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The increased market volatility in recent months as well as Vanguard's announcement that it will launch a market-neutral fund for institutional investors before the end of the year got me thinking -- a dangerous development, to be sure.
Are any of Vanguard's funds any good at reducing volatility without sacrificing the potential for capital appreciation like a market-neutral fund is supposed to do? And if market-neutral funds are such a great idea, does the typical Vanguard investor need one in his or her portfolio?
To answer these questions I looked at the bear-market ranks of Vanguard funds and at measures of their volatility, such as standard deviation. I also checked how the funds have held up relative to their peers during the tumultuous third quarter.
I found that quite a few Vanguard funds looked good according to the bear-market ranking, which gauges how funds have done in down markets over the past five years. So the answer to the first question is a resounding yes.
That also answers the second question. With so many options with long histories of minimizing market risk while delivering some capital appreciation, most Vanguard investors could live long and happy lives without a market-neutral fund.
Funds with good downside protection
I've highlighted below what I think are the best Vanguard funds for a bear market. Granted, they don't use the sophisticated strategies of a market-neutral fund, but they've delivered pretty good downside protection and absolute returns at less than half the projected cost of the proposed Vanguard Market Neutral Fund.A caveat: I'm not predicting that the end is nigh. I'll leave that to Jeremy Grantham, the famed Boston money manager who recently said he thought the stock market was a "slow-motion train wreck." Nor do I urge you to dump all your holdings and buy one of these funds. I still believe that the best safeguard against a bear market is to be a long-term investor with a sound long-term plan.
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But if the recent undulations have been giving you panic attacks in the shower or causing you to check out the return prospects of shoe boxes and mattresses, it may be time to re-evaluate your risk profile and perhaps consider funds like these.
Vanguard LifeStrategy Income
Vanguard LifeStrategy Income (VASIX) is a fund of funds that keeps most of its money in fixed-income portfolios: the Vanguard Total Bond Market Index (VBMFX) and Vanguard Short-Term Investment-Grade (VFSTX) funds.But its equity stake can vary from 5% to 30% depending on the asset-allocation calls of Tom Loeb and his team at Vanguard Asset Allocation (VAAPX). This last fund gets 25% of LifeStrategy's assets devoted to equity investments. The Vanguard Total Stock Market Index (VTSMX) fund gets the rest of the LifeStrategy's stock holdings.
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Loeb uses quantitative models to figure out how much of his portfolio to devote to S&P 500 Index ($INX) stocks and the Lehman Bros. Long-Term Treasury Index, and his calls have been consistent and accurate over the years. (Loeb's fund has about three-fourths of its assets in stocks, so this fund's equity allocation hangs around 20%.)
That gives this conservative fund a little upside potential, but it's really designed to preserve capital and generate income. The fund's bear-market rank is better than 97% of its conservative-allocation-category peers. In the third quarter through Aug. 28, it eked out a small gain that put it ahead of 96% of its peer group.
Continued: Two funds for risk-tolerant investors
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