A Milestone for Two Divergent Vanguard Funds

It's been three years since two vessels joined the Vanguard flotilla, and boy did they chart different courses. Both were disciplined funds, but one was strict value and the other was extreme growth.  Vanguard U.S. Value  was a new fund managed by the firm of Grantham, Mayo, Van Otterloo & Co., while  Vanguard Growth Equity  was an existing fund run by Turner that was rechristened and given a cheaper expense ratio.

The beauty of these funds is that they're fairly predictable on a relative basis because of their disciplined, but extremely different strategies. U.S. Value uses a quantitative model to look for companies with improving fundamentals that are trading at valuations below their normal levels. Growth Equity pays little attention to valuations and instead looks for companies exceeding earnings expectations.

So, if investors are bailing out of high-priced stocks in favor of value, then U.S. Value should look like a champ compared with other value funds, and Vanguard Growth Equity should look like a chump compared with other growth funds. Find a momentum-dominated market like today's, and the reverse is true.

Through Thick and Thin
The hard part of investing in funds like these is that you have to hold a fund at each extreme to make it work. That means you would have needed to hold on to Growth Equity, even though you'd have lost about half your money if you had invested three years ago. 

In the aggregate, the funds weren't held in equal proportions, though. Growth Equity ended 2000 with $900 million while U.S. Value had just over $100 million. That's probably due to a combination of the fact that Growth Equity had a track record and that growth investing was still in favor at the time. 

Interestingly, you'd have done better dividing your money between those two funds rather than investing in  Vanguard 500 Index (VFINX). A $10,000 investment split between Growth Equity and U.S. Value on July 1, 2000, would be worth $7,643 at the end of June 30, 2003. That compares with $6,229 for a $10,000 investment in Vanguard 500 Index.

But talk about different paths. Vanguard Growth Equity's returns landed in the bottom 15% of large-growth funds for the past three years while Vanguard U.S. Value is in the top 15% of large-value funds. That's why I'd be more likely to recommend Vanguard 500 over a combination of the two, even if I thought the combination would outperform by a little. It wasn't easy holding on to a deep-value fund in the late 1990s, and it's not easy to hold on to a large-growth fund today.

So far in 2003, Growth Equity has surged ahead as speculative fare has rallied, yet U.S. Value has seen its performance fall only to about average for the large-value category. That's pretty impressive considering how well U.S. Value's defenses worked in the bear market.

Investing at the Extremes
It's a good idea to determine whether you have any funds with extreme disciplines, so that you can use them correctly and have realistic expectations. If a fund had extreme swings in total returns and relative performance in the late 1990s and again in the past three years, it might be in this camp.

To really be sure, though, you should examine the holdings and strategy to see if the fund is deep-value or momentum. Signs such as very high valuations or very low valuations provide a clue. You can also check our Analyst Reports and pay particular attention to the strategy section.