From the March 2008 issue of Wealth Manager Web • Subscribe!

March 1, 2008

A Sign of the Times

Mention the name Vanguard and while several images come to mind in the world of money management and fund companies, alternative investing probably isn't among them. Low-cost indexing? Sure. Several well-regarded actively managed mutual funds? Yep, those too. And a growing list of ETFs targeting conventional betas? Absolutely.

How about market neutral? Whoa, market what? That's not associated with the Vanguard of popular lore, is it?

It is now. Late last year, the money management behemoth expanded its strategic horizons by adopting the former Laudus Rosenberg U.S. Large/Mid Capitalization Long/Short Equity Fund, now rebranded as the Vanguard Market Neutral Fund. The "reorganization" of the fund, according to Vanguard's press release, pairs the existing manager, AXA Rosenberg Investment Management LLC, with the Vanguard Quantitative Equity Group.

Strategically speaking, the fund remains more or less the same. Like many long/short portfolios, Vanguard Market Neutral focuses on buying stocks that are considered undervalued and shorting those identified as overvalued--all the while keeping longs and shorts balanced, thus the tag of market neutral. The fund fishes in domestic waters in the mid- and large-cap space. As an added bonus, Vanguard reports that it has lowered the expense ratio relative to the price tag under the previous sponsor, Charles Schwab Investment Management.

Vanguard is adopting one of the oldest products focusing on market neutral strategies in a mutual fund wrapper. It doesn't hurt that the fund has distinguished itself at times, including its delivery of robust returns during 2000 to 2002, a period when stocks generally were tumbling.

But why has Vanguard decided to jump into the alternative investment space now, and with this fund? When a company as large and influential as Vanguard moves beyond its core competency of standard betas and conventional money management, the decision invariably attracts attention and raises questions.

The rising popularity of alternative investing in general probably figured into Vanguard's thinking. In any case, we just happen to be in the questions business and, to be frank, we're also a little curious. Until now, one could be forgiven for thinking that Vanguard was immune to all the portfolio-engineering strategies that have become increasingly common. So, what's changed? In search of an answer, we called Vanguard's Joe Brennan, principal of the firm's portfolio review group which selects and oversees managers for the company's products.

Your new market neutral fund is Vanguard's first alternative strategy portfolio sold publicly. Is the company's investment philosophy changing?

No, because we've always been in favor of diversification and low costs. And that's exactly what this fund represents. Alternative strategies are mainly diversifiers--there's no magic there. They're set up in a way that the return series is unrelated to the traditional asset classes. We're proponents of that for portfolio construction reasons.

We also believe that any investment strategy should be able to overcome its cost hurdle. We're bringing this fund out with an expense ratio that won't be a headwind to the alpha. I'm not sure that's the case with all the alternatives in the marketplace. Our expense ratio is low and probably will be the lowest in the marketplace.

How low is low?

It's a little tricky. The stated expense ratio for the investors' shares is 200 basis points and 190 basis points for institutional investors. But those numbers include what's called the expense for short-sale dividends, which are about 150 basis points. So what the shareholder is really experiencing for expenses is 50 basis points, which is the operating expense ratio for the investors' share class. In other words, there are factors on the long side of the portfolio that offset the 150 basis points on the short side.

In one of our regular long funds, if you look at the gross and net returns, the difference is roughly the expense ratio. In this case, the expense ratio is 200 basis points, but the difference between the gross and net returns is 50 basis points, which is the equivalent of the operating expense ratio. So it's the lowest of its kind, and we're proud of that.

Is this the first time Vanguard has "adopted" an existing fund?

We've done adoptions before. We have three funds that were adopted, meaning that we took them over as the fund sponsor from the prior sponsor, and so the shareholders become Vanguard shareholders and the fund becomes a Vanguard fund. In this case, the advisor, AXA Rosenberg, remains on board, and we're adding our quantitative equity group as the second advisor.

Why offer a market neutral fund now?

We were contemplating launching this type of fund on our own. At the same time, there was an opportunity to adopt a fund from an advisor [AXA Rosenberg] we know well--an advisor that runs money for us in other portfolios. So the stars aligned with respect to adopting a fund that we were thinking of launching anyway. Meanwhile, the fund meets a client need; we think it's a good long-term solution because it's a diversifier. We think it will have a lot of appeal to institutions, endowments, foundations as well as high-net-worth clients who are looking for another diversifier.

Has Vanguard managed market neutral funds previously?

We didn't have a fund for public purchase, but we were running the strategy, although we didn't have clients in the strategy. We test a lot of strategies in-house before offering them to shareholders.

Some might say that this is a marketing decision, and that Vanguard's jumping on the alternative-investing bandwagon.

Again, we think the market neutral fund is another diversifier for clients. We're not going to offer something because it's hot or a fad--that's not our style. In fact, when we publicly announced our plans last August, there were a lot of articles about quantitative managers and long/short funds having a lot of trouble. If anything, our timing was against the grain of what was popular. But this is something that was thought through carefully, and it had nothing to do with the current market environment.

Your market neutral fund is quantitatively managed. Is that a new approach for Vanguard?

We've embraced quantitative management for some time. We have our own internal quant group as well as relationships with four external quant managers. Some of our largest funds are quantitatively managed, including a big chunk of Windsor II and a piece of our Explorer fund.

There's a $250,000 minimum for the market neutral fund--why so high?

The natural buyer for this fund is an institution that's looking for a diversifier and low volatility, but isn't particularly sensitive with respect to taxes. So, we thought the higher minimum was appropriate for the target market. All else equal, if the natural buyer is an institution, the fund has better economics if the minimum is higher.

Sounds like no one will confuse the fund with a tax-efficient portfolio.

I wouldn't necessarily recommend this for taxable assets because of what will be thrown off from the gains, which are realized relatively quickly because of the turnover with the longs and the shorts. The turnover will be relatively high, probably ranging between 100 percent and 200 percent [a year]. When you get up into that turnover range, it's probably not as tax efficient as some other options. So, the fund's really better for tax-sheltered assets, endowments, pension funds, or an individual with a very large tax-exempt portfolio looking for a diversifier.

Why are the fund's assets so meager? As of this past October, the fund held just $14 million, according to Morningstar.

One of the reasons is that Schwab had three market neutral funds and they were probably more interested in one than another. So Schwab was interested in talking to us about adopting the fund. We're hoping it grows, and with the lowering of expenses and the quality management, I'm sure it'll attract investors. [The Laudus Rosenberg long/short adopted by Vanguard was formerly a member of Schwab's Laudus family of funds. In fact, Schwab had intended to shut down the fund because its strategy was similar to two other Schwab funds, a Schwab spokeswoman told Bloomberg News last September.]

The appeal of adopting this fund boils down to what?

The manager [AXA Rosenberg Investment Management LLC], certainly. It's a manager running two other portfolios for us. We could have and would have started a fund like this anyway with this manager and an internal team at Vanguard. But it's just easier to have the shell already created. And, yes, it had a low amount of assets, but it's easier to get a fund off the ground that already has assets.

Morningstar labels it a long/short fund, and by that standard its trailing three-year returns looking middling. You should compare it against a market neutral universe. Keep in mind that the long/short universe includes funds that don't match their longs with their shorts, so they can be net long or net short. Our fund is run as a complete offset in terms of the amount of longs and shorts. So, if you look at the fund in terms of the Lipper market neutral group, it's almost at the top of the category. For the three years through November 30, 2007, the fund was up 9.16 percent annualized versus the category's 4.09 percent.

The way to think about this fund is its attempt to isolate the manager's alpha generated by both the long and short positions. The fund's return will be a cash return plus or minus the alpha--alpha that, hopefully, is a plus, and in fact has been a plus so far. Meanwhile, the correlation for this type of strategy is very low with a general stock or bond portfolio.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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