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Vanguard Wades Deeper into Alternative Investments

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If you find the above title puzzling, then you may not be aware that Vanguard offers a market neutral fund (VMNFX) that engages in a long/short equity strategy. Among all the Vanguard funds, it has far and away the highest expense ratio at 1.60%. Setting the minimum investment at $250,000, Vanguard clearly is not looking for an investment from Joe Sixpack or Joe The Plumber. In its product summary, Vanguard cautiously notes, “The fund may be appropriate for a small portion of an already well-diversified portfolio.” Since its inception date of 11/11/1998, VMNFX has obtained an annualized return of 2.90% (as of 2/28/2015, according to Vanguard.com) compared to 2.19% for its benchmark (Citigroup 3-Month US T-Bill Index). As 1990 Nobel Laureate Bill Sharpe pointed out, if all active management were done via long/short, their pre-expense returns in aggregate would be the same as Treasury Bills. Alternative investment mutual funds are commonly thought of as the poor man’s hedge fund, and so far, they have certainly helped poor investors stay that way.

Just when we thought Vanguard had decided to stay out of the troubled waters of alternative investments comes this announcement that Vanguard had filed papers with the SEC to open an Alternative Strategies Fund. Vanguard’s first intention with this fund will be to further diversify its $1.6 billion Managed Payout Fund which currently deploys 10% of its assets in the Market Neutral Fund and 5% in commodities. The new Alternative Strategies Fund will have an estimated expense ratio of 1.10%, well below the alternative fund category average of 2.05%, based on Morningstar data. The expense ratio of the Managed Payout Fund will increase from 0.34% to 0.42%. Regarding the fund’s investment strategy, the press release states:

“Vanguard Alternative Strategies Fund follows an actively managed approach and seeks to generate an absolute return by investing in a range of well-defined, diversified alternative strategies, which will be implemented using a combination of long and short positions in equities, forward foreign currency contracts, commodity and Treasury futures, swaps, and other investments.”

At Index Fund Advisors, we have never used the term “absolute return” to describe our Index Portfolios because the simple truth is that nobody can offer an absolute return above T-Bills without risk. As M. Barton Waring and Laurence B. Siegel said1 in the Financial Analysts Journal, “The term ‘absolute-return investing’ has no meaning. It misleads the listener into thinking it has substance that it does not have, and in our opinion, the term simply should not be used.” We couldn’t agree more.

Every year, Vanguard makes its powerful and compelling “Case for Indexing” which we have written about here. While many of Vanguard’s active funds (especially on the bond side) have more in common with index funds (low cost, highly diversified, style consistent, low turnover, and low cash drag) than they do with the rest of the active universe, we cannot say the same about this new fund, and we view it as a step in the wrong direction.

 

1M. Barton Waring and Laurence B. Siegel, “The Myth of the Absolute-Return Investor”, Financial Analysts Journal, March/April 2006.