March11 Vanguard Presentation

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The evolution of indexing: An active / passive discussion

March 9, 2011

Walter H. Lenhard, CFA Senior Investment Strategist Vanguard Quantitative Equity Group

Indexing philosophy

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Indexing philosophy

The success of index investing does not depend on market efficiency Beating the market is extremely difficult Costs matter By consistently earning the return of the broad market, you have the potential to outperform most investors

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The zero sum game means that after cost, a majority of dollars will underperform the costless market benchmark
The holdings of all investors aggregate to form a market Outperformance by one, necessarily means underperformance by another The key to increasing the likelihood of remaining on the winning side is by lowering costs (but maintaining skill)

Distribution of fund returns

Tax impact

Expense ratio impact

After all costs, fewer dollars exceed the benchmark

Source: Vanguard.

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Most equity funds lagged the broad market over 15 years


General equity funds versus the Dow Jones Wilshire 5000 Composite Index over 15 years
55% Worse (596 funds)
236

45% Better (483 funds) Wilshire 5000

183 165

135 111

71 43 10
<-6

48 38

26

3 10
-5 to -6 -4 to -5 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 >5

Sources: Lipper Analytical Services, Wilshire Associates, and Vanguard. Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. As of December 31, 2010.

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Most large-cap funds lagged the S&P 500 over 15 years


Large-cap funds versus S&P 500 over 15 years
67% Worse (280 funds) 33% Better (140 funds)

110 104

S&P 500

79

47 41

3 <-6

1 -5 to -6

2 -4 to -5

13 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2

15

5 >3

2 to 3

Sources: Lipper Analytical Services, S&P, and Vanguard. As of December 31, 2010.

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Large-cap funds vs. the S&P 500 Index

Percentage of large-cap funds outperformed by the S&P 500 Index


88% 76% 71% 61% 50% 43% 46% 42% 70% 57% 57% 58%

85% 78% 71% 65% 67% 65% 61% 51% 54% 73%

73% 63% 66% 67%

48% 41% 42%

Sources: Lipper Analytical Services, S&P, and Vanguard. Number of funds for each time period: 1year, 2,391; 5year, 1,767; 10year, 1,044; 20year, 173. As of ended December 31, 2010.

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Index fund history

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Index fund history: Net flow to index funds


Net flow to index funds in billions of dollars from 1995 to 2009
70 62 60 61 56

50

47 40

40 35 30 25 20 12 10 35 28 25 33 34

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0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Investment Company Institute.

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Equity index funds share continued to rise


Percentage of equity mutual fund total net assets from 1995 to 2009
16.0 13.7 13.0 11.3 11.1 11.2 11.5

14.0

12.0 10.5 10.0 8.9 8.2 8.0 6.5 6.0 4.0 4.0 5.1 9.7 9.0 10.9

2.0

0.0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Investment Company Institute.

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Index fund management

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Investment process: Which indexing technique

Replication versus Optimization


Key factors to consider: Portfolio size Index characteristics number of securities, length of tail Transaction costs and other market-specific issues Nature and size of cash flow profile Index-effect in relevant market

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Investment process: Equity indexing process

Reconciliation

Pre-trade compliance engine

Cash flow projection

Optimizer generates trade lists Monitor performance


Performance attribution Overnight compliance reporting

Index updates

Execute trades

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Three levels of risk control: Goal is to minimize risk to avoid unintended bets

us t ri al

ta pl e

Te ch no l

an c

cr et io

at er

En

th

un ic

at io

er s

ea l

Fi n

In d

on su m

er di s

um

on s

Large-Cap Equity

S&P 500 Index

Portfolio Characteristics
Weighted Median Market Cap Dividend Yield Price/Earnings Ratio (1-year forward) Price/Book Ratio Estimated 35 Years EPS Growth Rate Return on Equity Long-Term Debt/Capital Number of Securities

Te l

ec

S&P 500 Index Fund


$59.2B 1.8% 17.0x 2.9x 12.4% 19.9% 33.9% 500 $59.2B 1.8% 17.0x 2.9x 12.4% 19.9% 33.9% 500

3
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Portfolio level

om

tili tie

na r

1 2

Index Fund Replication: Maximum overweight/underweight Optimization: Maximum overweight/underweight


25% 20% 15% 10% 5% 0%

Individual stock level

< 0.5 bp < 1.0 bp

Sector Weights

Factor level
Sector weights Market capitalization Volatility Style

og y

ia ls

er g

ca r

ia l

Index methodology

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Clearly defined market segmentation

Sources: MSCI, Russell, and S&P. MSCI, Russell, and S&P market-capitalization ranges calculated by FactSet as of December 301,2 009.

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Index construction philosophy

Higher Frequency Rebalancing

Lower Frequency Rebalancing

+ More Style Purity - High Turnover - Higher Cost - Less Tax Efficient

- Less Style Purity + Lower Turnover + Lower Cost + More Tax Efficient

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Timely and efficient construction


Buffer zones for managing turnover

Buffer zones

Source: MSCI.

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Sector weight

MSCI US Broad GICS Sector


Consumer discretionary Consumer staples Energy Financials Health care Industrials Information technology Materials Telecommunication services Utilities Total

Russell 3000 Index


11.1% 9.7 10.2 17.1 11.6 11.5 18.4 4.0 2.8 3.7 100.0

S&P Composite 1500 Index


10.7% 10.5 10.2 16.9 11.4 11.2 18.5 3.8 2.8 3.9 100.0

Market Index
11.0% 9.9 10.4 16.4 11.6 11.4 18.8 3.9 2.8 3.8 100.0

Source: FactSet as of June 30, 2010.

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Performance Convergence

5-year average annual returns through January 31, 2011

Large-Cap Indexes
S&P 500 2.24%

Growth Indexes
S&P 500 Growth Russell 1000 Growth MSCI US Large Cap 300 Growth 3.44%

Value Indexes
S&P 500 Value 0.92%

Russell 1000

2.51%

3.91%

Russell 1000 Value MSCI US Large Cap 300 Value

0.96%

MSCI US Large Cap 300

2.49%

3.81%

1.05%

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Source: Vanguard

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Fair-value pricing

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Fair-value pricing protects shareholders


Vanguard funds employ fair-value pricing to reflect events after the close of a stocks primary market or exchange But it can cause a temporary pricing discrepancy thats normally corrected by the following day Fair-value pricing ensures NAV reflects true value, discourages market timing, and protects shareholders

Nestle

Nestle

$55
11:30 a.m. ET European markets close
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$53
4:00 p.m. ET U.S. markets close

Fair-value pricing example


Much can happen in a few hours

Tokyo market closes 1 a.m., EST

15-hour gap 4.5-hour gap

London market closes 11:30 a.m., EST

New York market closes 4 p.m., EST

Lehman declares bankruptcy

Share price for British bank:

$50

$55

$45 FVP

$40 FVP

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Indexing in a client portfolio

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Indexed strategies can benefit clients and advisors

The difficulty of active management The role of indexing in a client portfolio Combining active and passive strategies

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Excess Return Persistence


Institutional investment manager hire/fire decisions from 1996 to 2003

Amount of excess return


Years before manager change 3 2 1
Fired firm Hired firm Difference

Years after manager change 1 2 3

2.27 10.39 8.12

(2.06) 7.04 9.10

(0.74) 3.42 4.16

0.98 0.42 (0.56)

1.47 1.12 (0.35)

3.30 1.88 (1.42)

Data: 8,775 hiring decisions by 3,417 plan sponsors delegating $627 billion in assets. 869 firing decisions by 482 plan sponsors withdrawing $105 billion in assets. Analysis covers the period 1996 through 2003.

Source: The Selection and Termination of Investment Management Firms by Plan Sponsors Amit Goyal, Sunil Wahal (Journal of Finance Volume 63, Issue 4, printed August 2008)

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Combining active portfolios with indexed portfolios combines risk control with the opportunity to outperform
The returns of active/passive combinations fell between those of all active and all indexed portfolios Best
Rankings of semiannual returns, 19822009

Worst

Analysis of five possible portfolios in 56 semiannual periods during 19822009. A spliced indexthe Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index thereafter was used as a proxy for a broad-market index portfolio. (Index performance does not reflect real-world operating costs, which could alter the results.) The active portfolios were combinations of Lipper fund category averages roughly approximating the market capitalization of the broad market. Past performance is no guarantee of future results. These hypothetical examples are not representative of any particular investment, as you cannot invest directly in an index or a fund-group average. Sources: Vanguard and Lipper Inc.

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How will clients react when a strategy is out of favor?


No strategy works consistently year over year Its during those periods where a strategy is out of favor where clients may not appreciate the long-term track record This is where indexing can help
But the advisor faces a risk of losing clients
Update resume Client pulls some assets Client pulls most assets Client asks questions US Stock Market Return

On average this portfolio has added alpha for a client

Portfolios periodic returns


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Adding a broad market index fund dilutes alpha, but can temper the drawdown
Combining index and active strategies, maintains positive alpha, but truncates the extreme downside risk of active management
But the advisor faces a lesser risk of losing clients
Update resume Client pulls most assets Client pulls some assets Client asks questions

On average this portfolio has still added alpha

US Stock Market Return

Portfolios periodic returns

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Indexing offers additional benefits in portfolio construction

Greater control of asset class risks Diversification Style consistency Tax advantages

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Conclusion

On average active management has not met investor expectations Index funds derive their long-term performance advantage from lower costs, style purity and the relative efficiency of the capital markets Despite the averages, opportunities do exist for active management to add value Combining index and active strategies can truncate downside risk and lead to improved client retention

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Disclosures

All investing is subject to risk. Diversification does not ensure a profit or protect against a loss in a declining market. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. 2011 The Vanguard Group, Inc. All rights reserved.

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