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Vanguard's Best Bear Market Mutual Funds
Thursday August 30, 7:00 am ET
By Dan Culloton


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, as well as 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. 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) or urging 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. But if the recent undulations have been giving you panic attacks in the shower or causing you to check out the return prospects of shoeboxes and mattresses, it may be time to re-evaluate your risk profile and perhaps consider funds like these.

Vanguard LifeStrategy Income (NASDAQ:VASIX - News)
This is a fund of funds that keeps most of its money in fixed-income portfolios: Vanguard Total Bond Market (NASDAQ:VBMFX - News) and Vanguard Short-Term Investment-Grade (NASDAQ:VFSTX - News). 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 (NASDAQ:VAAPX - News), which gets 25% of assets here (Vanguard Total Stock Market Index (NASDAQ:VTSMX - News) accounts for the rest of stock holdings). Loeb uses quantitative models to figure out how much of his portfolio to devote to S&P 500 stocks and the Lehman Brothers Long-Term Treasury Index, and his calls have been consistent and accurate over the years. (Currently Loeb's fund has about three fourths of its assets in stocks, so this fund's equity allocation hangs around 20%.) That give 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 and in the third quarter through Aug. 28 it eked out a small gain that put it ahead of 96% of its peer group. Investors who are further away from their goals or who are more risk tolerant can check out Vanguard LifeStrategy Conservative Growth (NASDAQ:VSCGX - News) and Vanguard LifeStrategy Moderate Growth (NASDAQ:VSMGX - News), which devote more money to equity funds and have done well in bear markets relative to their peers.

Vanguard Wellesley Income (NASDAQ:VWINX - News)
A colleague of mine recently told me that this portfolio, which keeps most of its money in bonds, was the first fund she ever bought. My first reaction was to say that it seemed awfully conservative for someone whose retirement was still decades off. She retorted that she was looking for a one-stop fund that wouldn't burn an inexperienced investor. Since then she has built a more age-appropriate asset-allocation plan around this fund, but she has never regretted her first purchase because the fund has been so reliable. It has lost money in just three of the last 20 years, has done better than 97% of its peers in bear markets, and has succeeded in delivering a steady stream of income with a portfolio of undervalued, high-yielding stocks and high-quality (mostly corporate) bonds. That the fund has held up well (better than nearly 90% of its conservative-allocation peers for the third quarter through Aug. 28) in the middle of a credit crunch with such a large corporate bond stake is testimony to the security-selection skills of long-time fixed-income manager Earl McEvoy and his team from Wellington Management. Wellington's John Ryan on the equity side is no slouch either. He's leaving the fund next year but has a seasoned understudy lined up in Michael Reckmeyer III. My colleague argues that there are worse newbie-investor mistakes than buying this fund, and I'd have to agree.

Vanguard Short-Term Tax-Exempt (NASDAQ:VWSTX - News)
This fund is cautious and consistent. Longtime manager Pam Wisehaupt-Tynan keeps the portfolio's duration, a measure of interest-rate sensitivity, low and its credit quality high. Low expenses allow the fund's conservative approach to work in its favor over time. Put too much of your portfolio here and you could run the risk of not keeping up with inflation or not seeing enough appreciation to meet your goals, but it can take the edge off a taxable portfolio. It's done better than 96% of its peers in bear markets and outpaced almost 80% of them in the current quarter through Aug. 28.

Vanguard Balanced Index (NASDAQ:VBINX - News)
Once again, simplicity and low costs work in a Vanguard fund's favor. A mix of 60% MSCI U.S. Broad Market Index (essentially Vanguard Total Stock Market Index ) and 40% Lehman Aggregate Bond Index has produced reliable absolute returns. It's done better than 86% of its peers in bear markets and has bested about four fifths of them so far in the third quarter. The fund's correlation with the overall market is higher, but it's still a solid core holding.

Vanguard Wellington (NASDAQ:VWELX - News)
This is another old stalwart managed by the redoubtable Wellington Management. In June, my colleague Chris Davis highlighted this one of Morningstar's favorite "sleep-at-night funds", or offerings that don't keep you awake at night wondering what they are doing. Since then the fund has acquitted itself relatively well. It posted a 1.9% loss for the third quarter through Aug. 28, but that was still better than 82% of its moderate-allocation peers. Its long-term bear market rank also is still better than 86% of its rivals. And like its sibling Wellesley Income it has delivered consistent absolute results, losing money in just three of the last 20 calendar years.

Read more about Vanguard funds in our Vanguard Fund Family Report. To view a risk-free trial issue, click here.

Dan Culloton does not own shares in any of the securities mentioned above.