Small Caps in the Vanguard

05/05/2006 12:00 am EST


Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

When it comes to understanding Vanguard funds, no advisor is more informed than Dan Wiener , the leading expert on this fund family. In a recent special report, he focuses on the outlook for small-cap funds and highlights some of his current buys.

"You’d almost have to have been on a desert island not to know that funds investing in smaller stocks with an aggressive objective have been outpacing other funds over the course of the last several years. And, despite increasing calls by any number of market ‘strategists’ over the past 12 months for large-caps to take command, it hasn’t come to pass.

"Whether you measure from the bottom of the bear market, in October 2002, or just over the past 12 months, the numbers tell the same tale: Vanguard’s aggressive growth funds have been making mincemeat of the broad market index funds. And I would expect small-caps to continue to outperform until, at a minimum, the economy begins to slow dramatically. A little slowing, and slightly higher interest rates won’t hurt small-caps. But if it gets worse than that, investors may take their profits and move elsewhere—either into the relative safety of higher-yielding bond funds, or larger, better-known large-cap stocks.

"First, a warning. Investors should consider multiple time periods when assessing a fund’s performance, both up and down and should consider rolling returns showing both the average one-year, three-year, and five-year returns for each fund, as well as the absolute worst one-year, three-year, and five-year periods over the past decade. From this type assessment, there’s no question in my mind that Capital Opportunity is the clear winner, with Explorer and Strategic Equity as decent alternatives. There’s just one problem for new investors: they are closed.

"If you’re trying to fill a distinct small-cap piece of your portfolio, such as I’ve done for several of my private clients, buy my number one pick, PRIMECAP Odyssey Aggressive Growth (POAGX ). The PRIMECAP team operate as independent entities, each investing a portion of the portfolio, but all seeking the same types of companies: those with the potential for rapid earnings growth, but which are selling at a discount for one or more reasons. If the managers have done their homework properly (and they usually do), when a company’s fortunes turn, the stocks can take off on multiyear moonshots. The fund’s minimum of just $2,000 is a great deal.

"Strategic SmallCap Equity (VSTCX), the newest member of Vanguard’s quantitative fund line-up should be a chip off the old block, figuratively and practically. As its name implies, it will  focus exclusively on the small caps and be computer-driven by combinations of models developed under the direction of Gus Sauter and Joel Dickson. My best guess is that the pair have learned from the problems encountered during Strategic Equity’s early years and won’t be making those mistakes a second time.

"While some are calling for small-cap stocks to lose favor when long-term interest rates really rise (they haven’t yet) there could still be oomph in the small-cap rally. If so, this new fund will do quite nicely. If not, well, Vanguard has always said it doesn’t like to introduce funds just because particular market sectors are hot. Will Strategic SmallCap Equity’s launch mark the turning point in the small stock rally?

"I don’t know, but do know this fund should outperform a good number of its peers, and with Explorer and Equity both closed, it will be Vanguard’s only actively managed small-cap fund. Do not expect this fund to substitute for Equity, however. I would expect it to be more volatile. Also, would not expect it to get to $7 billion before closing. So, if you want in, you may want to put a minimum $3,000 here just to reserve a spot.

"And while I prefer active management, if you must index, than use the SmallCap Value Index (VISVX ). This fund, and the yield it generates, makes it an acceptable alternative. Financial and industrial companies are the biggest stakes in this fund, which now tracks the 950 or so stocks in a value subset of the Small Cap 1750 index. Companies in the two sectors represent more than 50% of assets which means that if the economy falters (which don’t think it will just yet) the stocks’ prices could be at risk.

"Remember, SmallCap Value Index charges a $10 annual account maintenance fee from smaller Vanguard shareholders. On a $3,000 minimum investment, that $10 increases the fund’s purported 0.27% expense ratio to 0.60%, still low but hardly the sub-30 basis points that is most often quoted. An alternative is to use the SmallCap Value VIPER (VBR ASE), an exchange traded fund."

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