Vanguard Life Strategy Funds

When I look at Vanguard’s Life Strategy Funds at first I asked myself why anybody with any sense would go elsewhere.

You want Asset Allocation in a box and an easy life – look no further. Would that I had had the prescience to follow such a strategy back in 1979 when I started my City career.

What a shining star John Bogle was. Now resting in the great Fund Manager’s Valhalla in the Sky our John is a modern hero.

What he did, long before anyone else, was to invent a very low cost way for people to avoid vastly over priced  useless active stock picking funds: the index tracker.

Vanguard then took it a stage further and made asset allocation just as simple and just as cheap.

Many won’t want to hear me but the vast majority of investors ought to be investing in simple fixed percentage mix of bonds and equities. That percentage mix should be maintained by periodic re-balancing.

The 20 year old might be advised to invest mostly in stocks for higher growth (but higher risk – in terms of volatility and draw down).  Perhaps 80% stocks and 20% bonds.  The retiree should reverse this and keep 80% in low risk bonds with an allocation of only 20% in stocks. The 20 year old can afford to ride out the inevitable stock market crashes, knowing he is likely to get his money back even if it takes 10 or 20 years.  The 60+ year old does not have that luxury.

In the middle lies the traditional 60/40 stock/bond mix.  Many people deride such simplicity. They are making a mistake.  In my view such a scheme should form the bedrock of Everyman’s investing philosophy.  Everyman does not need the risk of punting on some rising (or worse, risen) star in the stock picking world only to discover he has reached his zenith. Decline and fall is sure to follow as night follows day.

In sharp contrast to much of the market, there are no entry or exit costs. And of course no performance fee.  On-going annual charges are a mere 0.22%. Compare this with an actively managed fund and you will see the importance of index trackers.

All investments held by the fund are tracker funds.  For UK investors there will be a bias towards the UK markets and GBP risk, while US investors will be getting a higher proportion of US markets and US risk.

But international diversification is not forgotten. The UK 60/40 product for instance has a near 20% allocation in the Vanguard FTSE World (Ex UK) Fund.  It has separate allocations to the US (15%), emerging markets (5%) and other international markets.  Bond fund allocations are global across currencies and (partly?) hedged against sterling for the UK product.

Nobody should ever invest in a fund without reading the prospectus. I did so and still have a number of questions to put to Vanguard which were not made entirely clear in the prospectus. In general I was very surprised indeed at the great latitude given to the fund manager.  I had expected this to be a rule based fund – it is not. Wide discretion is given to the investment adviser. This would probably lead me to devise my own portfolio so that I could have complete control over risk, investments, re-balancing, bond duration and geographic markets.

Given the very wide discretion given to the investment adviser these Vanguard funds begins to sound more like stock pickers where managers make a guess on market movements and relative performance.

I must say I felt disappointed and let down once I had read the prospectus.  The vast majority of investors will not bother to read the prospectus nor will they understand the risks they are taking by giving the fund manager such very wide discretion over the investment policy of the fund.

I will send my comments to Vanguard in case I have misunderstood and misread the prospectus.  I will publish any comments they care to give me in this or another post.

These are principal points I noticed as regards the UK prospectus:

Portfolio Investment Techniques

The fund can hedge against market movements. The fund may also be leveraged up to (or over) 100% of its net asset value. Rather disingenuously the prospectus cross refers you to the Collective Investment Schemes Sourcebook  issued by the FCA. Apparently the Sourcebook may permit higher leverage. In my view it would be a lot more satisfactory to have an explicit statement of policy by the fund.   To what exact extent can the management either (a) hedge  or (b) leverage the fund and for what purposes and in what circumstances?   Unfortunately this sort of catch all provision is only too common in fund prospectus’ and you are supposed to take it on trust that the fund manager will act reasonably.  Leveraging should be used, if at all, to ease short term liquidity. It is to be hoped that leverage is not used to enhance the portfolio return.

Charge for Redemptions

“The ACD reserves the right to make a charge for redemptions”. What is this? It is stated elsewhere in the marketing materials that there is no redemption charge.

Investment Adviser Risk

“Each Fund is subject to the risk that the Investment Adviser (or a sub-investment adviser) may do a poor job of selecting investments” This is most unexpected.  I had thought this to be a rule based fund with periodic re-balancing.  I had expected there to be no discretion (or very little) involved.

Currency Risk

The fund needs to explain its policy on currency hedging. There is little point in talking about currency risk unless we are actually told what the hedging policy is. Are the underlying investments hedged or not? Fully hedged? Partially hedged? Or is the decision purely discretionary and there is no fixed policy?  And how is the hedging put on? What is the basis of the hedging arrangements?

Fixed Interest Rate Risk

When interest rates go up, bond prices gown down and vice versa. So an investor needs to know the average duration of each bond fund in the portfolio.  The longer dated the bonds in the fund, the greater the interest rate risk.  This information is not found in the prospectus. Once again is discretion used?  It seems so. Can the fund manager move out to longer dated bonds when interest rates look set to drop and vice versa? Or are the proportions fixed? Preferably the latter but not according to the prospectus.

Credit Risk

An investor would like to know how the underlying bonds are rated. Government securities from a stable country with a strong economy are less likely to default than bonds issued by a high risk commercial company. An investor should try and get a handle on the allocation of risk in the bond portion of the fund.  If you don’t know what bond funds are going to be chosen this information is not obtainable.

Derivatives

What percentage of the total assets of the fund are represented by derivatives?  The lower the better.  My preference is to avoid derivatives as investments and invest instead in the underlying stocks and bonds.  I do not like either the financial risk or the counter party risk of derivatives. Are derivatives used as part of the leveraging capability of the fund?

Collateral Reinvestment Risk

Is the fund lending out its securities to increase return? If so what limits and safeguards are in place?

Investment techniques risk

I find it rather alarming that this section talks of “the Investment Adviser’s ability to predict movements in the price of securities being hedged and movements in interest rates”.  I would be buying tracker funds precisely because I do not believe in the ability to predict the prices of financial instruments. Vanguard need to explain this further.

“The degree of leverage inherent in futures trading”.  I would avoid funds which make substantial use of derivatives. Vanguard needs to explain the extent of its use of derivatives.  I would prefer to stick to funds which invest the vast majority of their assets in cash securities such as cash stocks and bonds.

Securities lending arrangements risk

What percentage of the funds assets are lent out? And to what counter-parties? What is the credit risk of those counter-parties?  How concentrated is that risk – IE how many counter-parties are there and what is the maximum exposure per counter-party?  How much collateral is required for different classes of assets lent? What are the safety margins (excess collateral)?

Rebalancing

There is no clear statement as to when if or how often the funds assets are re-balanced in order to maintain the bond / equity split or the split between different underlying funds with the bond allocation or the stock allocation.  For instance is the allocation of 15% to US stock markets discretionary?  As a matter of principal I do not wish my fund managers to have discretion. Continuously successful forecasting of markets is impossible.