Vanguards Top 4 Funds

Dear Vanguard Investor,

No matter how the economy is actually doing, there always seems to be plenty of fodder for rumors, grumblings and alarmist headlines.

Now, this is different from legitimate concerns that investors might have—investing is serious business, and we’re right there with you navigating the ups and down of the markets.

But investing on headlines isn’t a strategy—at least rarely a profitable one. Too often, we see investors buying high and selling low in response to scary or overenthusiastic headlines. One of our all-time favorites is "Dow 5,000? Yes, It Could Happen." Sounds like serious business, right? Well, a week later the same writer had a headline that read "Why I’m Throwing Money at the Stock Market." Ridiculous to the extreme, and not a dependable gauge for when and where you should put your money to work.

We’re from the old school and old generation. We keep forgetting that it’s all about clicks. So it doesn’t really matter what you say, or how you reverse yourself less than a week later, so long as you get people to click on it.

The issue, of course, is that sensational headlines exacerbate a challenge that investors already face: not letting short-term worries or exuberance get in the way of doing what’s best for long-term financial health.

We recognize that going against the grain of our emotions is hard—it’s what makes investing so challenging. Would you have invested money—even into investments that you know and trust—after seeing the headline above, heralding the decline of a major index? On the other side of that coin, have you remained diversified in your portfolio even after seeing the tremendous gains that U.S. stocks have made since the bottom of the credit crisis from 2008-2017? Have you remained diversified after U.S. stocks in 2018 suffered their worst year since the credit crisis?

Great Expectations and Valuations

Take a step away from the headlines and consider one bit of analysis that, frankly, we haven’t seen anywhere else and which shows the significant impact that expectations can have in driving the markets up, up, and up.

Let me use an example. If we go back almost three years ago, two days before the 2016 Election, the S&P 500 Index had returned just 3.9% for the entire year. In the two days leading up to Election Day, the S&P gained another 2.7%, putting its year-to-date return at 6.6%. It then gained another 5.0% in the post-election rally, giving the index its 12.0% total return for all of 2016.

In other words, two days before the election, with 85% of the year’s trading behind it, the S&P index had earned less than one-third of what would eventually become its full-year return.

It earned another quarter of its full-year gain in the two days just prior to the election, and 42% of its full-year gain in the post-election period—which through year-end was 36 trading days long.

Let me say that again. The S&P 500’s total return for all of 2016 went from just 3.9% to 12.0% based first on rumors of a Clinton victory, and then on rumors of the impact of the surprising Trump victory. It wasn’t that corporate profits suddenly soared, nope.

Use Vanguard’s Best Managers
to Steady Your Portfolio

In our view, 2016 as a whole was an outlier of a year. And we were stunned to see how quickly so many of 2016’s trends reversed as soon as the year turned, to the point where 2017 and 2018 weren’t exactly a normal years, either.

Large caps underperformed small caps in 2016; 2017 saw that script flip (and the first half of 2018 saw it flip back). U.S. stocks were outperforming foreign stocks in 2016, but 2017 saw foreign stocks come roaring back (a trend that reverted back to U.S. stocks in 2018). Incredible. We hope these examples serve as reminders that diversification makes sense, that trends can change, and that, more than anything else, you need a smart investment plan and you need to stick to it.

Times of market trend reversals can offer tremendous opportunity, if you are partnered with the right managers. Top-notch managers, like those who are picking stocks for the funds subscribers to The Independent Adviser for Vanguard Investors invest in, know how to pick up bargains in market corrections and remain cool-headed during market rallies.

So, which Vanguard fund managers can be trusted to grow and protect your money? Vanguard won’t tell you, since the fund family has emphasized indexing over active management for years. But Vanguard certainly has actively managed funds that consistently beat the market and experience lower drawdowns in bear markets.

One place we know we’ll be safer than the average bull (or bear) is in Dividend Growth. Don Kilbride’s penchant for large, battleship-balance-sheet companies with decent yields and better-than-average growth expectations is a great counterbalance against the more volatile and growthier fare we’ll find in a fund like Capital Opportunity. We like both funds, of course, along with Short-Term Investment-Grade. Health Care is another winner, and is well positioned to benefit from trends in the sector no matter what happens with the Affordable Care Act.

#1: Dividend Growth

One of the few single-manager funds left at Vanguard, Dividend Growth’s returns have consistently made mincemeat of the fund’s indexed counterpart, Dividend Appreciation Index. That’s no coincidence. The current manager, Donald Kilbride, who fits the mold of the solid Wellington Management value investor, focuses on buying companies that pay a decent dividend yield but also are likely to increase that yield over time. His concentrated portfolio hovers around 50 stocks in total and is exactly what we look for in a fund, and a manager—someone with conviction and confidence in his picks (nearly 30% of the fund’s assets are in its top 10 holdings). We also like to see that Kilbride has over $1 million of his own dollars invested in the fund. You won’t find that among most of the managers sub-advising Diversified Equity, for example.

Three years ago, Kilbride celebrated 10 years on Dividend Growth in early 2016. Investors didn’t throw him a party, but they did throw enough dollars at the fund that Vanguard closed the fund a few months later. Makes sense, since Kilbride has proven his worth over the full market cycle—generating stellar returns while taking on less risk, as he backed it up with a positive return in 2018.

We own a lot of the fund, and we think you should, too. However, if you weren’t able to get into the fund before it closed its doors in July 2016, the best substitute in Vanguard’s stable is Dividend Appreciation Index (VDAIX).

#2: Health Care

Common investment wisdom is that sector funds add to portfolio risk, and, in most cases, can reduce returns because most sectors don’t outperform the market over the long term. That’s not the case when you have a top-flight team of analysts led by someone like Jean Hynes of Wellington Management, who’s been a part of the Health Care team for more than two decades.

Jean Hynes took the reins once Ed Owens, the Wellington Management portfolio guru who led Health Care since its May 1984 inception, retired at the end of 2012. Owens’ track record was outstanding. Had you invested $3,000 in Health Care at the end of May 1984 and held it throughout his tenure, reinvesting distributions along the way, you’d have had $227,770. Had you instead chosen 500 Index, your money would have grown to $54,570.

The real key to this fund’s success in all markets is diversification, investing in five major areas of the health industry, from biotech and pharmaceuticals to managed care and services and health care technology. Plus, a commitment to investing overseas (nearly 25% of assets, currently) helps.

Health Care has been a major holding of ours for years. In fact, except for a bit more than two years during the early 1990s, Health Care has been a component in one or more of the Model Portfolios since their 1991 inception. In fact, we should never, ever have sold a share, but the gains have been so strong for so long, we’ve recommended trimming our Model Portfolio position many times. Health Care has generated some very nice gains for readers of The Independent Adviser—outperforming Total Stock Market over just about any time period you’d care to consider.

The health care sector had a tough year in 2016, and while it was back on its feet in 2017, the fund still had some lingering symptoms. However, the managed fund was back to its winning ways in the latter half of 2018, still supported by the long-term tailwinds of Demograyphics (the graying of the U.S. population), globalization, the growing middle class in emerging markets and the research and development of new drugs and procedures

We spoke with Jean Hynes, manager of Health Care, around the time of the turnaround, and her outlook on the sector and its future might surprise you. But our interviews with fund managers are exclusive for members of The Independent Adviser for Vanguard Investors. You can get full access to them when you sign up today.

#3: Capital Opportunity

The strategy at Capital Opportunity is growth-at-a-reasonable-price, or GARP investing. The managers search for companies that can grow earnings at a better-than-market rate, but unlike most growth managers, they refuse to pay high prices for those companies’ stocks. So they wait. Many of the top holdings here can also be found in the aforementioned funds; however, Capital Opportunity is still run with an eye toward owning some smaller stocks. The median company here has a market size of about $40 billion, versus $50 billion for its siblings. That’s big compared to most of Vanguard’s mid-cap funds, but small compared to the large-cap funds.

The team at PRIMECAP Management, who runs Capital Opportunity, is fairly unique. Each manager takes a slice of the portfolio and invests as he sees fit. Though there is no collaboration on holdings, per se, several managers may find value in the same stocks.

This makes the fund resilient to manager changes. PRIMECAP was founded in 1983 and it’s only natural to expect some turnover in the firm’s fourth decade.

Capital Opportunity remains a top-notch fund; it’s just not the fund it once was. It is too big for its britches, and instead of being the small/mid-cap fund that it used to be, Capital Opportunity has become much larger-cap in focus. That’s not bad, but it’s an evolutionary change that you should be aware of, and you should hang onto your shares if you own it. However, if you don’t own it, you should know that it’s closed to new investors.

That’s okay—there’s an alternative to all of the closed funds PRIMECAP runs for Vanguard, and they’re smaller, younger funds who can trade in the smaller-cap funds that the huge Vanguard PRIMECAP funds can’t, and have been outperforming those funds for years. The secret is, the funds we are talking about aren’t Vanguard funds. Subscribe to The Independent Adviser for Vanguard Investors to find out what our alternatives are to the PRIMECAP funds and how to get into them.

#4: Short-Term Investment-Grade

This is our favorite Vanguard fund at the short end of the yield curve. Formerly called Short-Term Corporate, it is extremely safe, produces steady returns, and offers some diversification that the Short-Term Treasury and Short-Term Federal funds don’t. Rather than investing only in Treasury, Agency or other government-backed securities, Short-Term Investment-Grade invests in high-quality corporate bonds, asset-backed bonds and a smattering of other non-Treasury securities. The combination responds to rising or falling interest rates less rapidly than Treasurys, meaning that it rises a bit slower when rates drop and falls a bit less when rates rise, since its excess yields protect investors and prices. Over time a portfolio like this one will outperform a Treasury portfolio, as this one has.

We use this fund as a higher-yield cash substitute in our Model Portfolios and would recommend it in that role for most any portfolio invested for the long haul. Of critical importance from a portfolio diversification/safety standpoint is that this fund seldom loses money.

Before the unprecedented events of fall 2008, the worst losses suffered by investors in Short-Term Investment-Grade were quite small—a worst-case 2.2% loss over three months, a 1.0% loss over six months and a mere 0.1% loss over 12 months, all occurring in 1994, when the Federal Reserve began a sharp and fast series of interest rate hikes that saw the Fed Funds Rate move from 3.00% to 4.75% in six months. Since 1994, Short-Term Investment-Grade had not suffered a loss over any 6-month or 12-month period—until July 2008 as the financial markets began to falter and the rush to Treasurys began in earnest. After setting a new MCL of -7.6% in 2008, the fund recovered in six months and returned a whopping 14.0% in 2009.

The fund’s yield remains significantly higher than Prime Money Market’s, enabling it to put up significantly higher returns over 1-year, 3-year, 5-year, and 10-year periods. We credit the steely management of the fund as much as we do the turn in the markets. With yields as low as they are today, there’s no question in our minds you should be using a short-term bond fund, cognizant of the potential for short-term losses, in lieu of a money market for your longer-term cash holdings.

Of course, because some of the income earned in the government funds is free of state and local taxes, you might come out slightly ahead in those funds if you live in a high-tax state. But if taxes are a big concern, you should probably be considering a tax-exempt fund like Limited-Term Tax-Exempt instead.

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Leave the Active
Managers to Us

For the past several years, the amount of money going into actively managed equity funds has been small compared to the massive dollars pouring into all manner of indexed products, from open-end funds to ETFs. The more money that piles into index funds, the better, as it means fewer dollars chasing great investments, rather than average investments. Frankly, we’re happy as can be when investors put their money into index funds and leave the great active managers to you and me. If and when a market correction occurs, we’ll be the ones at ease that our money has a home with Vanguard’s best managers.

However, these four funds we’ve covered in this report are not the only ones you’ll need for a fully balanced and diversified portfolio. To gain full access to our Growth, Conservative Growth, Income and Growth Index Model Portfolios, subscribe to The Independent Adviser for Vanguard Investors risk-free today.

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