Help a Reader: Change to Index Funds?

Here's a question recently left by a reader:

I have money in the Vanguard Wellington fund. Its performance the last 1, 5 and 10 years is:

• 1 yr - 4.26
• 5 yr - 12.23
• 10 yr - 7.53

The expense ratio is 0.27%

The Vanguard Balanced Index fund performance over the same time period:

• 1 yr - 0.49
• 5 yr - 9.45
• 10 yr - 5.37

The expense ratio is 0.19%

Now these funds are not exactly the same, as Wellington's stated goal is a stock portfolio of 60-70% all in mid and large cap US stocks (my prospectus says the stock allocation can vary between 45-65). The bond portfolio is mostly in corporates with some exposure to US treasuries.

The balanced index fund's goal is 60% in the Vanguard Total Stock Market index (so you get some exposure to small caps) and 40% in the Vanguard Total Bond index.

My question is whether it makes sense to move from Wellington to Balanced Index. Do you think they are comparable funds? And if so, the track record suggests Wellington has better performance. Or do you think they are not comparable because of the small cap component in the index fund?

My goal in choosing Wellington many years ago was a 60/40 asset allocation. It looked to have better performance than the comparable index funds offered by Vanguard and with such a low expense ratio I thought it would be a cheap way to get some professional management and...............beat the market.

He and I discussed the issue back and forth a bit but didn't really come to a resolution. What's your take on the issue?

Comments

[marylandterps]

What's the reason for changing? Wellington is doing fine & the active management has better overall performance. Why change? Is it just b/c you now believe the index mantra? You may also have to pay capital gains tax & maybe a brokerage fee to change.

Another consideration is how did Wellington perform during the bear market of 2000-2002 compared to the index fund. Wellington gained 10.4% in 2000, gained 4.2% in 2001, & lost 6.9% in 2002. The Index fund lost 2.04% in 2000, lost 3% in 2001, & again lost 9.5% in 2002. So active management protected your money in a declining market, an advantage over a passive index that can not protect you in a down market but only suffer losses.

If your goals have not changed, & from the article it seems the goals are the same, I can't think of a good reason to change. Certainly not b/c the expense ratio is a bit cheaper. Wellington is better than the index, which is what you want from active management, & may protect you in the next bear market.

[Kyle]

It is not an apples-to-apples comparison. The Wellington fund includes some foreign equities while the balanced index fund does not. Furthermore, the Wellington is value-oriented and that particular style just happens to have had better returns over the past decade. Ditto for the foreign stocks in its portfolio. That will not always be the case. I would buy balanced index but if you're already in Wellington, it's probably not worth switching.

[Requisite]

I won't try to get into a discussion of index vs. active management, but Wellington is a different fund:

1) It has almost 12% of its equities in foreign holdings, vs. 0% for the index. The combination of hot foreign markets and the falling value of the dollar explain the difference in returns vs. the index; however taking on currency risk is not something a 'balanced fund' investor probably planned on.

2) The median market cap of Wellington is $57bil vs. $35bil for the balanced fund, so there's a significant difference in style.

3) The duration and average maturity of Wellington's bonds are significantly longer than the Balanced Index, allowing Wellington to perform proportionately better in a falling rate environment.

4) Wellington's management fee is 50% higher than the Index.

5) The index holds a 20% more financial stocks, proportionately, than Wellington; while this drags down past performance it will help the index when the financials recover.

6) Wellington's Top 10 holdings account for 16% of total assets, while the Balanced Index's Top10 only acount for 9% of total assets, so Wellington has a significantly higher concentration.

7) Surprisingly, the Index's annual turnover rate is actually 300 basis points more than Wellington.

I would go for the index if you want a pure balance-fund allocation, without currency risk, higher management fees, significant concentrations, etc.

[kitty]

The post doesn't say if it is a taxable account. If it is, tax efficiency has to be taken into consideration as well.

[AJM]

If you are really interested in the difference between the two, as well as how they compare to "the market", why not download the free trial of Quantext Portfolio Planner and input each (or holdings of each if the funds historical data is inadequate) and see for yourself? It runs a Monte Carlo simulation based on historical data to come up with projected returns, beta, R^2, standard deviation etc. I found it very helpful when comparing funds as well as analyzing how well my portfolio was negatively correlated in addition to what my portfolio's risk/reward looked like compared to the S&P 500. Hope that helps...

[rwh]

Thanks for the comments, and thanks to the host for making this a topic.

FYI: The fund is in an IRA.

For a more short term comparison I checked this morning, 4/1/08:

Wellington YTD: down 3.9%
Vanguard Balanced Index YTD: down 4.9%

I'm leaning toward keeping the Wellington fund.