Vanguard Manager Firing Fails to Fix Fund’s Faults - Adviser Investments

Vanguard Manager Firing Fails to Fix Fund’s Faults

December 23, 2019

 

Vanguard Manager Firing Fails to Fix Fund’s Faults

Earlier this month, Vanguard announced that it was ending its 34-year partnership with Barrow, Hanley, Mewhinney & Strauss (BHMS), which sub-advised three of the firm’s funds. At the same time, new-to-Vanguard managers Aristotle Capital and Cooke & Bieler were hired to replace BHMS on two of the funds.

We’ve talked for years about Vanguard’s multi-manager problem on some of its largest funds, including the $47.5 billion Windsor II. Just two months ago, we covered BHMS’ replacement of Jeff Fahrenbruch with Mark Giambrone, but that change marked the final chapter in Vanguard’s relationship with the firm.

Along with its dismissal from Windsor II, BHMS was also removed from management of the $8 billion Selected Value fund and the Diversified Value portfolio in Vanguard’s variable annuity lineup.

Perhaps related to taking a hard look at Windsor II, Vanguard quietly removed the two managers from its in-house quantitative management group from the portfolio as well. But instead of concentrating assets into a smaller number of stock-pickers, the Malvern, Pa. fund giant tapped Aristotle Capital to assume BHMS’ seat at the table.

At Selected Value, co-subadvisers Donald Smith & Co. (which itself went through a transition due to Donald Smith’s passing in October) and Pzena Capital have been joined by two managers from newcomer Cooke & Bieler. Finally, two current subadvisers on Windsor II, Hotckis & Wiley and Lazard Asset Management have replaced BHMS as managers of the Diversified Value annuity portfolio.

In a Barron’s interview, Vanguard’s Dan Newhall, a principal in its portfolio review department, said the decision to dump BHMS was based on performance, process and succession concerns. “We’re always asking ourselves, are investors ideally served by the managers we employ or would they be better off if we were to make a change?” Newhall said. “In this case, there was an accumulation of things.”

The multi-manager muddle makes it impossible to tell which subadviser is pulling its weight and which is sandbagging the fund’s overall (disappointing) performance, but there are some clues here. Vanguard had been slowly redistributing Windsor II’s assets to other subadvisers in the years since BHMS founder Jim Barrow, who had managed the fund since its 1985 inception, announced he was stepping down at the end of 2015.

At the time of Barrow’s retirement, BHMS managed about 60% of the overall portfolio. That number was nearly halved over the past four years, with the firm managing 37% of Windsor II’s assets at last report.

Even after removing BHMS and the Vanguard quant team, shareholders still have eight managers from Lazard, Hotchkis, Sanders and Aristotle elbowing for room to shine on Windsor II and picking stocks for their portfolios.

Value investing (which emphasizes paying less for something than the buyer thinks it is worth) has struggled to keep pace with growth investing (a strategy that banks on profit growth over asset values in determining a company’s worth) since the Great Recession. But that alone doesn’t explain Windsor II’s decade-long woes.

Sources: Morningstar, Adviser Investments. Line rises when Windsor II outperforms the comparison index or fund. Markers indicate manager changes. Time period ranges from 6/25/85 to 11/30/19.

We think the multi-manager approach typically will not produce winners. Vanguard can say until it’s blue in the face that adding managers improves results and reduces risks—the facts don’t add up. They can hire and fire as many managers as they want, but it’s little more than rearranging deck chairs on their struggling Titanics rather than addressing the problem where it lies: Too many cooks in their active funds’ kitchens.

The multi-manager muddle makes it impossible to tell which subadviser is pulling its weight and which is sandbagging the fund’s overall (disappointing) performance, but there are some clues here.

Active management is not at issue here. After all, we’ve built our business and reputation on buying the manager, not the fund. Our time-tested approach—investing in active managers with a long-term track record of strong risk-adjusted returns over full market cycles—stands on its merits. We let the managers we invest with do what they do best, while ensuring that we can monitor the results—something that is near-impossible to do for each subadviser when there are a number of them on the same fund. In our eyes, it makes no sense to dilute the impact of seasoned, verifiable investment chops in a murky multi-manager mire.

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Video: Adviser Investments Toasts 25 Years of Putting Clients First

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Does Portfolio Rebalancing Work?

Every year around this time, you’ll see media attention on the questions of when, why and how you should rebalance your portfolio. Despite all of the air time and column inches devoted to the subject and nudges from fund companies, the conclusions are often the same—sell your winners and buy your losers at least annually, if not every quarter. This discussion is particularly relevant after the strong year for U.S. stocks compared to nearly every other asset class in 2019 that pushed many portfolios away from their initial allocations.

Looking at the data, there’s ample reason to question if rebalancing that often—or at all—is necessary, even during times of increased market volatility.

Advocates for rebalancing argue that the strategy is all about risk control—that maintaining a target allocation between stocks, bonds and other asset classes can effectively manage the overall risk in your portfolio across market cycles. As an example, say you start out with a simple 50%–50% mix of stock and bond funds in a portfolio. After a period when stocks outperform, it may skew to a 60%–40% or 70%–30% mix, leaving you at increased risk of losing those gains if stocks drop. The overarching theory behind rebalancing: Keep allocations in check, thus reducing risk. On the face of it, sure, that’s good (if superficial) advice.

Rebalancing appears to have a positive effect on a portfolio’s volatility—you won’t hit the same heights, but you also are unlikely to experience the same losses than an untended portfolio can suffer.

Fidelity and Vanguard have periodically addressed rebalancing over the years, with the firms recommending to rebalance either on a semiannual or annual basis, or when allocations drift more than 5% or 10% away from their targets.

Those conclusions seemed a bit simplistic to us, but before making any judgments, we wanted to run a few numbers ourselves. We constructed a hypothetical portfolio of index funds with a 50%–50% split between stocks (Vanguard 500 Index) and bonds (Vanguard Total Bond Market Index) and tracked the results of several rebalancing scenarios from January 1987 (just after Total Bond Market Index’s inception) through November 2019.

In the first scenario, we rebalanced the portfolio every six months, in January and July. In the second test, we rebalanced once a year in January, and in the third, we rebalanced every third January. (We used January because it’s best to rebalance after December distributions and the tax-year has turned.)

When we examined rolling returns for each scenario, analyzing average returns as well as the best and worst returns for one-month, one-year, three-year and five-year periods, our findings were pretty conclusive: The less frequently you rebalance, the greater the return potential and greater the volatility over any given period. When we’ve run this analysis in the past, over shorter periods, some of the rebalancing strategies posted slightly better returns, but after a strong year for stocks in 2019, the no-rebalancing strategy showed the best overall average gains.

It’s worth noting that no matter which period we looked at, the average annual returns in each scenario are all very similar, with no more than 0.59% separating any two of them. But you can see much wider swings when comparing the best and worst periods. For example, there was a 65% swing from best to worst 12-month periods for the portfolio that was never rebalanced compared to a 51% or 52% swing for the three regularly rebalanced portfolios.

So rebalancing does appear to have a positive effect on a portfolio’s volatility—you won’t hit the same heights, but you also are unlikely to experience the same losses than an untended portfolio can suffer. A frequently rebalanced portfolio also stays much closer to its targeted allocation, but can still be impacted by periods of high market volatility.

Through November 2019, the portfolio that was never rebalanced ended up with a roughly 80%–20% split between stocks and bonds, while the most frequently rebalanced portfolio—most recently in July 2019—ended up fairly close to its original allocation with a 51%–49% stock/bond mix.

Sources: Morningstar, Adviser Investments. Dates range from Jan. 1, 1987 to Nov. 30, 2019.

As you can see in the chart above (which tracks the growth of $100 in hypothetical portfolios split between stocks and bonds using the various rebalancing schemes), over the long haul, returns really don’t suffer that much for the more frequently rebalanced portfolios even though they showed lower average returns over shorter periods. In fact, the difference in the end value of the never rebalanced and the semiannually rebalanced portfolios was $191. That’s hardly an argument for never rebalancing, but it’s not much of one for doing it often, either.

So what if you followed Fidelity’s and Vanguard’s recommendation, and rather than use a set time period to decide your rebalancing strategy, you used portfolio drift? In the table below, we tested what would have happened to that 50%–50% portfolio over the same 30-year period—this time rebalancing when the spread between stocks and bonds exceeded 5% or 10%.

Using Portfolio Drift Has Little Impact on Performance

Using Portfolio Drift Has Little Impact on Performance
Sources: Morningstar, Adviser Investments.

If you just look at the number of trades and the average months between, it seems like a pretty doable strategy—with a 5% spread threshold, you would have made a trade about once every nine months, and you would have traded a little more frequently than once every two years with a 10% threshold. But that’s misleading—the frequency of trades varied significantly over the three decades, with a few periods requiring a flurry of activity after longer gaps with no trades. For example, with a 5% threshold, from January 2008 to January 2010, you would have made seven trades as stock market declines regularly pushed the balance of the portfolio towards bonds—meaning that you would have been repeatedly faced with the difficult psychological task of putting more money into stocks as their value was falling.

But even if you were that disciplined, and you had made those painful trades—what would it have gotten you? From a return standpoint, not very much. As with the time-based rebalancing schemes, there was very little difference in overall return between the portfolio that was never rebalanced and the ones that were. The late Vanguard founder Jack Bogle summed it up pretty well: “Rebalancing is a personal choice, not a choice that statistics can validate.”


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