Wealth Manager

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 (hedge funds being the obvious example) 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.

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

A: 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.

Q: How low is low?

A: 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.

Q: Is this the first time Vanguard has
“adopted” an existing fund?

A: 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.

Q: Why offer a market neutral fund now?

A: 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.

Q: Has Vanguard managed market neutral
funds previously?

A: 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.

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

A: 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 hav-
ing 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.

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

A: 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.

Q: There’s a $250,000 minimum for the
market neutral fund—why so high?

A: 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.

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

A: 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.

Q: Why are the fund’s assets so meager? as
of this past October, the fund held just
$14 million, according to Morningstar.

A: 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.]

Q: The appeal of adopting this fund boils
down to what?

A: 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.

Q: Morningstar labels it a long/short fund,
and by that standard its trailing threeyear
returns looking middling.

A: 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.