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Strong Defense Wins the War for Vanguard Wellesley

Alec Lucas, Ph.D.

Alec Lucas: Hi, I'm Alec Lucas, an analyst for Morningstar's Manager Research team. Today I'm joined by Mike Stack of Wellington Management. Mike is part of the management team for Vanguard Wellesley, which won the 2015 Allocation Fund Manager of the Year Award.

Mike, congrats to you and the team, and thanks for joining us.

Mike Stack: Thanks, Alec. It's great to be here to represent the Vanguard Wellesley PM team, and we certainly appreciate the recognition of the consistent performance through the years of the fund.

Lucas: You come from the fixed-income side, and there is also an equity side. Can you talk about how the overall team works together?

Stack: There are two teams. There is a fixed-income team led by John Keogh and an equity team led by Mike Reckmeyer. The fixed-income team works with 10 investment-grade fixed-income analysts as well as four sector specialists who help support our investment decisions. Meanwhile, Mike's team includes seven individuals who work on bottom-up security selection.

Importantly, both of these teams are supported by 600 investment professionals at Wellington. And while in some investment firms, people can be siloed, the culture at Wellington is one that really emphasizes collaboration. That's important for our investment process, because we can tap into the views and opinions across geographies and across asset classes of all these people that are doing investment research.

Lucas: Wellesley is a distinctive kind of fund. It's named for the British General Arthur Wellesley, who helped to defeat Napoleon and was known for his defensive style of warfare. The fund takes a defense-minded approach to investing. Can you talk about the fund's investment approach in general?

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Stack: The approach has obviously an equity component and a fixed-income component. On the fixed-income side, we are investing in investment grade--very high-quality companies and securities--choosing to avoid the more volatile and riskier higher-yield sectors of the fixed-income market.

On the equity side we are emphasizing high-quality companies with very strong balance sheets that are offering a yield advantage over other alternatives in the equity market.

Importantly, we keep the overall allocation within a very tight range. We're not looking to market-time. What that means is the equity allocation remains between 35% and 40% of the fund, with the balance being invested in fixed income. That has a way of stabilizing; it allows us to be adding to the equity markets during periods of weakness and conversely shedding some of our equity risk when markets are stronger.

Lucas: That worked very well for you in 2015, a very challenging market environment. The fund was able to gain 1.3%, which was good enough to finish nearly ahead of all of its roughly 200 Morningstar category conservative-allocation peers. The fund has a very strong long-term track record as well. If you had to identify some of the key drivers of the fund's long-term success, as well as its success in 2015, what would you say they are?

Stack: In terms of long-term drivers of the fund's success, there are three key elements. The first is sticking to a strategy that's been proven over time, namely investing in the debt and equity of very high-quality companies.

Secondly is not trying to time the market. Being disciplined. And that gets back to that range on our equity exposure, and keeping it in a very tight range.

Then finally the low-cost nature of the fund, which is consistent with Vanguard's mission to shareholders in terms of enhancing shareholder value. Those three things are the key drivers over the long run of the success we've been able to have.

In terms of 2015--as you said, it was a very challenging year. Certainly the returns broadly in financial assets were not great. We did manage to post positive returns, and returns that were in excess of our benchmarks. I would point to, on the equity side, security selection within consumer staples, information technology, and the energy sectors. In particular, our investment in Kraft Foods, which was undergoing a merger with Heinz, stands out as being very additive to performance for 2015.

On the fixed-income side our security selection within the financials sector as well as our allocation away from corporate credit into the asset-backed sectors and the mortgage-backed sectors were all additive to performance.

Lucas: As you look ahead and think about 2016, it looks like a lot of the themes that were prominent in 2015 are poised to continue. You have slowing growth in China, depressed commodity prices generally, low price of oil, divergent central bank monetary policies. How is the team navigating these challenges?

Stack: The environment continues to be very, very challenging. If we look at the U.S. transitioning central bank policy toward tighter, less accommodative policy. Certainly the emerging markets and China continue to struggle with adjustments to a lower growth state. Those are all causing more volatility; we've experienced that certainly early in the year.

As we think about managing the portfolios, we don't think it's likely that the U.S. sees a recession in 2016. We do think growth in the U.S. and in Europe on a relative basis will be reasonable. However, we do acknowledge that there are a lot of factors and forces here that could cause asset prices to come under pressure. We're not changing anything in terms of our process. We're sticking to that long-term emphasis on balance sheets. We think that will serve us well in a challenging growth environment, where the strong balance sheets allow good companies to ride through those difficult periods, and hopefully be smart about adding in terms of mergers and acquisitions, etc. But very clearly the environment will remain challenging for the foreseeable future.

Lucas: So, a tough year ahead, potentially, but you guys are well positioned.

Stack: I think so. One of the things we're particularly emphasizing on the fixed-income side is liquidity. Liquidity is more challenged in the fixed-income markets, and I think that's a key feature and change in the markets over the last three or four years, post-crisis. Being able to accommodate that rebalancing into weaker equity markets and making sure that we can give Mike's team the liquidity they need to rebalance into attractive equity investments is something that is forefront in terms of our strategy here in 2016. That manifests itself in terms of allocations to sectors like U.S. Treasuries and some of the more liquid sectors, like agency mortgages, that give us that liquidity that we'll need to rebalance.

Lucas: Many thanks for your time today, for your thoughts on the fund, and congratulations to you and the team for winning the 2015 Allocation Fund Manager of the Year Award.

Stack: Thank you very much.

Lucas: For Morningstar, I'm Alec Lucas.