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S U MM ER 2 0 1 2 In The Vanguard ® A conversation with Vanguard clients on the global economy Peter Westaway (left) and Roger Aliaga-Díaz during a live webcast on vanguard.com. Vanguard economists Roger Aliaga-Díaz and Peter Westaway addressed clients’ questions about the global economy in a live international webcast on June 21. Clients submitted questions by e-mail and answered online polling questions about their own views. In This Issue page 3 Is it a different world when it comes to investing? Vanguard CEO Bill McNabb says no—the classic principles of investing still apply. page 5 Among their top concerns were the outlook for the U.S. economy and the European debt crisis. Mr. Aliaga-Díaz spoke from Vanguard headquarters in Malvern, Pennsylvania, and Mr. Westaway spoke from London. The discussion was moderated by Rebecca Katz, a principal in Vanguard’s Corporate Strategy Department. What follows are edited excerpts (you can see a full replay at vanguard.com). Risks to the U.S. economy Ms. Katz: Roger, I thought maybe you could share Vanguard’s views on the outlook for the U.S. economy. Mr. Aliaga-Díaz: Clearly, since the beginning of the year, we’ve been saying that our view on the economy is one of cautious optimism, which basically means positive economic growth but with reservations. First of all, we expect the U.S. economy to keep growing at a pace that is really modest by historical standards. Since the beginning of the recovery in 2009, gross domestic product, after inflation, has been advancing at the pace of 2% per year, which is half of the normal rate of growth during typical recoveries in the United States. So, positive growth, but a trend of weak growth; and that has implications also for the labor market in terms of slow progress with jobs and employment rates. continued on page 12 > Connect with Vanguard® > vanguard.com > 800-276-7230 A bear market in bonds: Likely less vicious than a stock market mauling. pages 8–9 When it comes to investing for retirement, Vanguard research suggests more saving trumps risk-taking. page 14 Want to help the children in your life learn about money? Tell their teachers about My Classroom Economy. CONTENTS FUND NEWS Managing Your Wealth Vanguard closes High-Yield Corporate Fund page 3 Uncertainty in the markets is nothing new. CEO Bill McNabb shares four principles of investing that apply in any market weather. page 4 With numerous tax breaks set to expire at year-end, we could face higher taxes in 2013. But the picture is still far from clear. page 5 While a bond bear market wouldn’t be any fun, it likely wouldn’t be as nerve-wracking or volatile as an equity bear market. page 6 Estate taxes are scheduled to jump in 2013. Take time now to review your estate plan— and watch out for these common mistakes. Investing Your Money pages 8–9 If you’re looking to beef up your retirement account, consider using a powerful lever that’s already in your tool kit: saving more. Vanguard High-Yield Corporate Fund was closed to new investors as of May 24, 2012, to curtail strong cash inflows. The fund, which is the industry’s third-largest high-yield corporate bond fund, had received cash flow totaling $2 billion over the previous six months. Vanguard determined that limiting new cash flow would protect the interests of shareholders by preserving the advisor’s ability to manage the fund effectively. Existing fund shareholders may make additional purchases without limit. Vanguard will monitor cash flows and take additional steps if needed to limit the size of the fund, which had $17 billion in net assets at the end of May. ■ Contingent redemption fees eliminated for 33 funds Earlier this year, Vanguard announced that 33 funds would no longer charge contingent fees on sales of their shares. These fees had applied to redemptions that occurred within a specified period after the shares were acquired. The funds’ trustees determined that the fees, which were among several measures in place to discourage frequent trading, were no longer needed. At the same time, Vanguard announced that both the purchase and redemption fees for the FTSE All-World ex-US Small-Cap Index Fund were being reduced from 0.75% to 0.50%. ■ pages 10–11 Mediocre returns have left some investors searching for more. But performance-chasing comes with its own set of risks. AT A GLANCE At Your Service page 14 Spread the word about My Classroom Economy and help kids everywhere learn about dollars and discipline. (Hey, teachers—it’s free!) Market Barometer page 15 A summary of financial markets’ performance. The Vanguard Viewpoint page 16 Remembering PRIMECAP’s Howard Schow, “the greatest investor you’ve never heard of.” Gus Sauter, Vanguard’s chief investment officer, to retire December 31 George U. “Gus” Sauter, managing director and chief investment officer of Vanguard, announced in late June that he will retire at the end of 2012. Mr. Sauter, who joined Vanguard in 1987, played a major role in the company’s rise to leadership in indexing. He currently directs Vanguard’s global investment management groups, which oversee aggregate assets of $1.6 trillion of Vanguard’s $2.1 trillion in global assets. Mortimer J. “Tim” Buckley, managing director, will become chief investment officer upon Mr. Sauter’s retirement. Mr. Buckley joined Vanguard in 1991 and has been a member of Vanguard’s senior staff since 2001. He discusses his investment perspectives and the new role he will assume in an interview at vanguard.com/buckley. ■ Vanguard’s Bob Auwaerter named to Fixed Income Analysts’ Hall of Fame On April 19, Bob Auwaerter, principal and head of Vanguard Fixed Income Group, was named to the Fixed Income Analysts Society’s Hall of Fame. Mr. Auwaerter has been at Vanguard since 1981. He currently has oversight management responsibility for all money market and bond portfolios managed by the Fixed Income Group, with total assets of approximately $650 billion. ■ Note: All investing is subject to risks. Past performance is not a guarantee of future returns. Investments in bond funds are subject to interest rate, credit, and inflation risk. Because high-yield bonds are considered speculative, investors should be prepared to assume a substantially greater level of credit risk than with other types of bonds. 2 In The Vanguard > Summer 2012 MANAGING YOUR WEALTH Vanguard CEO: There’s no ’new normal’—just the old investing truths This article is adapted from a guest editorial written by Chairman and CEO Bill McNabb for USA Today. It was published on May 11, 2012. It’s a tough time to be an investor—or so you’ve been told. Volatile markets, historically low bond yields, a shaky global economy, and an uncertain outlook for the future have prompted some in the financial community to raise the alarm: “It’s different this time.” “It’s a new normal.” “It’s a brave new world.” It’s a provocative message. It’s compelling. But I believe it’s wrong. A brave new world? Not really I recognize that investors have genuine concerns, and that the past decade’s volatility has scared young people, in particular, away from stocks. According to an October 2011 article in Forbes, 40% of investors in “Generation Y”—between ages 18 and 30—agree with the statement “I will never feel comfortable investing in the stock market.” Unfortunately, a few of our competitors have actually fanned the flames of investor anxiety. Playing on Americans’ understandable fear of losing money, they’ve created a host of novelty products and strategies, all but predicting success—or, at the very least, a modicum of safety. If you know anything about Vanguard, you know that’s not our style. We’re guided today by precisely the same philosophy that has served us and our client-owners well for nearly 40 years. True, some people think messages like “stay the course” and “tune out the noise” are boring. But if dedication to enduring and time-tested truths is boring, then Vanguard is happy to be boring. (I prefer to think of us as consistent.) I started working at Vanguard shortly before the 1987 “Black Monday” crash, and I became CEO a few weeks before the global downturn that began in September 2008. I’ve witnessed breathtaking advances and painful declines. What I’ve learned along the way is that the markets have always been volatile and uncertain. Bill McNabb Ultimately, though, history and experience make a powerful case for thinking simply and getting back to “first principles,” as Frank Lloyd Wright put it. Four guiding principles Whether in architecture or investing, it’s important to build on a solid foundation. That’s why we tell investors to consider a balanced portfolio with diversified exposure to the three primary asset classes: stocks, bonds, and cash. Second, save more than you think you’ll need, particularly where retirement is concerned. How much? Well, the right answer is different for everyone, but our experts at the Vanguard Center for Retirement Research believe that between 12% and 15% of your take-home pay is a good rule of thumb. If you can’t afford to save that much right now, start where you can and increase as your circumstances allow. Third, keep an eye on costs. Spending less money on your investment provider can lead to a higher overall savings rate. And even a 1% boost in your annual savings may compound dramatically over time. The fourth and final principle: Have a plan, and stick to it. When the markets are unsteady, investing requires discipline and confidence. I believe the secret to being a successful investor is that there really is no secret. It comes down to making some basic decisions: How to invest. How much to invest. How much to pay to invest. And how long to invest. It doesn’t get much simpler—or more fundamental—than that. ■ Note: Investments in bond funds are subject to interest rate, credit, and inflation risk. Connect with Vanguard > vanguard.com > 800-276-7230 3 MANAGING YOUR WEALTH ’Taxmageddon’: Be aware, but don’t panic Federal Reserve Chairman Ben Bernanke has called it “a massive fiscal cliff” and the media have begun to refer to it as “taxmageddon.” John Kilroy At the end of 2012, many of the tax breaks established during President George W. Bush’s administration are set to expire. In addition, new Medicare-related taxes for higher income brackets are scheduled to take effect in 2013. In total, the changes could amount to the biggest tax increase in American history. Or maybe not. There are a number of possible scenarios, including the chance that Congress could extend the current tax breaks for a time. But the resolution likely won’t come for several months. James Delaplane Contending with uncertainty “While there may be some noise around changes to tax policies this summer, it’s very unlikely that any real action will come until after November’s election,” said James Delaplane, who leads Vanguard’s government relations office. “The most likely outcome is a short-term extension of the Bush tax cuts while policymakers debate broader reforms to the tax code. The worst-case scenario is that we won’t know what the rules are for 2013 until after the year has already begun.” Changes to the taxation of capital gains and dividends are likely to be a primary concern for investors. Generally, investors now pay a maximum rate of 15% on long-term capital gains and qualified dividends. However, if Congress takes no action, the maximum capital gains tax rate will increase to 20% in 2013, while the maximum rate on dividends will jump as high as 39.6%. In addition, individuals with modified adjusted gross income above $200,000 (or married joint filers with MAGI above $250,000) may pay an additional 3.8% tax on net investment income, such as most long-term capital gains, interest (excluding municipal bond interest), and dividends that exceed those threshold amounts, as a result of the Affordable Care Act of 2010. Scheduled increases to all marginal tax rates and the return of various phaseouts (for personal exemptions and itemized deductions) may also affect the amount of tax due. Understandably, you may feel worried about all this. But avoid the temptation to make rash decisions based on speculation about what might happen, said John Kilroy, a senior wealth planner in Vanguard Asset Management Services™. Whether it’s market volatility or tax-law uncertainty, generally Vanguard believes your best strategy for coping is to stay focused on sound financial planning principles, he said. “If we let emotions dictate, we can end up making financial decisions we later regret,” Mr. Kilroy said. Keep sight of the big picture Regardless of what happens in Washington, here are a few timeless rules to keep in mind. tDon’t let the tax tail wag the dog. Make sure any tax-related decisions are truly in line with your long-term financial goals. For example, are you choosing to recognize capital gains this year because it’s a good move for your portfolio? Or simply because you’re speculating that rates are headed up? tRecognize that tax planning is a year-round commitment. It’s important to keep taxes in mind throughout the year, not just at the end. That gives you plenty of time to evaluate your situation and make necessary changes. tAsk a tax pro. “Everyone’s situation is unique, so it’s hard to make generalizations,” Mr. Kilroy said. “If you have questions about your particular situation, consult a tax professional or a financial advisor.” ■ Notes: The information provided here is for educational purposes only and isn’t intended to be construed as legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation. Vanguard Asset Management Services are provided by Vanguard National Trust Company, which is a federally chartered, limited-purpose trust company operated under the supervision of the Office of the Comptroller of the Currency. 4 In The Vanguard > Summer 2012 MANAGING YOUR WEALTH A bear market in bonds may not be as grisly as you think The term “bear market” refers to a sustained drop in the prices of stocks or bonds. The similarity ends there, just as there’s a difference between a panda and a woodland grizzly: Both can be dangerous if disturbed, but the grizzly much more so. “It’s the magnitude of returns that is the key differentiator,” says Fran Kinniry, a senior member of Vanguard’s Investment Strategy Group. “Stocks can earn a lot more than bonds, but they also can decline more ferociously.” Another difference is that it’s easier to pinpoint what typically triggers a bond price decline: an increase in interest rates. the bond’s duration (and vice versa). Note that this rule of thumb assumes an instantaneous rise for all interest rates, a rare event. When will rates rise? Nobody knows. “No one thought that money market funds would be yielding 0% for so long,” Mr. Kinniry says. “And Japan has been stuck in a low-rate environment for two decades.” Fran Kinniry Inflation, often a primary driver of increases in interest rates, has been fairly tame. For the products Americans buy, prices on average have actually declined, Mr. Kinniry says, despite “wallet inflation.” He’s referring to highly visible costs, such as for groceries and gasoline, that make inflation seem far worse than it really is. A long record of limited declines The difference between the two types of bear markets is striking. The worst 12-month span for U.S. bonds since 1926 was the period ended September 30, 1974, when the broad bond market returned about –14%. The worst period for U.S. stocks, the 1930s aside, were the 12 months through February 2009, when they returned about –40%.1 “A bear market in stocks is often defined as a 20% drop in prices,” Mr. Kinniry says. “A bear market in bonds is simply a period of negative returns.” A rule of thumb to help shape expectations The potential for price declines depends on a bond’s “duration” or, for bond mutual funds, the average duration. (For durations of Vanguard bond funds, visit vanguard.com.) Duration is a rough gauge of interest rate sensitivity: For each percentage-point increase in market rates, a bond’s price should fall over the next 12 months by a percentage about equal to Are rate worries beside the point? Rising interest rates can be viewed as bad news or good. Bond prices would fall, but holders of money market funds and short-term bond funds would see their income go up fairly quickly, and yields of all bond funds would rise. If you’re a longer-term bond fund investor, the immediate pain may eventually subside if your time horizon matches or exceeds your fund’s duration. Higher rates will then have time to work in your favor. To make that happen, you’ll need to reinvest your bond fund distributions to participate as your fund acquires new—and higher-yielding—bonds. Over time, this process can help offset, or more than offset, the impact of immediate price declines. It’s important to remember that, whether interest rates rise or fall, bonds can serve a vital function in any balanced portfolio by helping to cushion the impact of stock volatility. It’s a role investors should keep in mind no matter what rates are doing. ■ 1 Returns are based on these indexes: For U.S. stocks, the Standard & Poor’s 90 (1926–March 3,1957), the S&P 500 Index (March 4, 1957–1974), the Wilshire 5000 Index (1975–April 22, 2005), and the MSCI US Broad Market Index thereafter. For U.S. bonds, the S&P High Grade Corporate Index (1926–1968), the Citigroup High Grade Index (1969–1972), the Lehman Brothers U.S. Long Credit Aa Index (1973–1975), and the Barclays U.S. Aggregate Bond Index thereafter. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Note: Investments in bond funds are subject to interest rate, credit, and inflation risk. Connect with Vanguard > vanguard.com > 800-276-7230 5 MANAGING YOUR WEALTH Avoid these five common estate planning mistakes An expected jump in federal estate taxes next year has prompted many people to take a second look at their estate plans. If Congress takes no action, the maximum estate tax rate will jump from 35% to 55% in 2013. Alisa Shin Other taxes may change next year too— see page 4. If you plan to leave your heirs more than $1 million, it’s certainly a good idea to consult an estate planning attorney about your best course of action, said Alisa Shin, a senior wealth planner with Vanguard Asset Management Services. And even if your estate will have fewer assets, this may still be an opportune time to make sure your estate plan is current and reflects your wishes, Ms. Shin said. So now that you’re thinking about it, here are five common—and potentially costly—mistakes to watch out for. Not updating your estate plan. Experts recommend that you review your estate plan every three to five years to make sure it reflects changes in your family and financial circumstances, as well as changes in the law. “A lot of people think that after they go to a lawyer and prepare a will and power of attorney, they sign it and they’re done,” said Ms. Shin. “That is not quite correct.” Look over your will and other estate-related documents after each birth, death, marriage, or divorce in the family. Any substantial change in your finances—whether because of a stock market decline, a job change, or retirement— should prompt a checkup. Beneficiary designations in retirement plans, for example, don’t automatically transfer when you roll over your 401(k), open an IRA, or switch from a traditional IRA to a Roth IRA. 6 In The Vanguard > Summer 2012 It’s also important for your estate plan to take into consideration potential future changes to estate laws. The potential decline in federal estate tax exemptions from $5 million this year to $1 million next year could affect your tax liability and may influence how and when you distribute your assets. Ignoring conflicts between your estate plan and other beneficiary designations. If your will states that your home and retirement account go to your current husband, but your ex-husband’s name is on the deed and your 401(k) plan, there’s a problem. The deed and the beneficiary designation will likely trump what’s in your will. Unless your property titles—for both real estate and other kinds of assets—and beneficiary designations are consistent with your trust or will, they may not be subject to those expressed wishes. Not specifying who inherits your estate and how. Say, for example, you planned on dividing your assets equally among your three children. But your son predeceases you. Unless your will states that each child’s branch of the family gets an equal share, or that your son’s share of your estate should be distributed to his own children, your two daughters will inherit everything when you are gone. Even if your will makes clear that your son’s children should inherit, you may not want them to receive the assets outright if they are minors. Should their shares be placed in a trust? You may want to discuss this with your family or lawyer. Writing an inflexible estate plan. A rigid estate plan cannot adapt to changes in the law or family circumstances. If your plan was designed to take advantage of certain tax criteria, and those laws change, you want to make sure your heirs can amend it. “Make sure there is some room for flexibility in your documents,” said Ms. Shin. “Circumstances change, and many want their families to be able to adapt and manage the family assets in the most optimal way at any given point in time.” Letting emotions guide your choice of an executor. If your beloved eldest son, a high-powered lawyer, doesn’t get along with his five siblings and vehemently disagrees with your end-of-life directives, he may not be the best person to choose as executor or surrogate health care decision-maker. “Your fiduciaries don’t need to be experts in tax law,” said Ms. Shin. “They just need to be smart enough to know when to go get help and where to go to get help.” ■ 401(k) plans are becoming more transparent to participants If you participate in an employer-sponsored 401(k) plan, you’re about to learn more about what you’re paying to save for retirement and how your investments are performing. Under new U.S. Department of Labor regulations that go into effect this summer, retirement plan sponsors are required to disclose more fee and investment information to participants. The goal is to help people make better-informed choices about investing the money in their retirement accounts. The new requirements include enhanced annual and quarterly disclosures to plan participants and beneficiaries. The annual notice. Once a year, participants must be provided with general plan information, administrative and individual expense information, and investment information presented in the form of a comparative chart. Sponsors of 403(b) plans also will need to provide this notice to all eligible participants and beneficiaries, regardless of whether the plan currently has one or multiple service providers. If there are multiple providers, the regulations require that participants receive certain investment information from each provider simultaneously. For example, the comparative charts from all providers must be mailed together. The quarterly notice. Four times a year, a plan must disclose the dollar amount deducted from each participant’s account to pay any administrative and individual expenses. Participants must receive a description of fees expressed both as a percentage of an investment and as the actual dollar cost of a $1,000 investment. In addition, the regulations require the disclosure of historical performance data over one-, five-, and ten-year periods. For most plans, the initial fee disclosure notices must be provided by August 30, 2012. If you’re a plan participant, look for yours in the mail soon. ■ Connect with Vanguard > vanguard.com > 800-276-7230 7 INVESTING YOUR MONEY Harnessing the power of ’a penny saved’ Maria Bruno You can find the research paper Penny Saved, Penny Earned at vanguard.com/research. Modern portfolio theory—the concepts that underlie most financial thinking today—would argue that an aggressive allocation to stocks should generate higher returns over time than a comparable holding of lower-risk assets such as bonds. The flip side, of course, is greater risk of loss. During “the lost decade” of 2000–2009, which left the broad U.S. stock market under water, that risk came home to roost. The lesson was especially hard on investors closer to retirement who had a significant allocation to equities and were counting on “average” returns from stocks to reach their goals. A recent Vanguard study points out that some of the most reliable and powerful levers in your retirement toolkit have less to do with modern portfolio theory than with Benjamin Franklin. The study, Penny Saved, Penny Earned, illustrates that investors who increase risk with the objective of gaining higher returns might actually be less likely to meet their retirement goals than those who simply save more, whether by starting earlier or by saving at a higher rate. Maria Bruno, a Vanguard investment analyst who coauthored the study, noted, “The markets over the past few years have been a reality check for investors. In saving for retirement, it’s better to focus on the things you can control—when you start to save and how much you save—because that’s going to be the most reliable way to succeed in meeting your goals.” Looking at what you can control The study used the Vanguard Capital Markets Model® (VCMM) to simulate investment returns using various assumptions about salaries, asset allocations, and contributions. One data set from the study is shown in the accompanying table: a hypothetical 35-year-old investor planning to retire at age 65 who puts 12% of an annual salary into a retirement portfolio with a moderate asset allocation (50% stocks and 50% bonds).1 After 10,000 simulations based on different potential scenarios, the investor’s median inflation-adjusted balance at retirement was about $475,000. The study then examined the impact that each of three investment levers—portfolio risk, savings time horizon, and savings rate—could have on the investor’s portfolio balance at retirement. Behind door number 1—a 22% increase Asset allocation—the portfolio’s balance of riskier and safer assets—has been proven by a number of studies to be a powerful driver of portfolio performance over time.2 Choosing a more aggressive asset allocation (80% stocks and 20% bonds) would increase the investor’s median balance at retirement by 22%. It’s worth noting, however, that with this allocation the “worst-case” outcome is a much lower balance at retirement than the 50%/50% portfolio produced in its own worst case. 1 More details about the data and assumptions used in the calculations are provided in the paper Penny Saved, Penny Earned, available at vanguard.com/research. 2 The classic study is “Determinants of Portfolio Performance” by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower (Financial Analysts Journal, 1986). Related research includes the Vanguard paper The Asset Allocation Debate: Provocative Questions, Enduring Realities, available at vanguard.com/research. 8 In The Vanguard > Summer 2012 And door number 3—a 51% increase Save sooner, save more As the study shows, saving earlier and saving more are things you can control. Independently or together, they are more likely to help you reach your retirement goals than adding riskier assets in the hope of getting higher returns. While investors nearing retirement and facing a shortfall might be tempted to move more aggressively into stocks to try to catch up, a less risky option would be to keep working and keep saving. If you delay retirement by even a few years, the extra savings coupled with not spending from the portfolio can make a material difference in helping to fill the gap. Door number 2—a 25% increase As Ben Franklin would have guessed, the power of compounding has the potential to be the most effective strategy. By starting to save ten years sooner, even with the 50%/50% allocation and the 12% saving rate, our investor would have garnered 51% more, with a median balance of almost $720,000 at retirement. Ben’s adage holds true for costs, too Another way to save more for retirement is to make sure your investment costs are low. All else being equal, if you switch from a portfolio charging 1.0% to one charging 0.3%, you’ll effectively increase your savings rate by 0.7%—without even opening your wallet. ■ Adding more savings to the portfolio—in this case, contributing 15% of an annual salary rather than 12%—would result in a median balance 25% higher than the initial one, according to the VCMM simulations. Looking at the levers: How allocations and saving habits can affect investment outcomes Median level of wealth accumulated by age 65* Initial retirement plan ▲ ▲ ▲ &GGFDUPOQPSUGPMJPCBMBODF BUSFUJSFNFOUGSPNDIBOHJOH POFJOWFTUNFOUMFWFS Moderate asset allocation 12% savings rate Investor begins saving at age 35 t "HHSFTTJWFBTTFUBMMPDBUJPOJOTUFBEPGNPEFSBUF t TBWJOHTSBUFJOTUFBEPG t *OWFTUPSCFHJOTTBWJOHBUBHFJOTUFBEPGBHF $474,461 *Adjusted for inflation, calculated using median historical returns from stocks and bonds. These results are hypothetical and do not represent any particular mutual fund or other investment. Source: Vanguard, based on VCMM calculations. Important: The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. The asset return distributions discussed are drawn from 10,000 VCMM simulations based on market data and other information available as of December 31, 2010. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. Note: There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk. Connect with Vanguard > vanguard.com > 800-276-7230 9 INVESTING YOUR MONEY By any other name, it’s still performance-chasing—and it’s risky Christopher Philips “When in doubt, diversify.” That investment adage contains a lot of sense. Unfortunately, even such sage advice can undermine an investor’s long-term success if it’s used to justify short-term performance-chasing in the name of diversification. “Doubt” has defined the investment environment for more than a decade as the dot-com collapse, the worst financial crisis since the Great Depression, and disappearing bond yields rattled investors’ nerves. Portfolios that were broadly diversified among stocks and bonds have held up reasonably well, but for investors who remember returns from the 1980s and ’90s, the recent performance hasn’t been strong enough to dispel doubts about traditional investment strategies. (A portfolio with 60% of its assets in the broad U.S. stock market and 40% in the broad U.S. bond market would have returned a bit less than 4% a year, on average, from the end of 1999 to the end of 2011.)1 This doubt has sent some investors in search of opportunities to boost the returns of their portfolios. New horizons, familiar hazards Where have investors found these presumed opportunities? “If you look at cash-flow numbers, the biggest outflows have been from money market funds and broad U.S. stock funds, both of which have performed below expectations over the short and intermediate term,” said Christopher Philips, a senior analyst with Vanguard’s Investment Strategy Group. “And where have we seen the biggest inflows? Basically, investors have been adding credit and interest rate risk by moving from money markets into various bond funds. At the same time, they’ve been potentially increasing their volatility and downside risk by moving into more narrowly focused, riskier assets that have performed well.” The trend is clear in the numbers. Vanguard calculations using Morningstar data show that investors have pulled $172 billion from U.S. stock funds and ETFs over the past three years and are putting money into riskier sector funds and ETFs ($74 billion in net inflow); emerging markets equity funds and ETFs ($110 billion in net inflow); and alternatives such as commodities, currency, and leveraged products ($142 billion in net inflow). Meanwhile, money market funds have seen $1 trillion exit, while cash has moved into funds focusing on intermediate-duration bonds (capturing $250 billion), global bonds ($69 billion), high-yield bonds ($57 billion), and emerging-market bonds ($35 billion). 1 Past performance is not a guarantee of future results. This return is based on an index weighted 60% Dow Jones Wilshire 5000 Index and 40% Lehman Brothers U.S. Aggregate Bond Index through May 31, 2005, then 60% MSCI US Broad Market Index and 40% Barclays U.S. Aggregate Bond Index through December 31, 2009, after which the Barclays index was replaced by the Barclays U.S. Aggregate Float Adjusted Index. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 10 In The Vanguard > Summer 2012 More diversification can help to lower risk in a portfolio, and these more narrowly focused funds may play a part, either by filling in gaps to make the portfolio more balanced or by representing assets that tend to move differently from existing holdings in order to reduce overall volatility. For example, it may make sense for investors who have no exposure to, say, emerging markets or the energy sector to round out their portfolios in these areas if their investment horizon and risk tolerance allow. But the amount of money now flowing into such narrow segments of the financial markets suggests that the trend has less to do with adding diversification than with jumping on the performance bandwagon. Remember: The risks you take are real “I don’t think we can sugarcoat it,” said Mr. Philips. “If investors are putting significant amounts of their assets into narrowly focused funds to boost returns relative to a broadly diversified portfolio, they need to know that this can actually mean less diversification, higher risk, and an increased chance of falling short of reaching their long-term financial goals.” Investing more broadly can be a smart move— but keep in mind that the power of diversification lies more in reducing risk than in turbo-charging returns. ■ Net cash flows in equity mutual funds, including ETFs, and alternative investments, 2009–2011 In billions of dollars U.S. stock funds (non-sector) –$172 Sector funds $74 Emerging-market funds $110 Alternatives (commodities, currency and leveraged products, etc.) –$200 –150 –100 –50 $142 0 50 100 150 200 Sources: Vanguard and Morningstar data. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. You must buy and sell ETF shares through a broker, which may incur commissions. ETF shares are not redeemable directly with the issuing fund other than in Creation Unit aggregations. All ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value. Notes: Diversification does not ensure a profit or protect against a loss in a declining market. Stocks and bonds of companies in emerging markets are generally more risky than stocks of companies in developed countries. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Connect with Vanguard > vanguard.com > 800-276-7230 11 INVESTING YOUR MONEY continued from page 1 > About the economists Roger Aliaga-Díaz Peter Westaway Roger Aliaga-Díaz is a senior economist with Vanguard’s Investment Strategy Group. His areas of expertise are monetary policy, international macroeconomics, and finance. Before joining Vanguard in 2007, Mr. Aliaga-Díaz was a visiting professor of macroeconomics at Drexel University’s LeBow College of Business. He earned a B.A. in economics from Universidad Nacional de Córdoba, Argentina, and a Ph.D. in economics from North Carolina State University. Peter Westaway is Vanguard Asset Management’s chief economist for Europe. Based in London, he provides Vanguard’s perspective on European economic issues and their investment strategy implications. Mr. Westaway was previously chief economist–Europe for Nomura International and a senior official with the Bank of England. He holds a Ph.D. in economics from the University of Cambridge, which also awarded him a master’s degree, and he has an undergraduate degree in mathematics and economics from the University of York. And the second reservation relative to this cautious optimistic outlook is related to the very same risks that we are polling our audience about. Those include concerns about federal budget deficits and the European debt crisis. Even if the worst-case scenario for these risks doesn’t actually happen, all of the uncertainties may already be impacting businesses’ decisions in terms of hiring, in terms of capital spending, and even consumers’ spending plans, too. Ms. Katz: We have our poll results about what the audience thought would be the biggest risk to the U.S. economy. It looks like the majority of folks, 57.5%, said federal budget deficits. So we’re really concerned about our own debt issues. Mr. Aliaga-Díaz: And there are two dimensions to this risk. One is long-term, the sustainability of U.S. debt on a long-term basis. And there is also another dimension—which is really short- 12 In The Vanguard > Summer 2012 term, at the end of this year—around the so-called fiscal cliff. Unless Congress does something to avoid it, there are going to be massive, automatic tax increases and reductions in federal spending. So it’s a double risk that clearly people are concerned with. Will the Eurozone survive? Ms. Katz: Now we have a ton of questions about Greece, and we’re going to dive into those, but first let’s see what our audience thought about the future of the Eurozone. We asked, “Will the Eurozone survive?” Sixtytwo percent of our audience said yes, but only with major reforms, including a possible Greek exit. Does that result surprise you, or do you think that’s the most likely scenario, Peter? Mr. Westaway: I do think the Eurozone will survive, but I think major reforms are necessary. As it happens, I think Greece will still just about stay inside the monetary union, but I don’t think that’s a certainty at all anymore. I mean, if you’d have asked me a year ago, I’d have said the chance of any country leaving was pretty small. Now, it’s almost a coin toss whether Greece leaves or not. And I think the reason for that is simply, if they were to leave, it would change the nature of the monetary union. It suddenly becomes a sort of reversible arrangement that people can check in and out of. And that really changes matters for other countries like Spain and Italy. And that’s why we’re getting so much market pressure at the moment on those countries. Ms. Katz: Our next question pivots from this discussion. It’s from Boris in San Francisco, California, and he asks, “What’s the probability of the euro currency failing and countries returning to national currencies?” Mr. Westaway: If you ask me to put a probability on the euro unraveling, I’d say it’s a relatively small number but a lot higher than I used to think. I’d say 10%, 15%. I’d say the chance of one country, like Greece, leaving the euro is a slightly higher probability, perhaps 40%, 35%, something like that. So the numbers are much more worrying than they used to be. But I still think, in the end, policymakers in Europe know how difficult it would be if countries did start peeling off and, worse, if the euro area did unravel. So that’s why I think the policy response in Europe is going to be whatever is necessary to stop that from happening. Are central bankers risking runaway inflation? Several clients’ questions focused on the extraordinary steps the U.S. Federal Reserve and other central banks throughout the world have taken to stimulate economic growth. At various times in recent years, central banks have pursued a policy of “quantitative easing,” or “QE,” in which the banks buy financial assets to inject money into the economy. Critics contend that these moves could spur runaway inflation. Some observers have even speculated that central banks may be purposely courting high inflation because it would, in effect, make it cheaper for countries to pay their debts. Mr. Westaway: As a former Bank of England official myself, this was the sort of question that was asked a lot when the Bank of England first started rolling out QE. And I think the key point is that the purpose of QE is to prevent inflation from being too low or from straying into deflation territory. So the whole purpose of it is to generate enough inflation to offset the deflationary pressures. Of course, if you get it wrong, you’ll generate too much inflation, but that’s not the purpose. Some people think there’s a conspiracy—that this is a backdoor way of inflating away the debt. But that’s simply not the case. The risk that inflation is going to get out of hand because of loose monetary policy is, I think, sometimes overplayed by market participants. Mr. Aliaga-Díaz: And I’d like to [speak to] this idea that it’s somehow convenient for the government to inflate its way out of debt. That may have worked in the past, especially after the huge amounts of debt in World War II, but it may not work this time around. Even if the government managed to increase inflation, that wouldn’t decrease borrowing, because much of the government spending is actually inflationlinked. If you started to think in terms of Social Security payments, Medicare payments, even the salary paid to a schoolteacher, everything is linked to inflation. So the more the government inflates, the more borrowing it needs to do to fund the spending. ■ Connect with Vanguard > vanguard.com > 800-276-7230 13 AT YOUR SERVICE Tell a teacher! Here’s a free, fun program on dollars and sense At myclassroom economy.org, teachers can download materials for free and see how the program links to national curriculum standards. Megan Kauffman’s fourth graders at Stephan A. Decatur Elementary School in Northeast Philadelphia rent their desks, maintain bank logs, earn salaries for performing classroom jobs, pay bills, and spend some of their earnings at classroom auctions. Students across the country, at all grade levels, are doing the same. And there’s room for many more to get involved—using materials that teachers can get online for free. Vanguard hopes you’ll spread the word to all the teachers and educators you know. It’s all part of My Classroom Economy, a financial education program created at Vanguard and based on concepts by awardwinning teacher Rafe Esquith, the author of There Are No Shortcuts, Teach Like Your Hair’s on Fire, and Lighting Their Fires. By simulating an actual economy, the program provides realworld lessons that can last a lifetime, and it does so in a way kids enjoy. “It’s wonderful,” Ms. Kauffman said of the program. “It’s unbelievable what these kids know now about money.” Paying off the mortgage My Classroom Economy caters to students from kindergarten through 12th grade. The program’s concepts become more sophisticated as students progress in school. When they reach the upper grades, students can open a simulated retirement account and invest their classroom “dollars” in a personal asset mix of stocks and bonds. Mr. Esquith has had years of experience and success reaching his fifth-graders at Hobart Elementary School in Los Angeles. Through his books and media coverage, his ideas have spread to schools throughout the country. Shannon Nutter-Wiersbitzky, a Vanguard manager, learned about the program when her fourth-grade son, Ryan, wondered aloud when he’d be able to pay off his “mortgage.” 14 In The Vanguard > Summer 2012 “It was a simple question at the dinner table,” she said. “The program had made enough of an impact that he was talking about it at home.” Intrigued and impressed, Ms. Nutter-Wiersbitzky contacted Ryan’s teacher, and he introduced her to Mr. Esquith’s concepts and books. Through Ms. Nutter-Wiersbitzky, Vanguard came on board and a partnership with Mr. Esquith was formed. About 40 Vanguard crew members are involved in the project. “We want to make it accessible to all teachers,” Ms. Nutter-Wiersbitzky said. “One of the special things about the program is it allows kids to repeat and practice skills they otherwise wouldn’t get the chance to practice.” Spreading the word There’s a real need for financial education in the nation’s schools. Nearly half of adults grade their knowledge of personal finance as a C, D, or F, according to the 2012 Consumer Financial Literacy Study. A broader lesson of My Classroom Economy— one that kids can take into adulthood—is that there’s a great benefit to delaying gratification. Ms. Kauffman’s class is grasping and enjoying all that My Classroom Economy has to offer. Plans are under way to roll it out to the entire school. “I keep telling all my friends to tell their friends,” Ms. Kauffman said. ■ MARKET BAROMETER Second quarter 2012 Total Returns: Periods ended June 30, 2012 Annualized An anxious three months After an ebullient first quarter, U.S. stocks faltered in the second. The broad market returned –3.21% as measured by the Dow Jones U.S. Total Market Index. International stocks pulled back more sharply, reflecting investors’ apprehension about the Eurozone’s debt crisis. Many sought shelter in bonds. The taxable and municipal U.S. bond markets delivered solid second-quarter returns, as investors bid up prices and drove down yields. The returns of 3-month U.S. Treasury bills hovered near 0%, consistent with the Federal Reserve’s target for the shortestterm interest rates. Three months One year Three years Five years Ten years Dow Jones U.S. Total Stock Market Index –3.21% 3.78% 16.84% 0.63% 6.16% MSCI All Country World Index ex USA (International) –7.61 Stocks The wait is over. As global turmoil and Federal Reserve policy have driven bond yields to historical lows, the old pecking order has been restored. At the end of the second quarter, the S&P 500 Index yielded 2.08% based on its trailing 12-month dividends, exceeding all but the longest-term Treasury yields. The 10-year Treasury note yielded 1.62%. Operating P/E ratios drooped At the end of the second quarter, the S&P 500 Index’s price/earnings (P/E) ratio was about 14 based on operating earnings, which exclude extraordinary items and certain other items. Over the past 15 years, a period that includes the late-1990s tech bubble and the collapse in corporate profits in 2008–2009, the average operating P/E has been about 20. ■ 6.97 –4.62 6.74 Bonds Barclays U.S. Aggregate Bond Index (Broad taxable market) 2.06% 7.47% 6.93% 6.79% 5.63% Barclays Municipal Bond Index (Broad tax-exempt market) 1.88 9.90 7.62 5.95 5.28 Citigroup 3-Month U.S. Treasury Bill Index 0.02 0.04 0.08 0.87 1.77 The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Bond yields dip below stock yields Back to the future? 16% 12 Yield “In 1958, I’d been in the business for seven years when, for the first time in history, bonds yielded more than stocks,” the late Peter Bernstein explained to SmartMoney magazine in 2008. “My associates said, ‘It’s an anomaly, don’t worry, it will be reversed.’ It’s 50 years later, and I’m still waiting.”1 –14.57 8 4 0 Jan. 1955 Jan. 1965 Jan. 1975 Jan. 1985 Jan. 1995 Jan. 2005 S&P 500 Index dividend yield Yield of 10-year Treasury Sources: Standard & Poor’s and Vanguard. S&P 500 operating price/earnings ratio 30 30 28 15-year mean P/E Operating: 20.08 28 26 26 24 24 22 22 20 20 18 18 16 16 14 14 12 12 90 92 94 96 98 00 02 04 06 08 10 12 Last observation: June 30, 2012. Shaded areas indicate U.S. recessions. Sources: Standard & Poor’s; data are from Crandall, Pierce & Company. 1 The article is available at smartmoney.com/invest/markets/bullet-proof-your-portfolio-23867/. Connect with Vanguard > vanguard.com > 800-276-7230 15 THE VANGUARD VIEWPOINT The enduring legacy of PRIMECAP’s Howard Schow When Howard B. Schow died in April at age 84, the financial press called him “an unsung investing legend” and even “the greatest investor you’ve never heard of.” Of course, we at Vanguard had more than heard of Mr. Schow—we knew him well and were greatly saddened by his passing. Vanguard’s relationship with Mr. Schow dated back nearly 30 years to his co-founding of PRIMECAP Management Company and the launch of Vanguard PRIMECAP Fund. Over time, that relationship expanded, and ultimately Mr. Schow managed portions of four other Vanguard funds: PRIMECAP Core Fund, Capital Opportunity Fund, the Vanguard Variable Insurance Fund’s Capital Growth Portfolio, and the U.S. Opportunities Fund (which is available to non-U.S. investors). Vanguard is often linked publicly with index investing, but we also have a rich history of active investment management that dates to 1929, when the Wellington™ Fund was launched. Mr. Schow and his colleagues at PRIMECAP Management have made a distinguished contribution to that tradition. From its inception on November 1, 1984, through March 31, 2012, the PRIMECAP Fund had an average annual return of 13.08%; the S&P 500 Index’s average annual return was 10.72% during the same period. Mr. Schow’s strong record was based on a profound commitment to long-term investing— an enduring lesson for all investors. He and his colleagues sought out opportunities that would bear fruit over years, and then pursued those opportunities with discipline. Their patience was often rewarded, notably in the areas of technology and health care. We will always be grateful to Mr. Schow for his stewardship of client assets. Aside from his investment record, those at Vanguard who worked with Mr. Schow valued him greatly as a person. “Personally, I learned a great deal from Howard, and I will miss his perspective, his candor, and his balance of optimism and pragmatism,” Vanguard CEO Bill McNabb wrote in PRIMECAP Fund’s most recent report to shareholders. One of Mr. Schow’s lasting accomplishments is the deep and talented team of portfolio managers he helped to build at PRIMECAP Management. Noting that his co-managers have assumed responsibility for the assets he managed, Mr. McNabb said: “I am confident that they will continue to pursue the standards of excellence that PRIMECAP Management has become known for over the decades.” ■ Average annual total returns for periods ended 3/31/2012 PRIMECAP Fund (Investor Shares) One year Five years Since Ten inception years (11/1/1984) 2.95% 4.35% 6.24% 13.08% The performance data shown represent past results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance. Comments? Topics of interest? Write to us at [email protected]. For more information on Vanguard funds, visit vanguard.com, or call 800-276-7230, to obtain a prospectus. Visit our website, call 800-276-7230, or contact your broker to obtain a prospectus for Vanguard ETF ® Shares. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. Vanguard Brokerage Services is a division of Vanguard Marketing Corporation, Member FINRA. For information about Vanguard funds, Vanguard Brokerage Services®, or your account, call us toll-free Monday through Friday from 8 a.m. to 10 p.m. and on Saturday from 9 a.m. to 4 p.m., Eastern time: 800-600-4827. For automated fund and account information 24 hours a day, 7 days a week, call Vanguard Tele-Account®: 800-662-6273. Send your written comments to: Vanguard P.O. Box 2600 Valley Forge, PA 19482-2600 Overnight mailing address: Vanguard 455 Devon Park Drive Wayne, PA 19087-1815 S&P ®, S&P 500 ®, and 500 ® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and have been licensed for use by The Vanguard Group, Inc. The Vanguard mutual funds are not sponsored, endorsed, sold, or promoted by S&P or its Affiliates, and S&P and its Affiliates make no representation, warranty, or condition regarding the advisability of buying, selling, or holding units/shares in the funds. The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities. The prospectus or the Statement of Additional Information contains a more detailed description of the limited relationship MSCI has with Vanguard and any related funds. Morningstar data © 2012 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. P.O. Box 2600 Valley Forge, PA 19482-2600 © 2012 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. ITVC 082012