Ride Out The Next Market Storm With These Balanced Vanguard Funds

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About: Vanguard Wellington™ Fund Inv (VWELX), VWENX, VWIAX, VWINX, Includes: VFIAX
by: Minutemen

Summary

Investors who have ridden the current bull market to new highs over the past decade have accumulated a lot unrealized capital gains.

No one knows when the next bear market will occur or how steep the losses will be.

Investing in passively managed stock index funds won't protect you from the next market crash.

Adding these two actively managed funds from Vanguard can help mitigate your portfolio's losses and generate dividend income during the next market downturn.

The stock market has sailed to record gains of more than 400% since the 2007-2009 financial crisis, and investors who didn't abandon ship have weathered the storm and are now likely in terrific financial shape. However, as the market waters have risen to new heights, investors flush with unrealized gains may be looking to navigate toward calmer seas during the next crisis. In this article, I take a thorough look at two actively managed, balanced mutual funds from Vanguard that provide capital appreciation as well as income from stock dividends and bond distributions, and that also provide a level of capital preservation during periods of market turbulence. The data below reveal how adding these funds can help buoy your hard-fought portfolio from sinking to the next market bottom.

how to protect investments from stock market crash

Painting: Marcus Larson, "Stormy Sea", 1857. Public Domain Image.

Riding the Current Bull Market Tailwinds

For investors who have witnessed their portfolio value rise dramatically as we have officially entered the second-longest bull market in history, it may be difficult to remember the dread and angst that was felt by many as the S&P 500 index lost 56.8% of its value from Oct 9, 2007 to the market bottom on March 9, 2009. Since then the S&P 500 share price has more than quadrupled, rising 329.3% as of Sept. 18, 2018 and is currently trading near its all-time high. When factoring in reinvested dividends, the S&P 500 has done even better, generating total returns of 424.4%.

Source: YCharts

Investors who didn't jump ship to sell their holdings for losses during the 2007-2009 market crash, and who continued buying stocks at low prices during that period, have weathered the storm well and are now sitting on hefty gains and are substantially wealthier now than they were a decade ago. However, as the current bull market keeps trudging along, it is certain that we are getting ever closer to the next major market storm with each passing day. No one can say with any certainty when the next recession, market correction or bear market might occur, but investors who have accumulated a lot of wealth are likely looking for investment strategies or funds to help preserve some of their assets and weather the next storm with fewer losses than that of the broader stock market. Similarly, investors approaching retirement age with a high percentage of their portfolio in stocks may be looking to add ballast to their portfolios with an increased tilt toward bonds.

Besides simply setting anchor on a stockpile of cash in preparation for the next big market downturn, it would be nice if one could put some money into assets today that generate regular income above that of current money market funds, and that also provide capital appreciation as well as future downside protection. Is such an investment vehicle too good to be true you might ask? In this article, I analyze two actively managed, balanced mutual funds from Vanguard with different percentages of stocks and investment-grade bonds that have previously weathered severe market downturns better than the S&P 500 and that have also generated nice capital appreciation and income distributions for decades. Adding one or both of these funds to your portfolio can help mitigate the risk sinking with the market to the next bottom.

Overview: The Vanguard Wellesley Income and Wellington Mutual Funds

These two Vanguard mutual funds own both stocks and bonds and are categorized as "balanced" funds, meaning that they strive to keep a steady balance between the two asset classes. However, the allocation of stocks and bonds for each fund is somewhat of a mirror image of the other, with the Wellesley Income Fund allocating 60%-65% to bonds and 35%-40% to stocks, while the Wellington Fund allocates 30%-40% to bonds and 60%-70% to stocks. With its heavier bond weighting, the Wellesley Income Fund is categorized as having a conservative portfolio allocation while the Wellington Fund's heavier stock weighting tilts it to a more moderate allocation of stocks and bonds. The Wellington fund is Vanguard's oldest mutual fund (inception on 7/1/1929) as well as the oldest balanced fund in the U.S., and both are expertly managed by the Wellington Management Company for Vanguard.

Source: Vanguard

Each actively managed fund comes in two share classes (Investor Shares and Admiral Shares) with different minimum investment amounts and associated expense ratios depending on the share class. Both funds have minimum investment amounts of $3,000 for the Investor Shares and $50,000 for the Admiral Shares. The Wellesley Income Fund Investor Shares (VWINX) has a low annual expense ratio of 0.22% ($22 per $10,000 invested) while its Admiral Shares (VWIAX) are even cheaper with an expense ratio of 0.15%. Similarly, the Wellington Fund Investor Shares (VWELX) has an annual expense ratio of 0.25% and the Admiral Shares (VWENX) cost even less at 0.17% annually. The annual expenses for both share classes are very low considering the excellent management teams and stellar track records over the years. However, the differences in annual expenses between the Investor and Admiral share classes does impact the distribution yield, as shown in the table below and affects the long-term total returns as will be shown in the analyses to follow.

Source: Vanguard and Morningstar

According to Vanguard, the Wellesley Income Fund "seeks long-term growth of income, a high and sustainable level of current income, and moderate long-term capital appreciation by investing in high-quality bonds and stocks." This heavier focus on income with Wellesley is reflected in the fund's higher trailing 12-month yield compared to Wellington. Vanguard also states that a goal of the fund is "to provide an attractive and stable income stream that increases over time, with moderate capital appreciation and moderate risk." We will analyze the dividend distributions below to see whether the fund has been successful in increasing its dividend over time as stated.

In contrast to Wellesley, The Wellington Fund focuses more on capital appreciation in addition to providing "reasonable current income and capital preservation." Both funds have received Morningstar's highest 5-Star ratings based on their past performance, and both have received Morningstar analyst ratings of Gold for their allocation process, low risk-adjusted returns, and predicted future outperformance as compared to their benchmark and category peers.

Source: Morningstar

It should be noted here that the Wellington Fund is currently closed to new investors. However, the good news is that you can still purchase the fund as long as you have a Vanguard Brokerage account according to the recent prospectus.

So now let's take a deep dive into how these two mutual funds have fared in various market conditions over the past decade or so. In the following sections, we'll take a look at their performance during financial crisis of 2007-2009, as well as during the decade-long bull market that followed as compared to the S&P 500. We'll also see how several hypothetical million-dollar portfolios constructed of these funds weathered the market cycle. Finally, since a major objective of both of these funds is to provide investors with a regular source of annual income, we'll examine the income distributions over a 12-year period using a hypothetical investment of $10,000 into each mutual fund.

Anchors Aweigh!

Analyzing Wellesley Income and Wellington Fund Performance During Bull and Bear Markets

I. Performance During the 2007-2009 Bear Market

The financial crisis that occurred in 2007-2008 lead to bear market decline in stocks that began on October 9, 2007, and lasted until the market bottomed on March 9, 2009. If you happened to have your entire investment portfolio in an S&P 500 index fund and held to the bottom, then you would have watched (or closed your eyes) with nausea as your invested wealth plummeted by nearly 57%. While such investors may have thought they were adequately diversified by holding 500 stocks in a broad index fund, they weren't sufficiently diversified across other asset classes such as bonds (which may include treasury bonds, municipal bonds, corporate bonds, mortgage bonds, etc.).

The following chart compares the share price returns of the Wellesley Income and Wellington funds to the Vanguard S&P 500 Index Fund (VFIAX) during the 2007-2009 bear market. While both the Wellesley Income and Wellington funds also lost a lot of value during the market crash, they did not fall nearly as far as the S&P 500. Because of the Wellesley Income fund's greater allocation to bonds, it provided the most downside protection against capital loss. Also notable is that both the Investor Shares and Admiral Shares performed very closely during this bear market.

The blue and orange lines (Wellesley) and the green and red lines (Wellington) completely overlap on the chart above. Source: YCharts

It is important to keep in mind that although the share prices of all funds had large declines, investors would have also been receiving income from dividend distributions during the bear market, which would have eased some of the pain. The next chart below shows how the income generated from each fund would have cushioned the blow from the market storm even more if the distributions were reinvested to purchase more shares.

Source: YCharts

With income distributions reinvested, the Wellesley Income Fund declined by approximately 34% less than the 500 Index fund, while the Wellington Fund declined about 19% less. Had investors allocated a portion of their investments to the Wellesley and/or Wellington funds, their losses would not have been as great as investing 100% into an S&P 500 index fund, such as VFIAX. Indeed, the table below shows what would have happened to five hypothetical portfolios with initial values of $1 million dollars each at the start of the bear market on October 9, 2007 (using total return values of Admiral Shares from the chart above).

Portfolios with multiple fund holdings were equally weighted starting October 9, 2007. Source: Author's Calculations from YCharts Fund Returns

Based on the terminal values of these five portfolio allocations, one can clearly see how the Wellesley Income and Wellington funds can act to preserve investor capital during severe bear market downturns. What this analysis also demonstrates, of course, is what many financial advisors are consistently advocating, i.e., one should hold a diversified portfolio consisting of both stocks and bonds. The Wellesley Income and Wellington funds provide investors with a simple way to achieve such diversity and have the added benefit of active management, which is important for navigating the complex bond markets, especially in a period of rising interest rates that we are currently in.

II. Performance During the Bull Market Recovery: 2009 to Present

We've seen that the Wellesley Income and Wellington funds held up quite well during the 2007-2009 bear market compared to the S&P 500. But how have they performed since the bull market began immediately following the bottom on March 9, 2009? The next chart below compares the share price returns of the same funds from the market bottom in 2009 to the recent market close on Sept. 18, 2018.

Source: YCharts

Bull markets are where stocks really shine, and this was no exception with the various fund performances during the current decade-long bull market. While all the funds gained in share price since the market bottom, the Vanguard 500 Index Fund with its 100% stock holdings clearly trounced the Wellesley Income and Wellington funds. The next chart below adds in reinvested distributions from stock dividends and bond coupons to look at total return performance during the same period.

Source: YCharts

When taking fund income distributions into account, once again the S&P 500 Index is the clear winner in total return performance. However, note how substantially the income components of the Wellesley and Wellington funds added to total returns compared to the 500 Index Fund. While reinvested stock dividends increased the S&P 500 performance by a factor of 1.28, income distributions doubled the performance of Wellesley and Wellington funds by factors of 2.36 and 2.10, respectively.

As I did for the 2007-2009 bear market, I again constructed five hypothetical portfolios with initial investments of $1 million per portfolio, but this time invested each at the market bottom on March 9, 2009, and let them ride the bull market's rising tide up to September 18, 2018 (using Admiral Share Classes). As illustrated in the chart below, the bull market saw performance gains for the funds that were in the opposite direction and magnitude of the bear market declines, with the S&P 500 increasing more than 5-fold to an excess of $5 million. On the opposite end, Portfolio 5 with its total concentration in the Wellesley and Wellington funds and higher bond exposure increasing just under 3-fold to $2.92 million.

Portfolios with multiple fund holdings were equally weighted starting March 9, 2009. Source: Author's Calculations from YCharts Fund Returns

The results of these hypothetical portfolio allocations during bear and bull markets demonstrate how the Wellesley Income and Wellington funds, with their bond holdings, act to serve as ballasts during stormy markets to buoy the portfolios from sinking all the way down to the market bottom. But their bonds holdings also serve as anchors during the rising tides of bull markets and act as a drag on the portfolios that prevent them from reaching the market highs.

But you may be wondering how these same portfolios would have fared had they been allowed to run through the entire bear and bull market cycle from October 9, 2009 (start of the bear market) to the present, thus allowing the million-dollar investments to ebb and flow along multiple market currents.

This is where, in my opinion, the results are truly interesting. As the chart below shows, the portfolio terminal values all ended up being fairly close. However, the portfolio with the greatest total gains was Portfolio 3 that included the initial 50/50 investment into the Wellesley Income Fund and the S&P 500 Index Fund. In this example, we can see how the combination of a stock-heavy fund (VFIAX) and a bond-heavy fund (VWIAX) acted synergistically to favorably hedge both the bear and bull markets from 2007 to 2018.

Portfolios with multiple fund holdings were equally weighted starting October 9, 2007. Source: Author's Calculations from YCharts Fund Returns

III. Wellesley and Wellington Fund Income Distributions

In this last analysis section, I'll examine income distributions from the Wellesley Income and Wellington funds along with those from the S&P 500 Index Fund. Those dividend growth investors who look for annually increasing dividend incomes will be disappointed to learn that none of the funds was successful in growing the income distributions annually from 2006 to 2017. Nonetheless, as the results above demonstrate, the income component of the Wellesley and Wellington funds were important factors in their long-term performance and in providing downside protection during the 2007-2009 bear market.

The chart below shows the purchase price, number of shares purchased, and the trailing-twelve-month income yield at the time of a $10,000 hypothetical purchase in each fund based on the closing price on December 31, 2005. Notable is that the Wellesley Income Fund had the largest starting yield and the S&P 500 Index Fund had the smallest yield. Also noteworthy is the differences in yield between the Investor Share Class and Admiral Share Class within the Wellesley and Wellington Funds.

Source of Data: Seeking Alpha and individual fund annual reports. Calculations by the author.

The Wellesley and Wellington funds generate income from both stock and bond distributions (which I refer to as dividend income in the charts below) as well as income from realized capital gains as the fund manager sells the various assets within the funds. The following charts show the income from both dividends and capital gains independently, as well as the total income generated.

The first chart below shows the dividend income (including bond coupons) generated from the various funds and share classes. I didn't provide a table of the annual payouts for each year from 2006-2017, but there was quite a bit of variability and lack of consistency in growing the dividend income from year to year. This is reflected in the dividend payouts shown for the first year of the investment period (2006) and the last year of the investment period (2017), as well as for the low or negative dividend compound annual growth rates (CAGR). Interestingly, the S&P 500 Index fund had the least variability in growing its dividend and had the highest CAGR. Nonetheless, both the Wellesley and Wellington funds generated the most total dividend income and the highest dividend return on investment due to their higher yields at the time of purchase and throughout the holding period.

Negative or low CAGR values for Wellesley and Wellington indicate that there was no consistent increase in the annual dividend. However, the total income return from these funds was greater than the S&P 500 Index Fund.

Source of Data: Individual fund annual Reports. Calculations by the author.

The next chart shows the realized capital gains income generated from each fund. Note here that both the Wellesley and Wellington funds generated a significant amount of income from capital gains, while the S&P 500 fund generated no capital gains. The lack of capital gains is one reason the S&P 500 fund is considered tax efficient. In terms of taxes, investors should also consider that distributions from capital gains and from bond distributions from the funds (except from muni bonds) are taxable at ordinary income rates, which is an important consideration for deciding whether to hold the Wellesley and Wellington funds in taxable vs. tax-deferred accounts. My personal preference is to use Wellesley and Wellington funds in tax-deferred accounts.

Source of Data: Individual fund annual Reports. Calculations by the author.

This last chart combines the income amounts from dividends and realized capital gains to show the total distributions from each fund. Note that total income generated from the Wellesley and Wellington funds is more than double that of the S&P 500 Index Fund. Note also that over the 12-year holding period, the Wellesley and Wellington funds returned between 66% to 71% in income alone on the initial $10,000 investment.

Source of Data: Individual fund annual Reports. Calculations by the author.

Overall, these funds did not demonstrate an ability to annually increase the income distributions from dividends or realized capital gains. However, the income generated from the Wellesley and Wellington funds was substantially higher than that of the S&P 500 fund and was shown to be an important factor in preserving loss of capital during the 2007-2009 bear market.

Conclusions

Although it has often been stated that "a rising tide lifts all boats" in regards to an improving economy, as Warren Buffett famously quipped, "you only find out who has been swimming naked when the tide goes out." The popularity of passively managed index funds, such as S&P 500 funds, has grown in recent years as the economy has improved since the financial crisis of 2007-2009, and many investors have seen their investment portfolios grow substantially since then. Indeed, as the data in this article has shown, if you happened to invest 100% of your money into a low-cost S&P 500 index fund, then you would have watched your portfolio grow more than five-fold or over 400% since March 2009. A million dollars invested in an S&P 500 fund would be worth $5.2 million today with dividends reinvested.

However, what I hope to have shown in this article is that one can just as easily sink to the bottom as well as float along at the top by holding all of one's assets in even a highly diversified stock index fund. While the S&P 500 index fund handily beat the Wellesley Income Fund and the Wellington Fund during the current bull market period, the data presented above shows how diversification into these more conservative funds can help protect against loss of capital during a severe market downturn and even outperform the S&P 500 across bear and bull market cycles.

No one knows when the next recession, financial crisis, or bear market will occur. But I can state with certainty that there will indeed be another crisis and another bear market. How severe it will be and how long it will last, no one knows. But if you are an investor who has enjoyed cruising along with the stock market to new record highs during the past decade, you should ask yourself whether you are mentally ready to watch your portfolio value plummet by 20% to 60% or whether you would like to add some ballast to your portfolio to keep it from doing down with ship. As this article as shown, the Wellesley Income Fund and the Wellington Fund are two great choices for shoring up your ship.

Cartoon: Tim Eagan 2014

Disclosure: I am/we are long VWIAX, VWENX, VFIAX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.