Vanguard Wellesley Wins With Income Tilt: Riskless ReturnCharles Stein
Vanguard Wellesley Income Fund has used a mix of high-quality bonds and dividend-paying stocks to outperform all peers in the past five years, when record low interest rates put a premium on the assets it favors.
Vanguard Wellesley, which has about two-thirds of its $34 billion of assets in bonds, had the best risk-adjusted performance among large U.S. balanced funds since 2008, beating rivals holding a greater proportion of stocks. Managers John Keogh and W. Michael Reckmeyer III produced the third-lowest volatility and the second-highest total return among 34 U.S. balanced funds with at least $2 billion in assets, and had better absolute performance than both the stock and bond markets in the period, according to the BLOOMBERG RISKLESS RETURN RANKING.
The Federal Reserve’s decision to hold rates near zero since 2008 has sent investors scrambling for higher yields, creating demand for the income-producing securities and dividend stocks that Vanguard Wellesley buys. The fund’s focus on corporate debt, typically 75 percent of the fixed-income portfolio, also proved advantageous in an era in which such bonds outpaced government debt and stocks. The fund’s tilt toward bonds could be a handicap if rates climb over the next few years.
“This fund’s performance gives lie to the notion that active management doesn’t work,” Daniel Wiener, editor of the New York-based newsletter Independent Adviser for Vanguard Investors, said in a telephone interview.
The Vanguard Wellesley, started in 1970, keeps 60 to 65 percent in bonds and was designed to be the mirror image of the $69 billion Vanguard Wellington Fund, created in 1929, which holds 60 to 65 percent of its assets in stocks and the rest in bonds. Vanguard Wellington wasn’t part of the ranking because it has a relatively high weighting to stocks and is in a different fund category, according to data compiled by Bloomberg.
Vanguard Group Inc., the biggest U.S. mutual-fund company with more than $2 trillion in assets, is best known for its low-cost index funds. The Valley Forge, Pennsylvania-based firm also offers active strategies through funds managed by firms such as Boston-based Wellington Management Co., which runs $250 billion for Vanguard. Wellington Management, which oversees about $758 billion in total, manages both the Wellesley and Wellington funds.
The Vanguard Wellesley fund is aimed at investors “who have a goal of steady income and who are willing to accept modest movement in share price,” Vanguard said on its website.
“I think of Wellington and Wellesley as the original target-date funds,” Dan Newhall, a principal at Vanguard, said in a telephone interview, referring to funds designed to shift to more conservative investments as investors approach retirement. The Wellington fund is more suitable for someone in the accumulation phase, said Newhall, while the Wellesley fund is a better fit for retirees or more risk-averse investors.
The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.
Vanguard Wellesley gained 5.6 percent, adjusted for price swings, in the five years ended April 8, according to data compiled by Bloomberg. The $2.9 billion Hartford Balanced Income Fund, gained 4.4 percent, with the best absolute returns and below average volatility. The $34 billion Pimco All Asset Fund, also rose 4.4 percent, combining the third-highest absolute return and the fifth-lowest volatility.
The Vanguard Wellington fund, had it been included in the ranking, would be in the bottom third with a risk-adjusted return of 2.2 percent over the past five years.
Vanguard Wellesley also had the top risk-adjusted return over the past three years, two years, one year and so far in 2013, according to data compiled by Bloomberg.
That run may not last if interest rates rise.
“This is a great steady-Eddie fund, but you have to wonder how it will hold up in a different environment,” said Steven Roge, a portfolio manager with Bohemia, New York-based R.W. Roge & Co., which oversees $200 million.
Keogh, 56, who has run the bond portion of Wellesley since 2008, anticipates continued improvement in the U.S. economy and an eventual withdrawal of stimulus from the Fed.
“With rates where they are now, I don’t see room for much price appreciation in bonds, which is different from what we have experienced over the past five years,” he said.
Keogh said his challenge would be to cut the fund’s sensitivity to interest rates when they begin to climb. He would do so mainly by adjusting the duration, a measure of how much a change in rates will impact prices, of the bonds that he holds, Keogh said. Based on its current holdings, the fund would fall 0.6 percent were rates to rise 25 basis points, according to an analysis of portfolio data compiled by Bloomberg.
Like many conservative funds, Wellesley held up well in 2008 and 2011, difficult years for the stock market, said Kevin McDevitt, an analyst for Chicago-based Morningstar Inc. The fund beat at least 96 percent of peers in both years, according to data compiled by Bloomberg.
“A lot of defensive funds gave up all of that advantage during rallies, but not Wellesley,” said McDevitt, in a telephone interview.
Over the past five years, Wellesley fell only about two-thirds as much as peers in declining markets while almost matching their gains in periods when they advanced, Morningstar data show.
Keogh said the fund benefited in the past five years by being in the right place at the right time, citing declining interest rates and demand for dividend-paying stocks.
“We have had the ideal environment,” he said in a telephone interview.
The fund also benefited from holdings in corporate debt as the Bank of America Merrill Lynch US Corporate Index returned 8 percent a year in the five years ended April 8, compared with 5.6 percent for the Barclays U.S. Aggregate Bond Index and 5.1 percent for the Standard & Poor’s 500 Index.
Wellesley had one other edge over its peers: it is cheaper. The fund charges investors 25 cents for every $100 invested. U.S. balance funds charge an asset-weighted average of 87 cents, according to Morningstar.
Keogh said Vanguard Wellesley has been able to add value in both stocks and bonds through security selection.
In the 10 years ended Sept. 30, 2012, the fund’s equity portfolio returned 10.3 percent a year, compared with 8 percent for the S&P 500, according to a November regulatory filing. Over the same stretch the bond portion gained 5.9 percent annually compared with 5.3 percent for the Barclays Aggregate. Over the past two years, Keogh said, his belief that the U.S. economy was gradually improving led him to invest in the bonds of banks, food and beverage firms and cable operators, decisions that enhanced the fund’s returns.
Bank bonds returned a total of 17 percent over the past two years, food bonds gained 20 percent and telecommunications bonds advanced 19 percent, according to Bank of America Merrill Lynch indexes. The Barclays Aggregate Index returned 13 percent in the same two years.
Keogh manages the fund with Reckmeyer, 53, who oversees the equity portion of the portfolio. The two managers work in different cities. Keogh is based in Boston and Reckmeyer in Radnor, Pennsylvania. While they speak regularly about the economy and how their two asset classes should be divided in the portfolio, they make investment decisions separately.
Keogh pays attention to both the broader economy and individual industries, searching for sectors whose potential may be underestimated. Reckmeyer, a value investor, tries to find fundamentally strong companies whose shares are temporarily depressed.
On the equity side, Reckmeyer looks for quality stocks with high and sustainable dividends that can provide income to the fund’s shareholders. Vanguard Wellesley’s stocks yield about 3.2 percent, he said, in a telephone interview. The comparable number for the S&P 500 Index is 2.1 percent, according to data compiled by Bloomberg.
Reckmeyer said his decision to buy beaten down consumer stocks such as Home Depot Inc. during the financial crisis boosted returns over the five-year period. He more than doubled his stake in the Atlanta, Georgia-based home-improvement retailer between Sept. 30, 2008, and March 31, 2009, according to regulatory filings, making it one of his largest holdings.
“We used that opportunity to buy high quality names that could grow their way of the recession,” said Reckmeyer, who has managed Wellesley since 2007.
Home Depot returned almost twice as much as the S&P 500 Index between March 31, 2009 and Sept. 30, 2012, according to data compiled by Bloomberg. In an October letter to shareholders, Reckmeyer said he sold Home Depot because it had reached his target price.
Chevron Corp., the second-largest U.S. energy company, has been one of the fund’s largest stock holdings over the past five years. In that time, shares of the San Ramon, California-based company returned about seven times as much the S&P 500 Energy Index, according to data compiled by Bloomberg.
Reckmeyer said his results will lag behind the stock market if equity prices surge. For investors, a spike in rates is a bigger concern.
“Everyone believes that, given where we are with interest rates, the only eventual direction is up,” Thomas Chow, a Philadelphia-based money manager at Delaware Investments who helps oversee about $170 billion, said in an interview last month.
Wiener, the newsletter editor, said in the next five years, Vanguard Wellington, with its greater allocation to stocks, is a better bet than Vanguard Wellesley.
“Would I expect Wellesley to beat funds like it? Yes,” he said. “Do I expect it to generate returns that beat the stock market? Probably not.”