Time to Dump Volatile Funds?

Dear Beverly:

My concern is that my wife has about $100,000 in (VWUSX Quote)Vanguard's U.S. Growth fund. It's one of the limited choices through her 401(k) plan, and neither one of us has been watching it very closely. I would expect volatility from this fund, but at what point do I start being concerned with management improprieties? It's beyond me how the fund cannot even match the S&P.

The fund managers seem to be dancing as fast as they can. I was not aware until this morning that Alliance Capital was the adviser for the fund. It's my ignorance, but I'd assumed Vanguard would be the manager of its own fund.

My question is should I suggest my wife dump this fund and cut our losses or will the volatility at some point start to work in our favor. Again, excuse my ignorance, but I thought that if anyone could be trusted to hold money for long-term investment it would be Mr. Bogle, but he seems to have turned his back on this one. Any advice would be greatly appreciated.

Thanks,

Daniel M.

Daniel,

There are several issues to tackle here, but the main distinction I want to make is between a poorly performing fund and one in which investors should worry about impropriety.

Vanguard's U.S. growth fund is a poorly performing fund. While it lagged its peers 2.5 percentage points in 2003, its immensely subpar performance has landed it in the bottom quartile of its category the four years prior -- which includes the bull market of 1999.

Alliance Capital(AC Quote) was brought on in June 2001 to replace longtime adviser Lincoln Capital, but the new team has largely avoided the more speculative stocks that drove the market up in 2003. While 28% of the fund is in technology stocks, contributing to the volatility of the fund, the bulk of that allocation is in blue-chips such as Microsoft (MSFT Quote), Dell (DELL Quote) and Cisco (CSCO Quote), as well as biotechnology/pharmaceuticals companies such as Pfizer (PFE Quote) and Amgen (AMGN Quote).

Last month, Alliance settled charges with the Securities and Exchange Commission and New York State Attorney General Eliot Spitzer that it defrauded mutual fund investors by allowing market-timing in a number of its funds. Morningstar analyst Christopher Traulsen says that the bad news about Alliance is mitigated for this fund's investors, since none of the managers of this particular fund have been accused of wrongdoing. More important, though, Vanguard -- not Alliance -- controls all the flows in and out of the fund.

Still, though, "it does raise some ethical questions about the people [Vanguard] is doing business with," Traulsen says. "If I owned this fund I'd be looking for a replacement."

Fund companies frequently hire outside portfolio managers to do the buy-and-sell research and legwork. Each and every mutual fund has a board of directors -- 40% of those directors are supposed to be independent; the remainder can work for the investment management firm that oversees the fund. For instance, let's say this fund has 10 directors; four of them must be independent, and the other six can be Vanguard employees. It's the responsibility of the directors to hire the managers of the fund -- not just the individual, but also the firm. Management contracts should be drawn up to benefit the shareholders -- so minimizing costs is paramount. (Although not always -- for more on fee issues with subadvised funds, see this story.)