Vanguard's approach to target-allocation funds in the UK

 
Vanguard’s approach to
target-allocation funds in
the UK

Vanguard research                                                                          February 2014

Executive summary. This paper explores the theory and research that
informs and underpins the design and construction of Vanguard                         Authors
LifeStrategy™ Funds.                                                                  Peter Westaway, PhD
                                                                                      John Velis, PhD
Vanguard LifeStrategy™ Funds provide investors with simple, low-cost,
transparent vehicles designed to meet a wide array of needs. Built
with careful attention to Vanguard’s investment philosophy, outlined in
Vanguard’s Principles for Investment Success, they incorporate our
best thinking and practices of global strategic asset allocation with the
discipline and cost advantages of passive indexing, periodic rebalancing
and transparency. They include five funds with different allocations,
each to align with a range of investor risk tolerances, from 20% equity
and 80% bond through to 100% equities.

 Important information
 This document is directed at professional investors in the UK only, and should not
 be distributed to or relied on by retail investors. This document is published by
 Vanguard Asset Management, Limited, based on research conducted by Vanguard
 Group Inc. It is for educational purposes only and is not a recommendation or
 solicitation to buy or sell investments. The value of investments, and the income
 from them, may rise or fall and investors may get back less than they invested.

Connect with Vanguard > vanguard.co.uk
The funds incorporate global exposure to both stock and bond markets, allowing
     investors to combine exposure to equities – and the expected risk premium they
     traditionally offer – while benefiting from the diversification properties of bonds. This
     combination of globally focused equity and bond funds gives investors a variety of
     return sources while diversifying risks beyond those present in UK markets. At the
     same time, the target allocation funds allow UK investors the comfort and familiarity
     of a modest overweight to local markets.

     Vanguard designed the funds to act as total return investments, intended to deliver
     market-like returns over long time horizons, given a desired risk level. Advantages
     include a low-cost design, transparent construction and disciplined rebalancing
     towards target allocations.

2
Vanguard’s target-allocation funds apply a number                             global equity and bond allocations, all of which are
     of investment best practices, including global                                designed to enhance the ability of investors to
     asset allocation, broad diversification and a                                 meet their goals. In short, they represent an all-in-
     balance between risk, return and cost. The funds                              one instrument aligned with Vanguard’s Principles
     offer straightforward and transparent design, low                             for Investment Success,1 as depicted in Figure 1.
     investment costs and broad exposure across

       Figure 1.      Vanguard’s Principles for Investment Success

       1  Goals                                                                    2  Balance
       Create clear, appropriate                                                   Develop a suitable asset allocation
       investment goals                                                            using broadly diversified funds

        Working with a financial adviser, the investment                           A successful investment strategy starts with
        process begins by setting measurable and                                   an asset allocation suitable for its objective.
        attainable investment goals and developing                                 With your adviser’s help, you can then
        plans for reaching those goals.                                            establish an asset allocation using reasonable
                                                                                   expectations for risk and potential returns. The
                                                                                   use of diversified investments helps to limit
                                                                                   exposure to unnecessary risks.

       3  Cost                                                                     4  Discipline
       Minimise cost                                                               Maintain perspective and
                                                                                   long-term discipline
       You can’t control the markets, but you can
       control how much you pay to invest. Every                                   Investing evokes emotion that can disrupt the
       pound that you pay in costs and charges                                     plans of even the most sophisticated investors.
       comes directly out of your potential return.                                Some make rash decisions based on market
                                                                                   volatility.
       Indeed, research suggests that lower-cost
       investments have tended to outperform                                       But, with your adviser’s help, you can counter
       higher-cost alternatives.                                                   emotions with discipline and a long-term
                                                                                   perspective. This can help you stick to your plan.

     Sources: Vanguard’s Principles for Investment Success, United Kingdom. 2013

     Goals                                                                         the overall plan can include different portfolio
                                                                                   allocations for each goal. Alternatively, they can
     A sound investment plan for individuals – or an
                                                                                   generate a separate plan for each.
     investment policy statement (IPS) for institutions
     – begins with an outline of the objectives, as well
     as any significant constraints. Most investors have                           Clear, appropriate investment goals should
     rather straightforward objectives, such as saving                             be measurable and attainable. For example,
     for retirement, saving for children’s education,                              given that many objectives are long term, an
     preserving assets, funding retirement or meeting                              appropriate plan should be designed to endure
     a shorter term ‘need’ or ‘dream’. If the investor                             through changing market environments. On the
     has multiple goals, such as gathering enough for                              other hand, some investment time horizons could
     both retirement and a child’s university expenses,                            be much shorter and/or include less tolerance

3
1 See Vanguard (2013) Vanguard’s Principles for Investment Success
for risk. In these cases a less aggressive                                          costs is inverse. This is because investors see their
     asset allocation would be preferred. In general,                                    returns reduced pound for pound by the cost they
     investors may have many constraints, and they                                       incur. For example, a 2011 study 3 examined US
     could be either simple or complex. Examples                                         mutual fund performance between 2001 and 2010
     of other constraints include: taxes, liquidity                                      and concluded that the higher the fund’s expense
     requirements, legal issues or the desire to avoid                                   ratio, the worse it performed. The evidence shows
     certain types of investments. Constraints can                                       that higher costs tend not to be offset by better
     also change over time.                                                              performance.4

     All-in-one funds, such as Vanguard LifeStrategy™                                    Vanguard’s target allocation funds achieve their
     Funds, offer a range of risk and return profiles                                    mix of equity and bond exposures by employing
     designed to align with different investors                                          passive indexing. Indexing offers a competitive
     according to their individual objectives,                                           cost profile relative to active strategies thus
     constraints, age, income, risk attitude, time                                       increasing the likelihood that investors will
     horizon and preferences.                                                            achieve better overall performance.

     Balance                                                                             Discipline
     When building a portfolio to meet a specific                                        The asset allocation decision only works if
     objective, the critical first step is to choose an                                  investors adhere to it over time and through
     asset allocation: the combination of assets which                                   varying market environments. Investors are often
     offer an investor the best chance to meet their                                     tempted to try to ‘time’ the markets, changing their
     goals. A balanced plan incorporates reasonable                                      asset allocation in response to short-term market
     expectations for risk and return in a broad                                         developments. However, academic and practitioner
     and well-diversified asset allocation.2 Indeed,                                     research has repeatedly shown that even
     a portfolio’s asset allocation – the percentage                                     professional investors persistently fail to time the
     of a portfolio invested in various asset classes –                                  market successfully 5. Similar temptations include
     determines the overwhelming majority of its                                         the impulse of investors to ‘chase’ market sectors
     return variability and long-term performance.                                       or funds that have performed well in the recent
                                                                                         past. In practice this can often be a losing strategy
     LifeStrategy™ Funds provide the investor                                            since the past performance of any investment can
     with exposure to both the higher risk and return                                    never be relied upon to predict future returns.
     associated with investing in equities and the
     diversification, volatility-reduction and downside
                                                                                         Another pitfall is failing to periodically rebalance
     protection provided by global bonds. Given
                                                                                         a portfolio. As markets rise and fall, the investor’s
     that asset allocation is a primary determinant
                                                                                         portfolio often drifts away from the original target
     of investment outcomes over the long term,
                                                                                         asset allocation. So as not to stray too far from
     we discuss this concept and its application
                                                                                         one’s asset allocation, periodic rebalancing can
     in greater detail below.
                                                                                         keep the portfolio’s in line with the investor’s
                                                                                         goals and risk profile. Target allocation funds,
     Cost                                                                                which maintain a static asset allocation through
     All else being equal, the lower the costs incurred                                  periodic rebalancing, help mitigate this potential
     by investors, the greater their investment                                          hazard. LifeStrategy™ Funds can help investors
     returns. Research also suggests that lower-cost                                     avoid these common behavioural errors. They are
     investments have tended to outperform higher-                                       professionally managed, continually rebalanced
     cost alternatives. Contrary to conventional                                         back to their initial asset allocation and do not
     wisdom about the relationship between price and                                     take market bets in favour of or against any
     quality, the relationship between investing and                                     particular market or subsector.

     2 See Wallick, et al (2012).
     3 Wallick, et al (2011).
     4 Westaway, et al (2013) discuss the cost benefits of indexed funds, including the concept of the “zero sum game,” which postulates that on average,
       for every investors who outperforms the market, there will be one who underperforms the market. Deducting costs, this leaves the average fund
       underperforming its benchmark.
     5 For example, Becker, et al (1999) study US mutual funds and find no evidence that that these funds have significant market timing ability. See Vanguard’s
4     “Principles for Investment Success”(2013) for a more extensive discussion of the perils of market timing.
Asset allocation of target funds                                              equities are expected to generate over time with
                                                                                           the diversification and volatility-reducing properties
             Asset allocation – the proportion of a portfolio
                                                                                           offered by bonds. Because equities tend to be
             invested in various asset classes – determines
                                                                                           riskier and more volatile than bond investments,
             the majority of the return variability and long-term
                                                                                           they are expected to offer a higher return over
             performance of a portfolio. Countless academic
                                                                                           reasonably long periods of time. This concept is
             studies and years of investment experience have
                                                                                           known as the ‘equity risk premium’. Financial theory
             explored and confirmed this principle6.
                                                                                           suggests that – all else being equal – a riskier
                                                                                           investment on average and over the long run ought
             Vanguard LifeStrategy™ Funds allocate to global                               to offer a higher return to the investor. If relatively
             equities and global bonds, with a range of equity-                            riskier investments did not offer relatively higher
             bond mixes as shown in Figure 2. The funds are                                expected returns, investors would not buy them.
             intended to offer appropriate blends for different
             investors with diverse risk tolerances and
                                                                                           Of course, their more volatile behaviour can result
             investment goals.
                                                                                           in periods during which equities actually return less
                                                                                           than bonds. Because of equities’ downside risk and
             Target allocation funds maintain a consistent                                 volatility over short time periods, target allocation
             exposure to stocks and bonds through time and                                 funds maintain some exposure to bonds7, which
             market events through periodic rebalancing to                                 help mitigate, or diversify, the risk posed by holding
             the initial asset allocation. This policy allows the                          portfolios entirely made up of equities.
             investor to access both the higher return that

                      2.
               Figure 1.    Vanguard LifeStrategy
                            Vanguard LifeStrategy™TMFunds
                                                     Funds  target
                                                          target   allocations (as at 31 January 2014)
                                                                 allocations

             Vanguard LifeStrategyTM
                                        Vanguard LifeStrategy    TM
                                                                       Vanguard LifeStrategy    TM
                                                                                                      Vanguard LifeStrategy
                                                                                                                          TM
                                                                                                                                Vanguard LifeStrategy   TM

             20% Equity Fund            40% Equity Fund                60% Equity Fund                80% Equity Fund           100% Equity Fund

                Equities – Emerging Markets          Equities – Global Developed (ex-UK)         Equities – UK
                Bonds – UK Government             Bonds – UK Investment-grade        Bonds – UK Inflation-linked       Bonds – Global

             Sources: Vanguard Asset Management

6 Wallick, et al 2012; Brinson, et al 1986.
7 Four of the target allocation funds include fixed income, ranging from 20% equities and 80% bonds through to 80% equities and 20% bonds. There is also a
5100% equity fund, representing the riskiest fund in the lineup.
Understanding the equity-risk premium                                             of the business), equity holders by definition
                                                                                       face more intrinsic risk to their investment
     The equity-risk premium refers to the economic
                                                                                       than bond holders. In addition, while bond
     relationship which states investors in equities take
                                                                                       holders are contractually promised a stated
     on more risk and therefore expect a higher return,
                                                                                       payment, equity holders simply own a claim
     or ‘risk premium’, than investors in cash or bonds.
                                                                                       on future earnings. How the company uses
                                                                                       those earnings (paying them out in the form
     However, this expected risk premium may or may                                    of dividends and share repurchases, or
     not be realised over an investor’s time horizon.                                  reinvesting in the operations of the firm) is
     The realised risk premium can vary greatly from the                               normally beyond investors’ control.
     expected or historical risk premium. Equity returns
     can be highly volatile and long-term returns can
                                                                                       Again, by definition, equity ownership is
     deviate from the historical ‘average’ return. But just
                                                                                       riskier than debt ownership. Relative to gilts,
     because equities are sometimes volatile and can
                                                                                       where repayment of the loan is backed by
     trail bond returns for substantial periods of time,
                                                                                       the government, ownership of uncertain future
     does not mean that we should expect a negative
                                                                                       corporate earnings is indisputably riskier.
     risk premium for equities over the long term.
                                                                                       Because of this risk, investors must be enticed
                                                                                       to pay for a claim on uncertain future earnings
     Take the most recent financial crisis for example.                                and this ‘carrot’ is the premium or higher
     In 2008, the MSCI All Country World Equity Index                                  return that investors demand over time to
     fell by 39.2% from 31 December 2007 through                                       bear that risk.
     31 December 2008, while the BarCap Global
     Aggregate bond index (hedged to pounds sterling)
                                                                                       Another way of looking at the concept of
     rose by 7.6%.8 Does that mean that the idea of the
                                                                                       the equity risk premium is to recognise that
     equity risk premium is invalid? Not in the long run.
                                                                                       a firm’s shareholders are its owners. They
     Using the same indices and looking at the ten years
                                                                                       receive a return on the firm’s capital via
     ended 30 June 2013, equities rose by an average
                                                                                       their stake in the firm and their claim on its
     of 7.3% annually, while bonds returned an average
                                                                                       revenues. Bonds, which are essentially loans
     of 5.2%. This illustrates that the point remains: over                            made to the firm, require the payment of an
     short periods, equities sometimes underperform                                    interest rate that should represent the cost
     bonds (they are more volatile, after all), but over                               of capital to the firm. If this cost of capital
     sufficiently long periods, equities are expected to                               is higher than the return on capital, the firm
     outperform bonds. Of course, historical returns                                   will fail. Extending this to the entire market,
     are never a reliable predictor of future results.                                 it means that for investment and economic
     The value of investments, and the income from                                     growth, the return on capital should exceed
     them, may fall or rise and investors may get back                                 the cost of capital. As the owners of capital,
     less than they invested.                                                          shareholders should realise a higher return
                                                                                       than they pay to borrow. This excess return
     Because equity ownership means the investor is                                    is the equity risk premium9.
     on the front lines of business losses (bond holders
     have first claim to assets in the event of the failure

     Bonds typically return less than equities, but the                                better with lower volatility. Combining them
     variability of their return profile is usually lower.                             with equities therefore acts as a sort of ‘shock
     Indeed, they can often perform inversely to                                       absorber’ in dampening equity market volatility. In
     equities, as seen in the example given in the text                                some circumstances, bonds may actually increase
     box on the equity risk premium. When stocks                                       in price while equity markets fall. In these ways,
     enter a bear market period, bonds usually perform                                 they act as a diversifier of equity market risk.

     8 Index performance for both equities and bonds are reported as total returns.
6   9 This relationship assumes we are comparing an equity index to a corporate bond index for similar companies.
Figure 3 shows the risk/return trade-off over                                  On the other hand, as the proportion of bonds
                   long periods. As the proportion of equities in                                 increases, the variation of annual outcomes
                   the portfolio increases, average annual returns                                drops significantly, but so too does the average
                   increases, as does the range of annual outcomes.                               annual return.

                                       Figure 3.   Range of returns of UK balanced portfolios (by various bond/equity weighting schemes), 1900–2013

                             175%

                                       150

                                       125

                                       100
             Range of 1 year returns

                                        75

                                        50

                                        25
                                                   5.3%              6.2%             7.1%                  7.8%                    8.4%                    8.9%
                                         0

                                        -25

                                        -50

                                        -75
                                                   0/100             20/80            40/60                 60/40                   80/20                   100/0

                                                                                        Equity/bond allocation

                 Notes: Reflects the maximum and minimum calendar year returns, along with the average annualised return, from 1900–2013, for various equity and bond
                 allocations, rebalanced annually. From 1900 through 1984, equities are represented by the Barclays Equity Gilt Study from 1900 to 1964, Thomson Reuters
                 Datastream UK Market Index Jan.1965 – Dec.1969; MSCI UK Jan.1970 – Dec.1985. Thereafter, equities are represented by MSCI All Country World Index.
                 Bonds are UK as represented by Barclays Equity Gilt Study 1900-1976; FTSE UK Government Index Jan.1977-Dec 1984, Citigroup World Global Bond Index
                 from 1985 through 1989, Barclays Global Aggregate Index thereafter. Returns are in sterling, with income reinvested, through 2013.
                 Source: Vanguard, based on Barclays UK Equity Gilt study, Thomson Reuters, FTSE, MSCI, Citigroup and Barclays.

                Tactical allocation strategies: Are they                                          Furthermore, even if some managers can add
                worthwhile?                                                                       value by implementing tactical tilts, the return
                                                                                                  profile can be highly variable. For example,
                A tactical asset allocation (TAA) strategy actively,
                                                                                                  one of the most basic TAA strategies involves
                or opportunistically, adjusts a portfolio’s asset
                                                                                                  large shifts between equities and bonds
                allocation based on short-term market forecasts.
                                                                                                  or cash. When the manager feels that the
                It aims to exploit perceived inefficiencies or
                                                                                                  latter will outperform the former, they will
                temporary imbalances among different asset or
                                                                                                  re-weight towards bonds (or vice versa). If the
                sub-asset classes. When considering the potential
                                                                                                  timing is right, the investor will benefit, but
                inclusion of a tactical asset allocation strategy,
                                                                                                  at the cost of a large deviation from the initial
                investors should consider the significant risks
                                                                                                  risk exposure implied by the strategic asset
                and obstacles that can overwhelm any theoretical
                                                                                                  allocation. If the manager mis-times the move,
                benefits. Some studies10 have shown that while
                                                                                                  however, the drawdowns (short term losses)
                some strategies have added value at the margins,
                                                                                                  can be quite large and very hard to make up.
                on average, most tactical strategies have failed
                                                                                                  In addition, tactical strategies typically limit
                to produce consistent, or durable, positive
                                                                                                  transparency, increase cost and potentially
                excess returns.
                                                                                                  complicate management and oversight.11

10 S ee for example: J.L. Treynor and K. Mazuy, 1966, Can mutual funds outguess the market? Harvard Business Review 44:131–36 as well as Roy D. Henriksson
   and Robert C. Merton., 1981, On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills, Journal of Business
   54 (4, Oct.): 513–33..
7
11 Stockton and Shtekhman, 2010.
Sub-asset allocation: Diversifying within                                         Figure 4 shows, the relative performance of sub-
     asset classes                                                                     asset classes can vary greatly over time. The ‘hot’
     Once investors make their target asset                                            sector(s) one year can often fall out of favour the
     allocation to equities and bonds, they could look                                 next. Chasing returns often results in the double-
     at allocations across sub-asset classes. Some                                     whammy of higher trading costs for the investor
     investors use a bottom-up approach, investing                                     with disappointing performance of the portfolio.
     in those securities or sub-asset classes they
     reckon will deliver superior performance. Yet                                     On the other hand, a broadly diversified portfolio
     this practice is often fraught with pitfalls. Akin                                provides consistent exposure across key sub-
     to trying to look around corners, it is notoriously                               asset classes. Consequently, investors participate
     difficult to predict which sub-asset classes (be                                  in the entire market, with exposure to the
     they economic sectors, geographic regions,                                        stronger-performing sectors while mitigating
     or investment styles such as small-capitalisation                                 the negative impact of weaker-performing ones.
     or value stocks) will outperform the market over                                  This provides superior diversification across
     various time horizons.                                                            market cycles.

     Sometimes, investors will ‘chase’ performance                                     Analysing past returns reveals that taking
     by increasing their exposure in the forthcoming                                   advantage of market shifts could result in
     period to that market segment which performed                                     substantial rewards. However, the opportunities
     well in the most recent time period. But as                                       that appear clear in hindsight are rarely visible in

       Figure 4.           Annual returns for selected equity and bond asset classes, sorted by best (top) to worst (bottom)

       2000         2001       2002     2003      2004       2005       2006       2007       2008        2009     2010       2011       2012       2013

       9.9%         8.3%       10.7%   38.5%      19.3%      51.1%      20.1%     37.4%      13.0%        62.5%    23.6%     20.3%      17.8%      28.3%

                                                                                                                                                               Top-performing asset class
       8.9%         7.5%       9.4%    29.7%      13.8%      36.8%     16.8%      15.7%       7.6%        30.1%    21.3%      16.7%     15.5%      25.2%

       5.9%         5.2%       8.7%    25.3%      12.8%      24.9%     16.8%      10.8%       3.6%        21.2%    19.1%      6.5%      12.8%      21.0%

       1.7%         3.2%       8.0%    20.9%      11.5%      24.1%      7.2%       8.3%      -10.0%       20.1%    16.7%      5.8%      12.3%      20.8%

       0.6%         -1.1%     -15.1%   20.9%      8.5%       22.0%      3.3%       6.6%      -13.2%       14.8%    14.5%      1.2%      12.0%      13.6%

       -0.5%     -10.8%       -17.3%   16.4%      8.3%       20.2%      2.8%       5.8%      -13.3%       14.7%    8.9%       -3.5%     11.2%       1.6%
                                                                                                                                                               Bottom-performing asset class

       -4.3%     -13.3%       -22.7%    7.1%      8.0%       9.1%       1.7%       5.6%      -19.4%       13.6%    8.7%       -6.6%     10.7%       0.6%

       -5.9%     -13.8%       -26.6%    6.9%      6.7%       8.5%       0.8%       5.3%      -24.0%       6.3%     7.5%      -12.6%      5.9%       0.0%

      -20.0%     -20.0%       -27.0%    5.5%      6.6%       7.9%       0.5%       5.2%      -29.9%       5.3%     5.8%      -14.7%      2.9%      -4.2%

      -27.2%     -22.9%       -29.5%    2.1%       4.1%      5.8%       -0.2%      0.4%      -34.8%       -1.2%    4.8%      -18.4%      0.6%      -5.3%

      Global equities                                                             UK government bonds (gilts)
      North America equities (US/Canada)                                          UK index-linked gilts
      Emerging market equities                                                    UK investment grade corporate bonds
      Developed Asia equities                                                     Hedged global bonds
      Europe ex-UK equities
      UK equities

     Source: Vanguard calculations, using data from Barclays Capital and Thompson Reuters Datastream. UK equity is defined as the FTSE All Share Index,
     Europe ex-UK equity as the FTSE All World Europe ex-UK Index, developed Asia equity as the FTSE All World Developed Asia Pacific Index, North America
     equity as the FTSE World North America Index, emerging market equity as the FTSE Emerging Index, global equity as the FTSE All World Index, UK
     government bonds as Barclays Sterling Gilt Index, UK index-linked gilts as Barclays Global Inflation-Linked UK Index, hedged global bonds as Barclays Global
     Aggregate Index (hedged in GBP), UK investment grade corporate bonds as Barclays Sterling Corporate Index. Returns are denominated in GBP and include
8   reinvested dividends and interest.
advance. The importance of full market exposure        Vanguard’s target-allocation funds diversify a UK
within asset classes cannot be understated. While      equity portfolio with broad-based, non-UK equities
bets on specific market segments may seem              equal to approximately 75% of the total equity
appealing, these bets imply that the market is         allocation. Finance theory suggests a global equity
incorrect in its assessment of the valuation of        allocation that reflects the market capitalisation
a sub-asset class.                                     of the global market. In the case of the UK, this
                                                       would imply holding 92% of the equity portfolio
Some investors use quantitative tools such as          in non-UK equities. However investors in every
optimisation to periodically adjust their asset        country have historically displayed a significant
allocation based on expected returns and               bias towards their home markets. In the UK, for
correlations of the asset classes in the portfolio.    example, a 2005 study (Chan, et al) revealed that
They aim to achieve the maximum expected               UK investors, on average, constructed portfolios
return for some given level of risk. This approach,    with a 5.3 times bias to domestic equities. In
while rooted in basic financial theory, can often      other words, while the global market weight of
lead to significant swings in the portfolio weights    UK equities is approximately 8%, the embedded
from one period to the next. At the extreme, they      ‘home bias’ would suggest an allocation of
can result in portfolios that differ widely from the   approximately 48% to UK equities (and 52%
strategic asset allocation. Furthermore, forecasting   to non-UK equities).
expected returns and inter-asset class correlations
can be notoriously tricky.                             Previous Vanguard research (Schlanger, 2013)
                                                       weighed the short and long-term impacts to a
Target allocation funds maintain a static asset        portfolio of investing across a wider range of
allocation over time regardless of market events       markets, including the opportunity to invest in a
and cycles. This ensures a consistent exposure to      larger number of securities, risks associated with
equities and their expected risk premium over the      overweighting domestic markets, expected risks,
long term. Vanguard regularly reviews the asset        returns and correlations. It concluded that global
allocation of LifeStrategyTM Funds, employing the      diversification among the world’s equity markets
most up-to-date research on portfolio construction,    should be considered a reasonable starting point
investor attitudes and always mindful of the           for investors’ equity allocations.
lessons that long years of experience have taught
us. Quantitative methods, such as optimisation,        However, investor preferences and bias towards
can help but do not exclusively determine the          domestic markets must be weighed against
asset allocation of the funds. Instead, we use a
                                                       the relative advantages of global diversification.
number of inputs, which are aimed at meeting
                                                       Recognising this reality, the LifeStrategy™ Funds
Vanguard’s principles for investing success.
                                                       invest approximately 25% of their portfolios in
                                                       UK equities and the remaining equity portfolio in
Equity allocations in target allocation                unhedged market cap-weighted equities outside
funds                                                  the UK. Vanguard believes these allocations
                                                       represent a reasonable trade-off between investor
UK equities and global ex-UK equities account
                                                       preferences and ensuring that investors gain
for about 25% and 75%, respectively, of the
                                                       exposure the potential of global investing.
equity allocation. Within the UK equity allocation,
exposure across the various segments (large,
medium and small-cap, or growth and value)
aligns to the prevailing market capitalisations.
As a result, investors benefit from exposure to
all segments of the UK equity market.

9
UK and global ex-UK bond allocations                                                              grade corporate bonds. The funds do not include
            LifeStrategyTM Funds offer investors a range of                                                   high-yield, or ‘junk’ bonds due to the relatively
            asset allocations which include bonds. Historically,                                              poor diversification benefits associated with the
            the correlation between equity and bond returns                                                   asset class over time.
            has been low, providing diversification benefits.
            In extreme market conditions, an allocation to                                                    The funds allocate approximately 35% of their
            government bonds (both gilts and inflation-linked                                                 bond investments to the UK, with the remainder
            gilts) can provide meaningful downside protection                                                 allocated to global bonds outside the UK, with
            at a time when investors most need their bond                                                     currency exposure of the latter portion hedged
            allocation to react differently than their portfolio’s                                            into pounds sterling. This represents a small
            equity allocation (See Figure 5).                                                                 home bias, as UK investment grade bonds only
                                                                                                              make up 6% of global bond markets. A 35%
            Although target-allocation portfolios use bonds                                                   home country bias, which represents a 6 times
            as the primary diversifier to equity market risk,                                                 ‘overweight’, is still a bit lower than the home
            the sectors comprising the bond allocation                                                        country bias of the average UK bond investor’s
            can occasionally contribute to the portfolio’s                                                    portfolio. Data from 201212 suggest that the
            overall level of risk and to its return variability,                                              average UK bond investor holds 57%, of their
            particularly over shorter time periods. For example,                                              portfolio in UK bonds, or an overweight position
            in extreme market conditions, the correlation                                                     of nearly 9 times the global market.
            between equities and corporate bonds tends
            to move much higher, which can diminish the                                                       At the extreme, holding all of one’s bond
            diversification benefit of holding corporate bonds.                                               allocation in the UK ignores 94% of the global
                                                                                                              bond market. Even holding an allocation similar
            To achieve diversification the bond allocations                                                   to the typical UK bond investor, at 57%, results
            within the Vanguard LifeStrategy™ Funds invest                                                    in a portfolio highly exposed to UK-specific
            in both UK and global bonds. This includes                                                        economic variables, including the business
            allocations to government bonds (domestic and                                                     cycle, interest rates, inflation rates, etc.
            global), UK inflation-linked bonds and investment

                                           Figure 5.    Bonds provide downside risk protection in variety of macro environments

          Figure 5a: Distribution of monthly returns during worst                                          Figure 5b: Distribution of monthly returns during worst
          months of equity returns		                                                                       months of bond returns

                                           15%                                                                                            15%

                                            10                                                                                             10
       Distribution of quarterly returns

                                                                                                      Distribution of quarterly returns

                                             5                                                                                              5

                                             0                                                                                              0

                                             -5                                                                                             -5

                                            -10                                                                                            -10

                                            -15                                                                                            -15

                                            -25                                                                                            -25

                                            -25                                                                                            -25
                                                          Equities                  Bonds                                                        Equities   Bonds

                                                       Median          Top: 75th percentile      Top: 95th percentile
                                                                       Bottom: 25th percentile   Bottom: 5th percentile

             Notes: Displays the 5th/25th/median/75th/95th distribution of monthly returns for both equities and global bonds, during a 10th percentile or worse month
             for either the equity market or bond market. The equity market is defined as FTSE All World Index and global bond returns are defined as the Barclays
             Global Aggregate. The bond market is defined as UK bonds from Barclays Equity Gilt Study 1900–1976; FTSE UK Government Index Jan.1977-Dec. 1984;
             Citigroup World Global Bond Index from 1985 through 1989; Barclays Global Aggregate Index thereafter. Figure covers Jan. 1976 to Dec. 2013. All returns are
             measured with currency impact removed, with income reinvested.

10          12 See Phillips et al (2012)
Increasing exposure to global bonds has                                                                                    UK bond market to the global equity market
                  the potential to offer significant long-term                                                                               has offered no benefit over a hedged global
                  diversification benefits13. Figure 6a provides                                                                             bond allocation, as demonstrated in Figure 6b.
                  evidence of this. Interest rate movements within                                                                           Starting from a balanced portfolio of global stocks
                  a group of the 12 largest government bond                                                                                  and hedged global bonds, and adding higher
                  markets are not correlated with those of the UK.                                                                           portions of UK bonds to the allocation would have
                  The benefits of this diversification can be shown                                                                          increased overall portfolio risk for any particular
                  in a portfolio context; the low correlation of the                                                                         equity/bond mix.

                                                          Figure 6a.        Correlation of monthly changes in each country’s 10-year government bond yield to that of the UK,
                                                                            Jan 1998–Dec 2013

                1.00

                                                                                                                      0.76                                                0.75                     0.76             0.74
                0.75
                                                                 0.68

                                                                                0.56       0.56

               0.50                                                                                    0.47
                                                                                                                                                                                      0.43

                0.25                                                                                                             0.22                       0.21
                                                                                                                                               0.13

              0.00
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               Notes: Shows the correlation of the monthly change in the yield of each country’s 10-year government bond to the change in the 10-year UK gilt yield.
               Source: Vanguard, based on data from Thomson Reuters Datastream.

                                                          Figure 6b.        Volatility change from adding UK bonds to the bond portion of a global stock/global hedged
                                                                            bond portfolio

                                                          1.5%
           Change in volatility from a global portfolio

                                                          1.25

                                                           1.0

                                                          0.75

                                                          0.50

                                                          0.25

                                                           0.0
                                                                      5     10       15    20     25    30       35        40   45      50     55      60       65     70       75    80     85     90         95    100%
                                                                                                            Overweight to UK bonds within the fixed income allocation

                                                                          20% equity / 80% bond               40% equity / 60% bond                   60% equity / 40% bond
                                                                          80% equity / 20% bond

                 Notes: Displays the historical change in volatility from a global/stock bond allocation that results from overweighting the UK bond market within the bond allocation.
                 Source: Vanguard, based on the data described in the appendix.

11
13 For a more detailed discussion of the desirable properties of global bond investing for UK-based investors, see Westaway and Thomas, 2013.
One reason that adding global bonds to a bond                                             market being much more sensitive to interest
       allocation improves diversification is the presence                                       rate changes, with more volatile prices. In other
       of some unique structural features of the UK                                              words, they have a much higher duration14.
       market. Relative to the global market, the UK                                             Figure 7b shows that as of December 2013, the
       market has a much higher proportion of long dated                                         UK’s duration was close to 9, much higher than
       bonds, while the global market is more evenly                                             any other individual large bond market as well as
       distributed (See Figure 7a). This leads to the UK                                         the global average of just over 6.

          Figure 7.         Comparisons of UK and global bond markets

       Figure 7a: Maturity band weights

       16.0

       14.0        13.6

       12.0
                                   10.1            9.7
       10.0
                                                                  8.8
                                                                            8.0
        8.0                                                                                 7.6
                                                                                                           7.0
                                                                                                                          6.5
        6.0                                                                                                                                   5.6
                                                                                                                                                             4.6            4.4
        4.0

        2.0

        0.0
                   t

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       Figure 7b: Average duration

       10.0
                   8.7

        8.0                        7.7
                                                   7.2            7.2

                                                                            6.1
        6.0                                                                                 5.8
                                                                                                           5.5            5.5
                                                                                                                                              4.6
                                                                                                                                                             4.0            3.8
        4.0

        2.0

        0.0
                   t

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       Source: Vanguard analysis based on Barclay’s Capital Global Aggregate, Sterling, and Inflation linked indices, data as at 31 December 2013.

       14 D
           uration is a measure of the change in price of a bond (or bond index) given a change in the interest rate. Bonds or indices which have higher duration are
12       therefore much more sensitive to interest rate changes.
The UK market also leans heavily towards                                                   Investors cannot manage inflation risk with any
  government, government-related debt and                                                    certainty in a portfolio of nominal bonds. A bond
  investment grade corporate debt and away from                                              portfolio’s real, or inflation adjusted, value falls
  securitised debt. Comparatively speaking, UK                                               when actual inflation exceeds the expected rate of
  bond investors are taking less credit risk                                                 inflation built into market interest rates at the time
  (potentially forgoing higher yields) than is available                                     the investor purchased the bond. Since inflation-
  in the global market as a whole (See Figure 7c).                                           linked gilts provide inflation-adjusted increases to
                                                                                             both principal value and interest payments, an
  Figure 7d also illustrates a unique feature of the                                         investor can manage the extent to which their
  UK bond market with respect to inflation-linked                                            bond portfolio is subject to short term inflation
  bonds. Since 1999, inflation-linked gilts have, on                                         risk. For this reason LifeStrategyTM Funds include
  average, represented approximately 21% of the                                              an allocation to inflation-linked UK bonds.
  overall UK bond market and 30% the UK gilt
  market respectively. This is much higher than the
  proportions offered globally.

  Figure 7c: Sector distribution of UK and global bond markets

                   80%

                       70                 69

                       60
                                    53
Weight in market

                       50

                       40

                       30
                                                                                                           21   20
                       20                                                                                                                16
                                                                         14
                       10                                                         8
                                                                                                                                               3
                        0
                                   Government                       Government-related                     Corporate                    Securitised
                                                                                            Sector

                            Global aggregate          Sterling aggregate

 Figure 7d: Proportion of inflation-linked bonds in local markets

 25%

              20            19.3

              15

                                              11.2
              10                                                 9.1

                                                                                      4.8            4.7               4.7        4.6
                   5

                                                                                                                                                      0.5
                   0
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 Source: Vanguard analysis based on Barclay’s Capital Global Aggregate, Sterling, and Inflation linked indices, data as at 31 December 2013.

13
The non-UK portion of the bond allocation in                                      Allocating approximately 35% of the bond
       the LifeStrategy™ Funds is hedged into sterling.                                  portion of the portfolio to UK bonds, spread
       Currency fluctuations impart significant volatility                               among government (including inflation-linked),
       into a global bond portfolio well above the                                       government-related and investment grade
       volatility of the underlying bonds themselves.                                    corporate sectors, and the remainder of the
       This currency-induced volatility can overwhelm                                    allocation to global ex-UK bonds hedged back to
       much of the diversification appeal of going global                                sterling is a reasonable strategic asset allocation.
       with bonds. Hedging this currency exposure                                        It allows the investor access to the sources of
       reduces the currency volatility, and allows foreign                               risk and return available in the global market while
       bonds in a UK portfolio actually to ‘behave like                                  maintaining exposure to local factors. While less
       bonds’, independent of the gyrations of the                                       radical than a pure market weighting of 92% to
       bond’s issued currency.                                                           non-UK bonds, a 65/35 split between non-UK and
                                                                                         UK bond still represents a reasonable balance.

       Interest rates and bond investing                                             reflected in the shape of the yield curve. An
       Given the inverse relationship between bond                                   upward-sloping yield curve by its very nature
       prices and interest rates, combined with the                                  indicates that the market already expects interest
       higher sensitivity of long bonds to rate changes,                             rates to increase in the future. With longer-term
       many investors might wonder about the                                         bond yields much higher than those of short-
       relationship between duration risk and the interest                           term bonds, by lowering duration, the investor
       rate outlook. Is it a good idea to change portfolio                           effectively gives up income in return for lower
       duration in order reduce interest rate risk, at least                         exposure to duration risk. But investors are
       until the worst of the rate uncertainty passes?                               much better served by taking a ‘total return’
       While any given investor might have very good                                 approach. Over any given time horizon, both
       reason to adjust their bond exposure, we believe                              price return and income will drive an asset’s total
       that the future outlook for interest rates should                             return. Because of this, investors should weigh
       generally not be a significant factor.                                        their expectations for interest rate movement
                                                                                     against the income they give up by altering their
                                                                                     portfolio duration.15
       Interest rates are notoriously difficult to forecast
       correctly with any consistency (Davis, et al, 2010)
       but, to the extent that a consensus exists on
       the future path of rates, it should already be

       Role of inflation-linked gilts for investors                                      for investors to add to their portfolio using
       at, or near, retirement                                                           additional earnings. As a result, investors
       Inflation-linked gilts can be particularly relevant                               must balance their need to preserve capital,
       for investors at, or near, retirement, who hold                                   often through bond and cash-like investments,
       more conservatively allocated portfolios. In the                                  with their need to preserve their portfolio’s
       accumulation stage, salaries and higher real                                      purchasing power, or real value. Holding
       returning assets, such as equities, can provide                                   inflation-linked bonds can provide investors
       effective inflation protection for investor portfolios.                           with a direct hedge to inflation, helping to
       But, once in retirement, it becomes more difficult                                preserve the real value of the portfolio.

14    15	See Westaway and Thomas, Bond investing in a rising rate environment, 2013.
Publically traded property securities                                           However, it is difficult to assess the degree
                                                                                             to which investors can consistently rely upon
             To the extent that property-based securities are
                                                                                             these asset classes and investment strategies
             part of the global equity portfolio, the Vanguard
                                                                                             to deliver their potential benefits, especially for
             LifeStrategy™ Funds include exposure to UK and
                                                                                             those strategies where investable beta is not
             non-UK property at their market weights as part
                                                                                             available for comparison. Strategies such as long/
             of the respective equity allocations. However, the
                                                                                             short, market-neutral and private equity depend
             funds do not hold Real Estate Investment Trusts
                                                                                             exclusively on manager skill. This subjects
             (REITs) or Real Estate Operating Companies
                                                                                             investors to significant manager risk, as the
             (REOCs). Because property based securities
                                                                                             distribution of manager skill is such that investor
             currently account for less than 2% of the UK
                                                                                             success depends on consistently accessing and
             equity market capitalisation (according to FTSE
                                                                                             selecting top managers.17
             EPRA/NAREIT as at 30 September 2013) and
             2.6% of global equity market capitalisation
             (according to FTSE), any additional allocation                                  Vanguard does not include commodities,
             would represent a significant sector overweight.                                and specifically commodities futures, in target
                                                                                             allocation funds based on our assessment of the
             In order to justify a strategic over-weighting to                               risks, costs and complexities. While recognising
             property-based securities, investors must be                                    the historical diversifying benefit of commodity
             comfortable with the fact that property-based                                   futures, Vanguard cautions against making such
             equities tend to perform more like equities                                     an allocation solely based on historical commodity
             than property. Property investors must also be                                  returns. The long-term economic justification
             comfortable with the possibility that the property                              for expecting significant, positive returns from a
             portion of their investment portfolio may correlate                             static, long-only commodities futures exposure is
             with the value of other property holdings in their                              subject to ongoing debate, especially in the costs.
             total portfolio, such as their primary residence.16

             Non-traditional asset classes and
             strategies
             Vanguard’s target-allocation funds do not include
             non-traditional asset classes or investment
             strategies. Non-traditional asset classes include
             commodities, private equity, sub-investment grade
             bonds and emerging market bonds. Additionally,
             common alternative investment strategies may
             also include equity long/short, market-neutral and
             managed futures. These asset classes and
             strategies may offer potential advantages
             compared with investing in traditional equities,
             bonds and cash, including:

             • Potentially higher expected returns

             • Lower expected correlation and volatility to
               traditional market forces

             • The opportunity to benefit from market
               inefficiencies through skill-based strategies

             16	For example, according to the 2011 UK census, approximately 2/3 of homes were owner occupied while 1/3 were rented. Source: Office for National
                 Statistics, www.ons.gov.uk.
17	For more detailed discussion on the use of alternatives, see Philips and Kinniry (2007) and for additional detail and empirical analysis of commodities as
    investments, see the Vanguard publications “Understanding Alternative Investments: The Role of Commodities in a Portfolio” and “Investment Case for
15 Commodities: Myths and Reality”.
The role of passive fund management                                                 Vanguard investigated the construction of
            Vanguard strongly believes that any risks                                           portfolios using actively managed funds. We
            investors bear should be expected to produce a                                      compared the average returns and volatility of
            compensating relative return over time. Modern                                      a portfolio constructed with actively managed
            financial theory and years of investment practice                                   funds to market benchmarks in both UK equity
            lead us to conclude that diversified, broad-                                        and UK bond fund categories. Figure 8 shows
            based index exposures represent precisely this                                      that, on average, most actively managed
            kind of compensated risk. While some active                                         portfolios had lower returns and/or a higher level
            managers can add value at least some of the time,                                   of volatility – the exact opposite of the desired
            outperformance cannot be guaranteed.                                                result of an efficient portfolio.

                                   Figure 8.   Annualised return and volatility

                                   12%

                                    10
       10-year annual volatility

                                     8

                                     6

                                     4

                                     2

                                     0
                                         0           2            4          6           8             10             12               14              16                18

                                                                                       10-year annual return

                                         GBP diversified bond index       GBP diversified bond funds
                                         GBP government bond index        GBP government bond funds
                                         Global equity index              Global equity funds
                                         UK Equity index                  UK Equity funds

            Notes: Active funds are represented by the median returning active fund within each broad asset class. UK equity funds are defined as those active funds
            available for sale in the UK and classified by Morningstar in one of the following categories: UK Flex-Cap Equity, UK Large-Cap Blend Equity, UK Large-Cap
            Growth Equity, UK Large-Cap Value Equity, UK Mid-Cap Equity, or UK Small-Cap Equity. The UK equity market is represented by the FTSE All Share Index.
            UK bond funds are defined as those active funds available for sale in the UK and classified by Morningstar as GBP Diversified Bond. The UK bond market is
            represented by the Barclays Sterling Aggregate Index. All returns are in GBP, income reinvested and cover the 10 years ending 31 December 2013. Active
            fund returns are net of fees and include surviving funds only.
            Source: The Vanguard Group, Inc., based on data from Morningstar, FTSE and Barclays.

16 
While active management offers the potential                                                            As shown in Figure 9, success also tends to be
             to outperform, the evidence suggests that                                                               fleeting, as even the best funds in one time period
             investors do not consistently see this benefit.                                                         can rapidly fall out of favour. Vanguard found that,
             According to data from Morningstar, over the                                                            of the top 20% of funds in five-year performance
             5, 10 and 15 years ended 2013, 66%, 70%,                                                                ending in December 2008, over 65% of those
             and 63% of actively managed UK equity funds                                                             previously top-performing funds had fallen to the
             underperformed their respective benchmarks,                                                             bottom 40% in fund performance or were merged
             or were merged/liquidated within the period.                                                            or closed over the following five years ending
             Investors did not fare better in bond funds,                                                            in 2013. Of course, if fund managers displayed
             where 66%, 92% and 80% of actively managed                                                              persistence in achieving top performance over time,
             UK diversified bond funds underperformed their                                                          nearly 100% of the top performing funds would
             respective benchmarks or were merged/liquidated                                                         remain at or near the top. Instead, the data reflects
             over the 5, 10 and 15 periods ending in 2013.18                                                         the daunting challenge of maintaining top-quintile
                                                                                                                     performance over the long term.

                                                         Figure 9.   Subsequent ranking of former top-quintile active UK equity funds

                                                         30%
     Percentage of funds remaining in the top quintile

                                                          25                                                                                  24.5
                                                                                                                                                                   23.6

                                                           20
                                                                                                                            17.3

                                                           15
                                                                      12.8
                                                                                       11.0              10.8
                                                           10

                                                            5

                                                            0
                                                                 Highest Quintile   2nd Quintile      3rd Quintile       4th Quintile    Lowest Quintile       Liquidated/
                                                                                                                                                                 Merged

                       Notes: We ranked all active UK equity and bond funds based on their risk-adjusted returns (total return divided by volatility) during the five-year period
                       through 31 December 2008. We then re-ranked the fund universe as at December 2013 and identified where each fund ended that period. The columns show
                       the percentage of top-performing funds (top 20%) as at 31 December 2008 and the subsequent performance ranking those funds achieved over the five years
                       through 31 December 2013. To account for survivorship bias, we identified funds that existed at the start of the time period, but were either liquidated or
                       merged during the stated period. The funds included in this analysis are taken from the following Morningstar categories: UK Large-Cap Blend Equity, UK
                       Large-Cap Growth Equity, UK Large-Cap Value Equity, UK Mid-Cap Equity, UK Flex-Cap Equity UK Small-Cap Equity.
                       Source: Vanguard Group Inc. and Morningstar.

17
18	Source: Vanguard Asset Management based on data from Morningstar.
Index investing and the ‘zero sum’ game                • Efficient: Portfolio turnover is limited to
                                                                additions and deletions from an index, M&A
       The concept of a zero-sum game starts with the
                                                                and other corporate actions. Rebalancing is
       understanding that at any one time, the holdings of
                                                                continuous and costless since security weights
       all investors in a particular market make up that
                                                                reflect the market weight.
       market. As a result, for every invested pound that
       outperforms the total market over a given period,      • Transparent: Because an index fund holds
       there must by definition be another pound that           all or most of the securities in a given index
       underperforms. Another way of stating this is that       benchmark at the same weights as that of
       the asset-weighted performance of all investors,         the index benchmark, investors can always
       both positive and negative, will equal the overall       determine which securities constitute their
       performance of the market. In other words, if you        portfolio and how they performed.
       ‘sum’ the positive and negative performance
       of each individual invested pound before costs,        • Diversified: Index funds tracking broad
       it will equal ‘zero’.                                    benchmarks hold all or most of the securities
                                                                that comprise that benchmark. Investors
       However, after accounting for costs, such                benefit from the mitigation of security and
       as transaction, management and other costs,              sector concentration risk.
       a majority of portfolios fall to the losing side       • Lower cost: Index funds typically have low
       of the index’s performance. The funds that do            management fees and low operating costs.
       successfully outperform a benchmark over a given
       period often find it extremely difficult to maintain
       that outperformance in subsequent periods19.

       Index funds provide lower-risk, efficient,
       transparent, diversified and low-cost investment
       vehicles with the potential to increase shareholder
       wealth through exposures in a broad range of
       asset and sub-asset classes.

       • Lower risk: Whether measured by the number
         of security holdings, return volatility, downside
         risk or likelihood of outperforming, active
         management is generally riskier than passive
         management.

18    19	Westaway, et al. 2013.
Financial advisers and target-allocation                                          goals. They are designed with rigourous attention
  funds                                                                             to our latest views on best practice and they
  Vanguard believes target allocation funds provide                                 incorporate Vanguard’s principles for investment
  financial advisers with a number of ways to add                                   success. Nevertheless, using target-allocation
  value for their clients.                                                          funds within a core-satellite investment approach
                                                                                    gives advisers the chance to add value for their
                                                                                    clients in a risk-controlled way.
  Target-allocation funds as a core investment
  For many clients, broadly diversified, low-cost
                                                                                    Target-allocation funds as a source, not a use,
  portfolios may serve as the core component of
                                                                                    of focus and time
  a broader investment strategy. By using a target
                                                                                    Investing in the Vanguard LifeStrategy™ Funds
  allocation fund as the core portfolio, a financial
                                                                                    can allow advisers to focus their time and
  adviser achieves low costs and a high level of
                                                                                    resources on others aspects of their client
  risk control in the investment portfolio, while also
                                                                                    value proposition. Here’s how. Let’s take the
  having the flexibility to invest in more specialist
                                                                                    example of an adviser who serves as a financial
  indices or actively managed funds. In addition to
                                                                                    planner to an individual client. Figure 10 shows
  low costs and a high level of risk control, a core
                                                                                    a representative multi-step investment advice
  investment in a Vanguard LifeStrategy™ Fund
                                                                                    process. The financial planner may work very
  can potentially mitigate the downside risk of an
                                                                                    closely with an investor on steps 1 and 2,
  adviser’s total portfolio when compared with the
                                                                                    which offer the opportunity to build credibility
  broader capital markets and the adviser’s peers20.
                                                                                    and exercise some level of control over
  But the adviser may still seek to outperform the
                                                                                    client outcomes, such as developing trust or
  market average or index, or achieve a specific
                                                                                    documenting a well thought out investment plan.
  investment objective, using the ‘satellite’
                                                                                    The adviser may then decide that a risk-graded,
  component of their investment programme.
                                                                                    professionally-constructed target-allocation fund
                                                                                    ensures both prudent and suitable portfolio
  Based on Vanguard’s research and experience,                                      construction and implementation, thereby
  Vanguard LifeStrategy™ Funds by themselves can                                    fulfilling steps 3 and 4 with a straightforward,
  be wholly appropriate for the majority of investors’                              yet sophisticated, investment selection.

    Figure 10.       Sample investment advice process

                                                          1      Know your client
                                                         Review of client’s financial position
                                                        „„
                                                         History, values, transitions goals
                                                        „„
                                                         Goals-based planning
    5      Monitor progress
                                                        „„
                                                                                                                 2      Develop a plan
   Periodic financial check ups
  „„                                                                                                           Categorise and evaluate
                                                                                                              „„
   Significant life events
  „„                                                              Statement of                                 Determine risk/return requirements
                                                                                                              „„
   Review progress                                                                                             Develop a written plan
  „„
                                                              Investment Principles                           „„

                        4      Implement plan                                                3      Construct portfolio
                      Best execution
                     „„                                                                    Strategic asset allocation
                                                                                          „„
                      Tax efficient trading
                     „„                                                                    Sub-asset allocation
                                                                                          „„
                      Automate rebalancing
                     „„                                                                    Passive/active mix
                                                                                          „„
                                                                                           Asset location
                                                                                          „„
                                                                                           Manager selection
                                                                                          „„

  20	For more on the benefits of using index funds as a core portfolio, see Phillips and Kinniry “Enhanced practice management: The case for combining active
19
and passive strategies.”
This investment selection may free up the                                          The key point is that the decision to invest in a
       time and resources traditionally spent on                                          target-allocation fund is only as effective as the
       activities such as active manager selection and                                    suitability assessment and ‘know your client’
       oversight, while helping to mitigate the risk that                                 process that precedes it. In this way, the adviser
       performance-based promises hurt the adviser’s                                      can provide a single-fund option, such as a target
       credibility. Once an adviser makes an appropriate                                  allocation fund, with the appropriate investment
       investment selection for the client, the periodic                                  strategy and execution to help meet investors’
       adviser-client review, as represented by step five,                                goals and objectives in accordance with their
       offers opportunities for the adviser to enhance                                    risk tolerance.
       a long-term client value proposition. During this
       step, financial advisers can play a central role in
       periodically 21 reassessing a client’s investment
       objectives, risk tolerance, changes in personal
       circumstances and progress toward reaching
       chosen financial goals. This should ensure the
       target allocation fund selected continues to
       suit the client’s current situation.

       Selecting a suitable target-allocation fund
       can also allow advisers to focus on building a
       sustainable and valuable business by enhancing
       relationships with existing clients, or prospecting
       for new clients, as opposed to picking funds.
       It may also help advisers shift client conversations
       from the sometimes-difficult topic of investment
       performance to critical financial planning areas
       such as estate and family planning, areas
       which entail less market risk. These services
       can provide a more reliable foundation for an
       enduring advice practice.

       21	Based on Vanguard’s work with financial advisers, a good rule of thumb is to conduct annual adviser-client reviews. It is important to note the importance
           of appropriately ‘framing’ these periodic reviews. A narrow frame may often lead to an annual review process that is overly focused on short-term
           portfolio performance and, consequently, to regular, inappropriate changes to an investor’s plan. A wide frame, however, may allow a client to recognise
           that short-term volatility and long-term investing success coexist. A well thought out investment plan should not change significantly year after year, but
20        it should reflect significant changes in investor circumstances, such as retirement, having children or a large unanticipated health expense.
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