initial payout but lower odds of growth), with Growth and Distribution in the middle.

Investors will need $25,000 to make an initial investment and $100 to add to their accounts. The funds' expense ratios will range from 0.57% to 0.58%. That's higher than the early estimates of 0.34%, largely because the new levies factor in the Market Neutral Fund's "short-sale dividend expenses." Shorting stocks involves borrowing shares from another investor or institution and selling them with the intention of buying them back at a lower price and pocketing the difference. However, when you borrow stocks to sell them short, as the Market Neutral fund will do, you still have to pay the dividends that stocks may issue to the original owners. The Market Neutral expects to more than make up the dividend expenses by putting the proceeds of its short sales in interest-bearing accounts, but the SEC still makes funds that short include dividend costs in their expense ratios anyway. Without the dividend expenses, the funds' expense ratios would be 0.27% to 0.28%. In contrast, Fidelity's recently launched income-replacement funds charge between 0.54% and 0.65%.