Vanguard research February 2014

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

Authors

Peter Westaway, PhD

John Velis, PhD

Executive summary. This paper explores the theory and research that informs and underpins the design and construction of Vanguard LifeStrategy™ Funds.

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.

Connect with Vanguard > vanguard.co.uk

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.

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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.

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Vanguard’s target-allocation funds apply a number of investment best practices, including global asset allocation, broad diversification and a balance between risk, return and cost. The funds offer straightforward and transparent design, low investment costs and broad exposure across

global equity and bond allocations, all of which are designed to enhance the ability of investors to meet their goals. In short, they represent an all-in-one instrument aligned with Vanguard’s Principles for Investment Success,1 as depicted in Figure 1.

Figure 1. Vanguard’s Principles for Investment Success

Goals

A sound investment plan for individuals – or an investment policy statement (IPS) for institutions – begins with an outline of the objectives, as well as any significant constraints. Most investors have rather straightforward objectives, such as saving for retirement, saving for children’s education, preserving assets, funding retirement or meeting a shorter term ‘need’ or ‘dream’. If the investor has multiple goals, such as gathering enough for both retirement and a child’s university expenses,

the overall plan can include different portfolio allocations for each goal. Alternatively, they can generate a separate plan for each.

Clear, appropriate investment goals should be measurable and attainable. For example, given that many objectives are long term, an appropriate plan should be designed to endure through changing market environments. On the other hand, some investment time horizons could be much shorter and/or include less tolerance

1 See Vanguard (2013) Vanguard’s Principles for Investment Success

1 Goals Create clear, appropriate investment goals

Working with a financial adviser, the investment process begins by setting measurable and attainable investment goals and developing plans for reaching those goals.

2 BalanceDevelop a suitable asset allocation using broadly diversified funds

A successful investment strategy starts with an asset allocation suitable for its objective. With your adviser’s help, you can then 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 CostMinimise cost

You can’t control the markets, but you can control how much you pay to invest. Every pound that you pay in costs and charges comes directly out of your potential return.

Indeed, research suggests that lower-cost investments have tended to outperform higher-cost alternatives.

4 DisciplineMaintain perspective and long-term discipline

Investing evokes emotion that can disrupt the plans of even the most sophisticated investors. Some make rash decisions based on market volatility.

But, with your adviser’s help, you can counter 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

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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 “Principles for Investment Success”(2013) for a more extensive discussion of the perils of market timing.

for risk. In these cases a less aggressive asset allocation would be preferred. In general, investors may have many constraints, and they could be either simple or complex. Examples of other constraints include: taxes, liquidity requirements, legal issues or the desire to avoid certain types of investments. Constraints can also change over time.

All-in-one funds, such as Vanguard LifeStrategy™ Funds, offer a range of risk and return profiles designed to align with different investors according to their individual objectives, constraints, age, income, risk attitude, time horizon and preferences.

Balance

When building a portfolio to meet a specific objective, the critical first step is to choose an asset allocation: the combination of assets which offer an investor the best chance to meet their goals. A balanced plan incorporates reasonable expectations for risk and return in a broad and well-diversified asset allocation.2 Indeed, a portfolio’s asset allocation – the percentage of a portfolio invested in various asset classes – determines the overwhelming majority of its return variability and long-term performance.

LifeStrategy™ Funds provide the investor with exposure to both the higher risk and return associated with investing in equities and the diversification, volatility-reduction and downside protection provided by global bonds. Given that asset allocation is a primary determinant of investment outcomes over the long term, we discuss this concept and its application in greater detail below.

Cost

All else being equal, the lower the costs incurred by investors, the greater their investment returns. Research also suggests that lower-cost investments have tended to outperform higher-cost alternatives. Contrary to conventional wisdom about the relationship between price and quality, the relationship between investing and

costs is inverse. This is because investors see their returns reduced pound for pound by the cost they incur. For example, a 2011 study3 examined US mutual fund performance between 2001 and 2010 and concluded that the higher the fund’s expense ratio, the worse it performed. The evidence shows that higher costs tend not to be offset by better performance.4

Vanguard’s target allocation funds achieve their mix of equity and bond exposures by employing passive indexing. Indexing offers a competitive cost profile relative to active strategies thus increasing the likelihood that investors will achieve better overall performance.

Discipline

The asset allocation decision only works if investors adhere to it over time and through varying market environments. Investors are often tempted to try to ‘time’ the markets, changing their asset allocation in response to short-term market developments. However, academic and practitioner research has repeatedly shown that even professional investors persistently fail to time the market successfully5. Similar temptations include the impulse of investors to ‘chase’ market sectors or funds that have performed well in the recent past. In practice this can often be a losing strategy since the past performance of any investment can never be relied upon to predict future returns.

Another pitfall is failing to periodically rebalance a portfolio. As markets rise and fall, the investor’s portfolio often drifts away from the original target asset allocation. So as not to stray too far from one’s asset allocation, periodic rebalancing can keep the portfolio’s in line with the investor’s goals and risk profile. Target allocation funds, which maintain a static asset allocation through periodic rebalancing, help mitigate this potential hazard. LifeStrategy™ Funds can help investors avoid these common behavioural errors. They are professionally managed, continually rebalanced back to their initial asset allocation and do not take market bets in favour of or against any particular market or subsector.

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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

100% equity fund, representing the riskiest fund in the lineup.

Asset allocation of target funds

Asset allocation – the proportion of a portfolio invested in various asset classes – determines the majority of the return variability and long-term performance of a portfolio. Countless academic studies and years of investment experience have explored and confirmed this principle6.

Vanguard LifeStrategy™ Funds allocate to global equities and global bonds, with a range of equity-bond mixes as shown in Figure 2. The funds are intended to offer appropriate blends for different investors with diverse risk tolerances and investment goals.

Target allocation funds maintain a consistent exposure to stocks and bonds through time and market events through periodic rebalancing to the initial asset allocation. This policy allows the investor to access both the higher return that

equities are expected to generate over time with the diversification and volatility-reducing properties offered by bonds. Because equities tend to be riskier and more volatile than bond investments, they are expected to offer a higher return over reasonably long periods of time. This concept is known as the ‘equity risk premium’. Financial theory suggests that – all else being equal – a riskier investment on average and over the long run ought to offer a higher return to the investor. If relatively riskier investments did not offer relatively higher expected returns, investors would not buy them.

Of course, their more volatile behaviour can result in periods during which equities actually return less than bonds. Because of equities’ downside risk and volatility over short time periods, target allocation funds maintain some exposure to bonds7, which help mitigate, or diversify, the risk posed by holding portfolios entirely made up of equities.

Figure 2. Vanguard LifeStrategyTM Funds target allocations (as at 31 January 2014)

Sources: Vanguard Asset Management

Equities – Emerging Markets

Bonds – UK Government

Equities – Global Developed (ex-UK)

Bonds – UK Investment-grade

Equities – UK

Bonds – UK Inflation-linked Bonds – Global

Vanguard LifeStrategy™ Funds target allocationsFigure 1.

Vanguard LifeStrategyTM 100% Equity Fund

Vanguard LifeStrategyTM 80% Equity Fund

Vanguard LifeStrategyTM 60% Equity Fund

Vanguard LifeStrategyTM

40% Equity FundVanguard LifeStrategyTM 20% Equity Fund

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Bonds typically return less than equities, but the variability of their return profile is usually lower. Indeed, they can often perform inversely to equities, as seen in the example given in the text box on the equity risk premium. When stocks enter a bear market period, bonds usually perform

better with lower volatility. Combining them with equities therefore acts as a sort of ‘shock absorber’ in dampening equity market volatility. In some circumstances, bonds may actually increase in price while equity markets fall. In these ways, they act as a diversifier of equity market risk.

Understanding the equity-risk premium

The equity-risk premium refers to the economic relationship which states investors in equities take on more risk and therefore expect a higher return, or ‘risk premium’, than investors in cash or bonds.

However, this expected risk premium may or may not be realised over an investor’s time horizon. The realised risk premium can vary greatly from the expected or historical risk premium. Equity returns can be highly volatile and long-term returns can deviate from the historical ‘average’ return. But just because equities are sometimes volatile and can trail bond returns for substantial periods of time, does not mean that we should expect a negative risk premium for equities over the long term.

Take the most recent financial crisis for example. In 2008, the MSCI All Country World Equity Index fell by 39.2% from 31 December 2007 through 31 December 2008, while the BarCap Global Aggregate bond index (hedged to pounds sterling) rose by 7.6%.8 Does that mean that the idea of the equity risk premium is invalid? Not in the long run. Using the same indices and looking at the ten years ended 30 June 2013, equities rose by an average of 7.3% annually, while bonds returned an average of 5.2%. This illustrates that the point remains: over short periods, equities sometimes underperform bonds (they are more volatile, after all), but over sufficiently long periods, equities are expected to outperform bonds. Of course, historical returns are never a reliable predictor of future results. The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Because equity ownership means the investor is on the front lines of business losses (bond holders have first claim to assets in the event of the failure

of the business), equity holders by definition face more intrinsic risk to their investment than bond holders. In addition, while bond holders are contractually promised a stated payment, equity holders simply own a claim on future earnings. How the company uses those earnings (paying them out in the form of dividends and share repurchases, or reinvesting in the operations of the firm) is normally beyond investors’ control.

Again, by definition, equity ownership is riskier than debt ownership. Relative to gilts, where repayment of the loan is backed by the government, ownership of uncertain future corporate earnings is indisputably riskier. Because of this risk, investors must be enticed to pay for a claim on uncertain future earnings and this ‘carrot’ is the premium or higher return that investors demand over time to bear that risk.

Another way of looking at the concept of the equity risk premium is to recognise that a firm’s shareholders are its owners. They receive a return on the firm’s capital via their stake in the firm and their claim on its revenues. Bonds, which are essentially loans made to the firm, require the payment of an interest rate that should represent the cost of capital to the firm. If this cost of capital is higher than the return on capital, the firm will fail. Extending this to the entire market, it means that for investment and economic growth, the return on capital should exceed the cost of capital. As the owners of capital, shareholders should realise a higher return than they pay to borrow. This excess return is the equity risk premium9.

8 Index performance for both equities and bonds are reported as total returns.9 This relationship assumes we are comparing an equity index to a corporate bond index for similar companies.

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Figure 3 shows the risk/return trade-off over long periods. As the proportion of equities in the portfolio increases, average annual returns increases, as does the range of annual outcomes.

On the other hand, as the proportion of bonds increases, the variation of annual outcomes drops significantly, but so too does the average annual return.

Tactical allocation strategies: Are they worthwhile?

A tactical asset allocation (TAA) strategy actively, or opportunistically, adjusts a portfolio’s asset allocation based on short-term market forecasts. It aims to exploit perceived inefficiencies or temporary imbalances among different asset or sub-asset classes. When considering the potential inclusion of a tactical asset allocation strategy, investors should consider the significant risks and obstacles that can overwhelm any theoretical benefits. Some studies10 have shown that while some strategies have added value at the margins, on average, most tactical strategies have failed to produce consistent, or durable, positive excess returns.

Furthermore, even if some managers can add value by implementing tactical tilts, the return profile can be highly variable. For example, one of the most basic TAA strategies involves large shifts between equities and bonds or cash. When the manager feels that the latter will outperform the former, they will re-weight towards bonds (or vice versa). If the timing is right, the investor will benefit, but at the cost of a large deviation from the initial risk exposure implied by the strategic asset allocation. If the manager mis-times the move, however, the drawdowns (short term losses) can be quite large and very hard to make up. In addition, tactical strategies typically limit transparency, increase cost and potentially complicate management and oversight.11

10 See 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..

11 Stockton and Shtekhman, 2010.

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

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.

175%

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5.3% 6.2% 7.1% 7.8% 8.4% 8.9%

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Sub-asset allocation: Diversifying within asset classes

Once investors make their target asset allocation to equities and bonds, they could look at allocations across sub-asset classes. Some investors use a bottom-up approach, investing in those securities or sub-asset classes they reckon will deliver superior performance. Yet this practice is often fraught with pitfalls. Akin to trying to look around corners, it is notoriously difficult to predict which sub-asset classes (be they economic sectors, geographic regions, or investment styles such as small-capitalisation or value stocks) will outperform the market over various time horizons.

Sometimes, investors will ‘chase’ performance by increasing their exposure in the forthcoming period to that market segment which performed well in the most recent time period. But as

Figure 4 shows, the relative performance of sub-asset classes can vary greatly over time. The ‘hot’ sector(s) one year can often fall out of favour the next. Chasing returns often results in the double-whammy of higher trading costs for the investor with disappointing performance of the portfolio.

On the other hand, a broadly diversified portfolio provides consistent exposure across key sub-asset classes. Consequently, investors participate in the entire market, with exposure to the stronger-performing sectors while mitigating the negative impact of weaker-performing ones. This provides superior diversification across market cycles.

Analysing past returns reveals that taking advantage of market shifts could result in substantial rewards. However, the opportunities that appear clear in hindsight are rarely visible in

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 reinvested dividends and interest.

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

Top

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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

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%

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%

-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%

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Vanguard’s target-allocation funds diversify a UK equity portfolio with broad-based, non-UK equities equal to approximately 75% of the total equity allocation. Finance theory suggests a global equity allocation that reflects the market capitalisation of the global market. In the case of the UK, this would imply holding 92% of the equity portfolio in non-UK equities. However investors in every country have historically displayed a significant bias towards their home markets. In the UK, for example, a 2005 study (Chan, et al) revealed that UK investors, on average, constructed portfolios with a 5.3 times bias to domestic equities. In other words, while the global market weight of UK equities is approximately 8%, the embedded ‘home bias’ would suggest an allocation of approximately 48% to UK equities (and 52% to non-UK equities).

Previous Vanguard research (Schlanger, 2013) weighed the short and long-term impacts to a portfolio of investing across a wider range of markets, including the opportunity to invest in a larger number of securities, risks associated with overweighting domestic markets, expected risks, returns and correlations. It concluded that global diversification among the world’s equity markets should be considered a reasonable starting point for investors’ equity allocations.

However, investor preferences and bias towards domestic markets must be weighed against the relative advantages of global diversification. Recognising this reality, the LifeStrategy™ Funds invest approximately 25% of their portfolios in UK equities and the remaining equity portfolio in unhedged market cap-weighted equities outside the UK. Vanguard believes these allocations represent a reasonable trade-off between investor preferences and ensuring that investors gain exposure the potential of global investing.

advance. The importance of full market exposure within asset classes cannot be understated. While bets on specific market segments may seem appealing, these bets imply that the market is incorrect in its assessment of the valuation of a sub-asset class.

Some investors use quantitative tools such as optimisation to periodically adjust their asset allocation based on expected returns and correlations of the asset classes in the portfolio. They aim to achieve the maximum expected return for some given level of risk. This approach, while rooted in basic financial theory, can often lead to significant swings in the portfolio weights from one period to the next. At the extreme, they can result in portfolios that differ widely from the strategic asset allocation. Furthermore, forecasting expected returns and inter-asset class correlations can be notoriously tricky.

Target allocation funds maintain a static asset allocation over time regardless of market events and cycles. This ensures a consistent exposure to equities and their expected risk premium over the long term. Vanguard regularly reviews the asset allocation of LifeStrategyTM Funds, employing the most up-to-date research on portfolio construction, investor attitudes and always mindful of the lessons that long years of experience have taught us. Quantitative methods, such as optimisation, can help but do not exclusively determine the asset allocation of the funds. Instead, we use a number of inputs, which are aimed at meeting Vanguard’s principles for investing success.

Equity allocations in target allocation funds

UK equities and global ex-UK equities account for about 25% and 75%, respectively, of the 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.

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UK and global ex-UK bond allocations

LifeStrategyTM Funds offer investors a range of asset allocations which include bonds. Historically, the correlation between equity and bond returns has been low, providing diversification benefits. In extreme market conditions, an allocation to government bonds (both gilts and inflation-linked gilts) can provide meaningful downside protection at a time when investors most need their bond allocation to react differently than their portfolio’s equity allocation (See Figure 5).

Although target-allocation portfolios use bonds as the primary diversifier to equity market risk, the sectors comprising the bond allocation can occasionally contribute to the portfolio’s overall level of risk and to its return variability, particularly over shorter time periods. For example, in extreme market conditions, the correlation between equities and corporate bonds tends to move much higher, which can diminish the diversification benefit of holding corporate bonds.

To achieve diversification the bond allocations within the Vanguard LifeStrategy™ Funds invest in both UK and global bonds. This includes allocations to government bonds (domestic and global), UK inflation-linked bonds and investment

grade corporate bonds. The funds do not include high-yield, or ‘junk’ bonds due to the relatively poor diversification benefits associated with the asset class over time.

The funds allocate approximately 35% of their bond investments to the UK, with the remainder allocated to global bonds outside the UK, with currency exposure of the latter portion hedged into pounds sterling. This represents a small home bias, as UK investment grade bonds only make up 6% of global bond markets. A 35% home country bias, which represents a 6 times ‘overweight’, is still a bit lower than the home country bias of the average UK bond investor’s portfolio. Data from 201212 suggest that the average UK bond investor holds 57%, of their portfolio in UK bonds, or an overweight position of nearly 9 times the global market.

At the extreme, holding all of one’s bond allocation in the UK ignores 94% of the global bond market. Even holding an allocation similar to the typical UK bond investor, at 57%, results in a portfolio highly exposed to UK-specific economic variables, including the business cycle, interest rates, inflation rates, etc.

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

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.

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

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

Top: 75th percentileBottom: 25th percentile

Top: 95th percentileBottom: 5th percentile

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12 See Phillips et al (2012)

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Increasing exposure to global bonds has the potential to offer significant long-term diversification benefits13. Figure 6a provides evidence of this. Interest rate movements within a group of the 12 largest government bond markets are not correlated with those of the UK. The benefits of this diversification can be shown in a portfolio context; the low correlation of the

UK bond market to the global equity market has offered no benefit over a hedged global bond allocation, as demonstrated in Figure 6b. Starting from a balanced portfolio of global stocks and hedged global bonds, and adding higher portions of UK bonds to the allocation would have increased overall portfolio risk for any particular 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

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.

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

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.

13 For a more detailed discussion of the desirable properties of global bond investing for UK-based investors, see Westaway and Thomas, 2013.

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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

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One reason that adding global bonds to a bond allocation improves diversification is the presence of some unique structural features of the UK market. Relative to the global market, the UK market has a much higher proportion of long dated bonds, while the global market is more evenly distributed (See Figure 7a). This leads to the UK

market being much more sensitive to interest rate changes, with more volatile prices. In other words, they have a much higher duration14. Figure 7b shows that as of December 2013, the UK’s duration was close to 9, much higher than any other individual large bond market as well as the global average of just over 6.

Figure 7. Comparisons of UK and global bond markets

14 Duration 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 therefore much more sensitive to interest rate changes.

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Global

Swiss m

arke

t

Euro

mar

ket

Doll

ar m

arket

Austra

lian m

arket

Norweg

ian m

arke

t

Swedish

mar

ket

8.7

7.77.2 7.2

6.15.8

5.5 5.5

4.64.0 3.8

Figure 7a: Maturity band weights

Figure 7b: Average duration

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

13

The UK market also leans heavily towards government, government-related debt and investment grade corporate debt and away from securitised debt. Comparatively speaking, UK bond investors are taking less credit risk (potentially forgoing higher yields) than is available in the global market as a whole (See Figure 7c).

Figure 7d also illustrates a unique feature of the UK bond market with respect to inflation-linked bonds. Since 1999, inflation-linked gilts have, on average, represented approximately 21% of the overall UK bond market and 30% the UK gilt market respectively. This is much higher than the proportions offered globally.

Investors cannot manage inflation risk with any certainty in a portfolio of nominal bonds. A bond portfolio’s real, or inflation adjusted, value falls when actual inflation exceeds the expected rate of inflation built into market interest rates at the time the investor purchased the bond. Since inflation-linked gilts provide inflation-adjusted increases to both principal value and interest payments, an investor can manage the extent to which their bond portfolio is subject to short term inflation risk. For this reason LifeStrategyTM Funds include an allocation to inflation-linked UK bonds.

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

80%

Wei

ght

in m

arke

t

70

60

50

40

30

20

10

0Government Government-related Corporate Securitised

Sector

Global aggregate Sterling aggregate

53

69

14

8

21 2016

3

25%

20

15

10

5

0

UK

Sweden

Euroz

one

(Tot

al)

US TIP

S

Global

Austra

lia

Canad

aJa

pan

19.3

11.2

9.1

4.8 4.7 4.7 4.6

0.5

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

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

14

The non-UK portion of the bond allocation in the LifeStrategy™ Funds is hedged into sterling. Currency fluctuations impart significant volatility into a global bond portfolio well above the volatility of the underlying bonds themselves. This currency-induced volatility can overwhelm much of the diversification appeal of going global with bonds. Hedging this currency exposure reduces the currency volatility, and allows foreign bonds in a UK portfolio actually to ‘behave like bonds’, independent of the gyrations of the bond’s issued currency.

Allocating approximately 35% of the bond portion of the portfolio to UK bonds, spread among government (including inflation-linked), government-related and investment grade corporate sectors, and the remainder of the allocation to global ex-UK bonds hedged back to sterling is a reasonable strategic asset allocation. It allows the investor access to the sources of risk and return available in the global market while maintaining exposure to local factors. While less radical than a pure market weighting of 92% to non-UK bonds, a 65/35 split between non-UK and UK bond still represents a reasonable balance.

15 See Westaway and Thomas, Bond investing in a rising rate environment, 2013.

Interest rates and bond investing

Given the inverse relationship between bond prices and interest rates, combined with the higher sensitivity of long bonds to rate changes, many investors might wonder about the relationship between duration risk and the interest rate outlook. Is it a good idea to change portfolio duration in order reduce interest rate risk, at least until the worst of the rate uncertainty passes? While any given investor might have very good reason to adjust their bond exposure, we believe that the future outlook for interest rates should generally not be a significant factor.

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

reflected in the shape of the yield curve. An upward-sloping yield curve by its very nature indicates that the market already expects interest rates to increase in the future. With longer-term bond yields much higher than those of short-term bonds, by lowering duration, the investor effectively gives up income in return for lower exposure to duration risk. But investors are much better served by taking a ‘total return’ approach. Over any given time horizon, both price return and income will drive an asset’s total return. Because of this, investors should weigh their expectations for interest rate movement against the income they give up by altering their portfolio duration.15

Role of inflation-linked gilts for investors at, or near, retirement

Inflation-linked gilts can be particularly relevant for investors at, or near, retirement, who hold more conservatively allocated portfolios. In the accumulation stage, salaries and higher real returning assets, such as equities, can provide effective inflation protection for investor portfolios. But, once in retirement, it becomes more difficult

for investors to add to their portfolio using additional earnings. As a result, investors must balance their need to preserve capital, often through bond and cash-like investments, with their need to preserve their portfolio’s purchasing power, or real value. Holding inflation-linked bonds can provide investors with a direct hedge to inflation, helping to preserve the real value of the portfolio.

15

Publically traded property securities

To the extent that property-based securities are part of the global equity portfolio, the Vanguard LifeStrategy™ Funds include exposure to UK and non-UK property at their market weights as part of the respective equity allocations. However, the funds do not hold Real Estate Investment Trusts (REITs) or Real Estate Operating Companies (REOCs). Because property based securities currently account for less than 2% of the UK equity market capitalisation (according to FTSE EPRA/NAREIT as at 30 September 2013) and 2.6% of global equity market capitalisation (according to FTSE), any additional allocation would represent a significant sector overweight.

In order to justify a strategic over-weighting to property-based securities, investors must be comfortable with the fact that property-based equities tend to perform more like equities than property. Property investors must also be comfortable with the possibility that the property portion of their investment portfolio may correlate with the value of other property holdings in their 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:

• Potentiallyhigherexpectedreturns

• Lowerexpectedcorrelationandvolatilitytotraditional market forces

• Theopportunitytobenefitfrommarketinefficiencies through skill-based strategies

However, it is difficult to assess the degree to which investors can consistently rely upon these asset classes and investment strategies to deliver their potential benefits, especially for those strategies where investable beta is not available for comparison. Strategies such as long/short, market-neutral and private equity depend exclusively on manager skill. This subjects investors to significant manager risk, as the distribution of manager skill is such that investor success depends on consistently accessing and selecting top managers.17

Vanguard does not include commodities, and specifically commodities futures, in target allocation funds based on our assessment of the risks, costs and complexities. While recognising the historical diversifying benefit of commodity futures, Vanguard cautions against making such an allocation solely based on historical commodity returns. The long-term economic justification for expecting significant, positive returns from a static, long-only commodities futures exposure is subject to ongoing debate, especially in the costs.

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 Commodities: Myths and Reality”.

16

The role of passive fund management

Vanguard strongly believes that any risks investors bear should be expected to produce a compensating relative return over time. Modern financial theory and years of investment practice lead us to conclude that diversified, broad-based index exposures represent precisely this kind of compensated risk. While some active managers can add value at least some of the time, outperformance cannot be guaranteed.

Vanguard investigated the construction of portfolios using actively managed funds. We compared the average returns and volatility of a portfolio constructed with actively managed funds to market benchmarks in both UK equity and UK bond fund categories. Figure 8 shows that, on average, most actively managed portfolios had lower returns and/or a higher level of volatility – the exact opposite of the desired result of an efficient portfolio.

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.

Figure 8. Annualised return and volatility

12%

10

6

8

4

2

0420 6 8 10 12 14 16 18

10-y

ear

annu

al v

olat

ility

10-year annual return

GBP diversified bond indexGBP government bond indexGlobal equity indexUK Equity index

GBP diversified bond fundsGBP government bond fundsGlobal equity fundsUK Equity funds

17

While active management offers the potential to outperform, the evidence suggests that investors do not consistently see this benefit. According to data from Morningstar, over the 5, 10 and 15 years ended 2013, 66%, 70%, and 63% of actively managed UK equity funds underperformed their respective benchmarks, or were merged/liquidated within the period. Investors did not fare better in bond funds, where 66%, 92% and 80% of actively managed UK diversified bond funds underperformed their respective benchmarks or were merged/liquidated over the 5, 10 and 15 periods ending in 2013.18

As shown in Figure 9, success also tends to be fleeting, as even the best funds in one time period can rapidly fall out of favour. Vanguard found that, of the top 20% of funds in five-year performance ending in December 2008, over 65% of those previously top-performing funds had fallen to the bottom 40% in fund performance or were merged or closed over the following five years ending in 2013. Of course, if fund managers displayed persistence in achieving top performance over time, nearly 100% of the top performing funds would remain at or near the top. Instead, the data reflects the daunting challenge of maintaining top-quintile performance over the long term.

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

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.

30%

25

20

15

10

5

0

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

Per

cent

age

of f

unds

rem

aini

ng in

the

top

qui

ntile

12.8

11.0 10.8

17.3

24.523.6

18 Source: Vanguard Asset Management based on data from Morningstar.

18

Index investing and the ‘zero sum’ game

The concept of a zero-sum game starts with the understanding that at any one time, the holdings of all investors in a particular market make up that market. As a result, for every invested pound that outperforms the total market over a given period, there must by definition be another pound that underperforms. Another way of stating this is that the asset-weighted performance of all investors, both positive and negative, will equal the overall performance of the market. In other words, if you ‘sum’ the positive and negative performance of each individual invested pound before costs, it will equal ‘zero’.

However, after accounting for costs, such as transaction, management and other costs, a majority of portfolios fall to the losing side of the index’s performance. The funds that do 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.

• Lowerrisk:Whethermeasuredbythenumberof security holdings, return volatility, downside risk or likelihood of outperforming, active management is generally riskier than passive management.

• Efficient:Portfolioturnoverislimitedtoadditions and deletions from an index, M&A and other corporate actions. Rebalancing is continuous and costless since security weights reflect the market weight.

• Transparent:Becauseanindexfundholdsall or most of the securities in a given index benchmark at the same weights as that of the index benchmark, investors can always determine which securities constitute their portfolio and how they performed.

• Diversified:Indexfundstrackingbroadbenchmarks hold all or most of the securities that comprise that benchmark. Investors benefit from the mitigation of security and sector concentration risk.

• Lowercost:Indexfundstypicallyhavelowmanagement fees and low operating costs.

19 Westaway, et al. 2013.

19

Financial advisers and target-allocation funds

Vanguard believes target allocation funds provide financial advisers with a number of ways to add value for their clients.

Target-allocation funds as a core investmentFor many clients, broadly diversified, low-cost portfolios may serve as the core component of a broader investment strategy. By using a target allocation fund as the core portfolio, a financial adviser achieves low costs and a high level of risk control in the investment portfolio, while also having the flexibility to invest in more specialist indices or actively managed funds. In addition to low costs and a high level of risk control, a core investment in a Vanguard LifeStrategy™ Fund can potentially mitigate the downside risk of an adviser’s total portfolio when compared with the broader capital markets and the adviser’s peers20. But the adviser may still seek to outperform the market average or index, or achieve a specific investment objective, using the ‘satellite’ component of their investment programme.

Based on Vanguard’s research and experience, Vanguard LifeStrategy™ Funds by themselves can be wholly appropriate for the majority of investors’

goals. They are designed with rigourous attention to our latest views on best practice and they incorporate Vanguard’s principles for investment success. Nevertheless, using target-allocation 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 source, not a use, of focus and time Investing in the Vanguard LifeStrategy™ Funds can allow advisers to focus their time and resources on others aspects of their client value proposition. Here’s how. Let’s take the example of an adviser who serves as a financial planner to an individual client. Figure 10 shows a representative multi-step investment advice process. The financial planner may work very closely with an investor on steps 1 and 2, which offer the opportunity to build credibility and exercise some level of control over client outcomes, such as developing trust or documenting a well thought out investment plan. The adviser may then decide that a risk-graded, professionally-constructed target-allocation fund ensures both prudent and suitable portfolio construction and implementation, thereby fulfilling steps 3 and 4 with a straightforward, yet sophisticated, investment 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 and passive strategies.”

Figure 10. Sample investment advice process

�� Categorise and evaluate�� Determine risk/return requirements�� Develop a written plan

Know your client1

Develop a plan2Monitor progress5

Statement of Investment Principles

�� Review of client’s financial position�� History, values, transitions goals�� Goals-based planning

�� Periodic financial check ups�� Significant life events�� Review progress

Construct portfolio3�� Strategic asset allocation�� Sub-asset allocation�� Passive/active mix�� Asset location�� Manager selection

Implement plan4�� Best execution�� Tax efficient trading�� Automate rebalancing

20

This investment selection may free up the time and resources traditionally spent on activities such as active manager selection and oversight, while helping to mitigate the risk that performance-based promises hurt the adviser’s credibility. Once an adviser makes an appropriate investment selection for the client, the periodic adviser-client review, as represented by step five, offers opportunities for the adviser to enhance a long-term client value proposition. During this step, financial advisers can play a central role in periodically21 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.

The key point is that the decision to invest in a target-allocation fund is only as effective as the suitability assessment and ‘know your client’ process that precedes it. In this way, the adviser can provide a single-fund option, such as a target allocation fund, with the appropriate investment strategy and execution to help meet investors’ goals and objectives in accordance with their risk tolerance.

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 it should reflect significant changes in investor circumstances, such as retirement, having children or a large unanticipated health expense.

21

Target-allocation funds and the FCA’s ongoing focus on product design and suitability

DesignThe design of Vanguard’s target-allocation funds applies a number of investment best practices, including the principles of asset allocation, broad diversification and balancing risk, return and cost. The funds offer a straightforward design, a high degree of transparency, low investment costs and broad exposure to major asset classes, which help to maximise the usefulness of these funds for investors. These product features are clearly designed to benefit clients and put their interests first.

Additionally, Vanguard’s target-allocation funds use a naming convention that identifies the underlying equity exposure of each fund, since equity represents the riskiest asset class exposure in the funds. For example, the Vanguard LifeStrategy™ 20% Equity Fund includes a 20% defined, static allocation to broadly-diversified equities. Vanguard opted for this naming convention, as opposed to subjective descriptors such as ‘cautious’ or ‘balanced’, to achieve appropriate clarity and transparency for clients.

SuitabilityThe FCA (when it was the FSA) issued proposed guidance for consultation on the importance of establishing investors’ willingness and ability to take risk as part of the process of selecting suitable investment products.22 The investment philosophy and portfolio construction best practices underpinning Vanguard’s target-allocation funds may help to address the FCA’s concern about investment providers’ failing to consider diversification, but they do not substitute for the ‘know your client’ process. Vanguard believes that investors, often with guidance from their financial adviser, should strive to fully understand their personal situation, such as their ability and willingness to take risk and their investment goals, before setting out to develop an investment plan or select investments.

The adviser’s role as behavioural coach

Among the key benefits of Vanguard’s target allocation funds are the convenience of a predefined asset allocation policy and the risk control provided through automatic rebalancing and broad diversification. The fundamental simplicity of using a single fund to execute an investment strategy can help investors and their financial advisers avoid common behaviours that can reduce future returns or unknowingly increase the risk of the portfolio. As mentioned earlier in the paper, these behaviours may include performance chasing and market timing that often significantly reduce investors’ realised returns. Single-fund investments can help advisers coach individuals to overcome one of the greatest obstacles in developing a long-term investment programme–making the commitment to actually create a plan, implement it properly and stay the course through the inevitably fluctuating financial markets.

By acting as behavioural coaches to their clients, advisers provide the discipline and experience to investors who need it. On their own, investors often lack both understanding and discipline, allowing themselves to be swayed by the ‘investment du jour’, resulting in wealth destruction rather than wealth creation. Selected appropriately by advisers based on their clients’ circumstances, the Vanguard LifeStrategy™ Funds represent a well-constructed, broadly diversified, risk-controlled set of portfolios designed to help investors create wealth and manage risk.

22 Financial Services Authority. Guidance consultation. Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection. January 2011.

22

Conclusion

Target-allocation funds can align well with individual investors’ risk tolerance and investment objectives when selected as the result of a thorough ‘know your client’ and suitability process. The funds have been designed by combining extensive capital markets and portfolio construction research with Vanguard’s years of practical experience of working with investors, to offer broadly diversified target-allocation portfolios, professional portfolio management and automatic rebalancing, all at a low cost.

Vanguard’s investment philosophy is summarised by four principles for investment success, and the LifeStrategy™ Funds are designed to give investors an all-in-one solution aligned with these principles. The risk profiles and asset allocation are appropriate for a wide range of investor goals, providing diversification and balance, with disciplined rebalancing, all at low cost.

Straightforward design and transparency, an emphasis on a passive indexing approach that keeps investment costs low and removes active manager risk, coupled with broad-based exposure to major asset classes, maximises the usefulness of these funds for investors and their advisers.

23

References

Becker, Connie, Wayne Ferson, David Myers, and Michael Schill, 1999. Conditional Market Timing with Benchmark Investors. Journal of Financial Economics 52: 119-148.

Brinson, Gary P.,L. Randolph Hood, and Gilbert L. Beebower, 1986. Determinants of Portfolio Performance, The Financial Analysts Journal.

Davis, Joseph H., R. Aliaga-Diaz, D. Benyhoff, A. Patterson, and Y. Zilbering, 2010. Deficits, the Fed, and rising interest rates: Implications and considerations for bond investors. Valley Forge, PA.: The Vanguard Group.

Henriksson, Roy D., 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.

Phillips, Christopher, Francis Kinniry Jr., and Scott Donaldson, 2012. Role of Home Bias in Global Asset Allocation Decisions. Valley Forge, PA.: The Vanguard Group.

Schlanger, Todd, 2013. Considerations for Global Equities: A UK investor’s perspective. Valley Forge, PA.: The Vanguard Group.

Stockton, Kimberly, and Anatoly Shtekhman, 2010. A Primer on Tactical Asset Allocation Strategy Evalution. Valley Forge, PA.: The Vanguard Group.

Treynor, J.L. and K. Mazuy, 1966. Can mutual funds outguess the market? Harvard Business Review 44:131–36

Vanguard, 2013. Vanguard’s Principles for Investing Success: United Kingdom. Valley Forge, PA.: The Vanguard Group.

Wallic, Daniel W., Neeraj Bhatia, Andrew S. Clarke, CFA, and Raphael A. Stern, 2011. Shopping for alpha: You get what you don’t pay for. Valley Forge, PA.: The Vanguard Group.

Wallick, Daniel W., Julieann Shanahan, Christos Tasopoulos, and Joanne Yun, 2012. The Global Case for Strategic Asset Allocation. Valley Forge, PA.: The Vanguard Group.

Westaway, Peter, and Charles J. Thomas, 2013. Going Global with Bonds: Considerations for UK Investors. Valley Forge, PA.: The Vanguard Group.

Westaway, Peter, Charles J. Thomas, Christopher Phillips, Todd Schlanger, 2013. The Case for Index Fund Investing for UK Investors. Valley Forge, PA.: The Vanguard Group.

Westaway, Peter and Charles J. Thomas, 2013. Bond investing in a rising rate environment. Valley Forge, PA.: The Vanguard Group.

This document is directed at investment professionals in the UK only, and should not be distributed to or relied upon by retail investors.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this research does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this research when making any investment decisions.

All rights in a FTSE index (the “Index”) vest in FTSE International Limited (“FTSE”). “FTSE®” is a trademark of London Stock Exchange Group companies and is used by FTSE under licence. The Vanguard Fund(s) (the “Product”) has been developed solely by Vanguard. The Index is calculated by FTSE or its agent. FTSE and its licensors are not connected to and do not sponsor, advise, recommend, endorse or promote the Product and do not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b )investment in or operation of the Product. FTSE makes no claim, prediction, warranty or representation either as to the results to be obtained from the Product or the suitability of the Index for the purpose to which it is being put by Vanguard.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate.

Funds investing in overseas markets and the value of these investments may fall or rise as a result of changes in exchange rates. Funds investing in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

Movements in interest rates are likely to affect the capital value of fixed interest securities.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

The Authorised Corporate Director for Vanguard LifeStrategy Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard LifeStrategy Funds ICVC.

For further information on the fund’s investment policy, please refer to the Key Investor Information Document (“KIID”).

The KIID and the Prospectus for this fund is available in local languages from Vanguard via our website https://global.vanguard.com/.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2014 Vanguard Asset Management, Limited. All rights reserved. VAM-2014-01-28-1501

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