MARLA'S MUSINGS

. . . from the Publisher of Brill's Mutual Funds Interactive^®

Vanguard Siblings Are No Mirror Images

by Marla Brill
Publisher, Brill’s Mutual Funds Interactive

Vanguard's recent decision to hire a new co-manager for Windsor Fund underscores its many differences with its sibling, Windsor II.

Those differences began taking shape about 30 years ago. At the time, James Barrow was a young investment manager for an insurance company in Philadelphia, interviewing for a job as an assistant to John Neff, then manager of the Vanguard Windsor Fund. "It was really exciting to have lunch with him," says Barrow. "I was in awe of the man."

But admiration turned to disappointment when Barrow didn't get the job. He isn't sure why, but speculates "it may have been a matter of our personalities just not being in tune." Instead, the position went to a guy named Charles Freeman.

Although Barrow didn't realize it, he would have another chance to become associated with Windsor. He went on to start his own firm, Dallas-based Barrow, Hanley, Mewhinney & Strauss, in 1979. By 1985, his six-year-old firm had a comfortable $2.5 billion under management for pension funds and institutional clients.

A couple of interesting things happened that year. The Windsor Fund closed its doors to new investors as manager John Neff became uncomfortable handling the huge cash inflows of the highly popular fund. And Barrow got a phone call he would never forget.

"It was about 5:00 p.m. on a spring afternoon, and there were a few of us just sitting around the office when the phone rang," he recalls. "It was John Bogle, and he wanted to know if we'd be interested in managing a new fund that Vanguard was setting up. Coming out of the blue like that, it just about floored us."

This time Barrow got the job, but his expectations were modest. "Getting Windsor II was nice for the firm, but we didn't think we'd see much more than $1 billion in assets from it," he says.

Nearly fourteen years later, $31 billion Windsor II is one of the largest mutual funds in the country. Although Vanguard divides the fund's investment management among four different firms, Barrow is responsible for investing about 70 percent of Windsor II's assets, making his voice by far the most influential of the group. (The rest of the fund is managed by Equinox Capital Management of New York, Tukman Capital Management of Larkspur, Ca., and Vanguard Core Management Group.)

The fund that Barrow might have run if his lunch meeting with John Neff had gone a little more smoothly celebrated its 40th birthday in October. Charles Freeman, who joined Vanguard in 1969 to help Neff run Windsor, has been a key force through most of its history. He was named assistant portfolio manager of Windsor in 1974, and lead manager when Neff retired in 1996.

Few times, no doubt, have been more challenging for Freeman in his 30-year career at Vanguard than today. Over the last two years, Windsor, one of the most visible mutual funds in the country, has been trying to recover from a bout with performance anemia.

Coming up from behind may be a new experience for many Windsor shareholders. During Neff's 31-year tenure, the fund outperformed most diversified stock funds with track records dating back to 1958.

And things went well for Windsor in 1996, the first year Freeman was lead manager. Its total return of 26.4 percent exceeded that of the S&P 500 Index by a comfortable margin. Although the performance of Windsor I and Windsor II differed from year to year, their ten-year track records were about evenly matched as 1997 approached.

But Windsor's significant deep value positions in economically-sensitive paper, oil, construction equipment, and chemical companies have not fared well for much of the past two years. Freeman's gravitation toward mid-cap stocks also hurt the fund at a time when stocks of larger companies pulled ahead.

Freeman, who declined to be interviewed for this article, has stated publicly that he believes his cyclical and mid-cap holdings are poised for a rebound. A glimmer of hope may be on the horizon. During the first quarter of 1999, the fund gained 3.15 percent, beating the average growth-and-income fund, and within shooting distance of the 4.99 percent gain of the S&P 500 Index.

Whether Windsor's good fortunes will continue remains to be seen. Vanguard's recent decision to hire Sanford C. Bernstein & Co. to co-manage its portfolio may help things. For now, though, Windsor II still has a distinct performance edge over its older sibling over most of the last few years.

It's not that Windsor II hasn't had some disappointments. But for the most part, Barrow's strategy has been more in sync with the stock market lately than Freeman's. Windsor II has a minimal presence in the commodity-based industries largely responsible for Windsor's tepid performance. And it has stuck to stocks of large companies, which have been the best-performing asset class.

No mirror image

The recent sharp contrast in returns between the two funds underscores a point investors may sometimes forget. Despite wearing very similar labels, the two funds differ enormously in several key areas:

Definition of value. Windsor and Windsor II are value-oriented growth and income funds. Both look for out-of-favor stocks with blow-average price/earnings and price/book ratios, and above-average dividend yields.

But value means different things to different people. If these men shop the way they invest, Barrow might gravitate to sales. Freeman, who looks for deeper discounts, would probably head for the bargain rack.

Fund statistics show the disparity. While the stocks in both funds sell a discount relative to the S&P 500, Windsor's picks are considerably cheaper. At the end February, stocks in Windsor II's portfolio had an average price/earnings ratio of 19.4, and an average price/book ratio of 3.0. The average stock in Windsor had a price/earnings ratio of 16.8, and a price/book ratio of 2.0.

Holdings. Windsor and Windsor II rarely own the same stocks, and their sector weightings can vary dramatically. Windsor has 20 percent of its assets in materials and processing companies, versus 3 percent for Windsor II. Windsor II has 18 percent of its assets in utilities, compared to 8 percent for Windsor.
But they sometimes share common themes, and both maintain a strong presence in the financial services sector.

Portfolio concentration. Windsor is a more concentrated offering. It owns 109 stocks, with the top ten stocks representing 39 percent of total net assets. Windsor II spreads its bets more by owning 270 stocks, with the top ten equaling 27 percent of total net assets.

Market capitalization. Windsor II is a large-cap fund with a median market capitalization of $26.8 billion. Windsor's median market capitalization is $11.1 billion, less than half that of Windsor II and about one-fifth that of the S&P 500 Index. Vanguard spokesman Brian Mattes says Freeman has brought down the average size of the companies in the portfolio since he took over, and that Windsor "is now more mid-cappy than it was before."

What to do

Opinions are divided about how shareholders should handle Windsor's recent performance. After all, history has shown many times that today's under-performers can easily become tomorrow's winners if economic and market conditions shift in their favor.

Morningstar analyst Amy Granzin points out that while Windsor shareholders may be disappointed, the fund has been true to the course set by John Neff many years ago. "Windsor has always been a deep value fund," she says. "It's just that deep value didn't work in 1998. Because of Freeman's unpopular buys, investors should expect some slow periods. People with a long-term time horizon and a faith in the manager's investment style might even consider adding to their holdings."

Daniel Wiener, editor of the Independent Adviser For Vanguard Investors, is less forgiving. "Charles Freeman is a dyed-in-the-wool value player whose bets have gone bad," he says. "There will certainly be a day when things turn around for him. Still, for my money, I prefer Windsor II, particularly if the economy slows down further and some of Windsor's cyclical bets slow with it."

Aside from whether Windsor's shareholders should hang on, another question remains: if Windsor and Windsor II are so different, why are their names virtually identical?

The answer lies in how one defines the word "different." Vanguard spokesman Brian Mattes points out that both are growth-and-income funds that use a value approach. While their styles diverge on some points, he says, the funds are "similar enough to wear the same label."

While James Barrow has acknowledged that Windsor II differs from Windsor, he also believes that Vanguard's desire to build on Windsor's reputation and visibility were perfectly logical when the firm started Windsor II in 1985.

"Vanguard had a well-known trademark and decided to use it," he says. "It's kind of like Coke and Diet Coke. People know they are not the same drink, even if the names are similar."

That may be true. But the lesson fund investors should remember is that, as with soda, a mutual fund's internal ingredients mean a lot more than its external label.