(PUB) Investing 2015

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Explorer vs. Russell 2500 Growth Index

Which Index Fund Is Better?

They aren’t saying.And finally,Vanguard makes a point, in the footnotes, of say- ing that all the underlying funds in its Target Retirement series are consid- ered Select Funds . Anyway, you are probably catch- ing my drift here. The Select Funds serve another Vanguard agenda besides continuing to promote indexing, which is typical of the fund family: Driving assets into middling active funds where performance will be not dissimilar to indexes, so investors won’t ever underperform too dramatically, but also won’t outperform. Vanguard also says the fund manag- ers on Select Funds are experienced and “have a history of putting clients first.” But do they actually eat their own cooking? Do they, indeed, invest in the funds they are managing, which would truly be a sign that the managers are aligned with their shareholders? Let’s dig a little deeper into the Select Funds , starting with the domestic stock choices and then working through foreign funds and bond funds. Also, you’ll notice I’ve added one more fund to this Funds Focus, because while it isn’t a Select Fund , it is a common rec- ommendation in many of the portfolios Vanguard designs for clients. 500 Index andTotal Stock Market You really can’t blame Vanguard for promoting its two domestic index behe- moths. 500 Index used to be the index fund of choice, until Total StockMarket stole its thunder. While the former con- tinues to track the S&P 500 index, Total Stock Market has seen a revolving door of benchmarks, originally being tied to the Wilshire 5000, then the MSCI U.S. Broad Market Index, and finally the CRSP U.S. Total Market Index. Is one better than the other? Take a look at the first chart above. After almost 23 years sinceTotal StockMarket’s incep- tion, the differences in performance are almost imperceptible. Sometimes having the small-caps in Total Stock Market’s portfolio helped, other times it hurt. As far as I’m concerned, if you’re going to index, you have to decide

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what kind of indexer you’ll be. Are you an efficient-market die-hard who believes in buying the market? Well, in that case, neither of these funds works for you. You should buy Total World Stock Index and be done with it. If you’re going to try to be more nuanced in how you index, then you need to decide if you want more or less diversification amongst your domestic stocks. But as you can tell, there’s little to differentiate the two funds when it comes down to performance and risk. Frankly, for a core, large-cap fund, I don’t think you can do better than Dividend Growth . As for managers aligning their inter- ests with shareholders, 500 Index’s Michael Buek reportedly has between $100,001 and $500,000 invested in his fund, while Total Stock Market’s Gerard O’Reilly reports having between $500,001 and $1 million in his fund. Explorer This small-cap growth fund is the poster child for the Portfolio Review Department’s misguided belief that add- ing more and more and more managers to a fund somehow makes it better. Explorer currently sports a manage- ment roster of eight different manage- ment teams made up of no fewer than 16 different portfolio managers. If they were chefs in a kitchen, I’d head over to McDonald’s. One fairly simple chart (which, by the way, Vanguard would never show you) tells the tale. Just take a look above for a relative performance chart comparing Explorer to its index bench-

mark, the Russell 2500 Growth Index, over the past decade. You can see that other than a few brief periods, it’s been a long, slow slide into mediocrity. It isn’t that the managers aren’t good at what they do. But you can’t mix them all together and expect the results to be satisfying. Historically, if investors indeed wanted a small-cap growth fund, they would have been much better off investing in SmallCap Growth Index , which since inception has generated an average rolling five-year return that is a full 1.5% better than Explorer’s. That’s 1.5% per year, compounded every year, over rolling five-year periods. Vanguard won’t tell you that, nor that only seven of Explorer’s 16 man- agers own shares in the fund. Only Wellington’s Ken Abrams has more than $1 million invested here. Abrams’ co-manager Daniel Fitzpatrick has between $500,001 and $1 million invested, and the other five managers who own shares have stakes ranging from just $10,001 to $500,000. That’s not confidence-inspiring. For my money, a fund like PRIMECAP Odyssey Aggressive Growth gives me plenty of small-cap exposure. It’s closed now, so you may have to look outside Vanguard for a small-cap growth fund if you feel you really need it, or simply buy an index fund and earn an average return. MidCap Index I’m a fan of MidCap Index for a couple of reasons. First, the mid- cap area of the market is one that

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