(PUB) Vanguard Advisor

whether other Vanguard managers at less-diversified funds are indeed “wor- ried” about their benchmarks. Shouldn’t they simply be worried about follow- ing the investment process Vanguard hired them for in the first place? Active managers aren’t supposed to be paid to be closet indexers, so what’s the point of saying they’ll be less worried about their benchmarks? Vanguard also says that in choosing multiple managers they look for perfor- mance histories that don’t overlap. In other words, they don’t want all the man- agers earning excess returns at the same time. That might work with two manag- ers, or maybe even three. But eight? In fact, if you take their comment that they are seeking little or no over- lap to its logical extreme, then that would suggest that every eight months, one manager is outperforming while the other seven are underperforming. Weird, and not particularly productive. “What we’re really doing,” Vanguard says, “is what thoughtful investors should always do. We try to find >

Explorer vs. Russell 2500 Growth Index

Relative Risk

2.25

Explorer SmallCap Growth Index

1.05

rising line = Explorer outperforms

2.00

1.75

1.00

1.50

0.95

1.25

1.00

0.90

0.75

-Manager hiring -Manager firing

0.50

0.85

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

3/04

3/05

3/06

3/07

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3/09

3/10

3/11

3/12

3/13

3/14

Explorer has slightly reduced risk, at times. In the chart above, you’ll see that, based on 24-month relative volatility at the end of each year, Explorer used to be slightly riskier than SmallCap Growth Index , and has over time become less so. But in 2013, for instance, the index fund’s two-year volatility was higher. So where’s the consistency? Also, the notion that diversification will allow managers to worry less about their benchmarks begs the question of

the rationale given in a web-based mis- sive, “Adding Value Through Multiple Investment Managers,” posted concur- rently with the Explorer announcement. The value-adds that Vanguard cites include broader diversification, which I would call “diworsification.” Also, they say that by focusing on their best ideas, managers will both reduce volatility and won’t have to worry about focusing on their benchmark. It is true that the kind of broad diworsification that exists at

After more than 30 years of declining interest rates, most inves- tors have little experience with a real bear market in bonds. How would you define a bond bear market? If you had a significant rise in rates in a short period of time—so a couple hundred basis points, say 200 or 300 basis points. A back-up of 100 basis points—which we’ve seen over the course of the last year— that’s not a bear market. When I think about the people investing in bonds, the question is, ”Why are they investing in bonds?” Part of it is for income, and part of it is for diversification and capital stability. Ultimately, if you are matching up your risk tolerance and time horizon with the right type of bond prod- uct, rising rates aren’t necessarily a bad thing. Say you have a long time horizon, and you are invested in either a short-term or an intermediate-term bond fund. The fact that you are going to have coupon and principal that gets reinvested at higher rates is actu- ally a better thing for you than if rates were to stay the same or go lower. The worst-case scenario would be someone who has a very short-term time horizon and is invested in a very long-term product that is very sen- sitive to changes in interest rates. Going back to defining a bond bear market, you said a rise in rates over a short period. What’s a short period? If you saw that [200 to 300 basis point increase] happen in the course of a year or two, that could be viewed by the broader market as pretty negative. The question becomes, what would be a catalyst for something like that happening? One, the economy is clearly growing faster than expected or inflation is picking up more than what’s been expected by

the marketplace…or a combination of those two things. The market would then be potentially thinking, “Hey, the Federal Reserve is behind the curve and will need to play catch up,” and there’d be a pretty rapid adjustment in terms of where Fed policy is going to be. For individual investors and for professional investors, it can be very difficult to pick those exact points when you get a transition into a rising rate environment or a declining rate environment. If you are investing in bonds because you are chasing the returns that you’ve received over the last 10 years or so, that’s not the right reason, because those returns are very unlikely to be met over the next five or 10 years, given where we are starting with today’s yields. So, reinvestment is the silver lining that investors can take from rising rates. Investors don’t appreciate that fact. Right? Whether or not you own individual bonds or a fund, as those bonds get closer to maturity and get reinvested at higher yields—people forget about the benefit you are going to get from that. We write about that quite often. It just doesn’t sink in for a lot of investors. And the other key piece, I would say, when you think about the argument that, “Hey, rates are ris- ing, I should sell out of bonds and go into money markets or something else,” you know, the reality is the slope of the yield curve tells you the market’s already pricing in rates rising. So it’s not enough to say that rates are going to rise. The question is, are rates going to rise more than what’s already priced in? That’s really what your breakeven is in

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The Independent Adviser for Vanguard Investors • July 2014 • 5

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