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This Move Could Be Vanguard's Worst Ever

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I believe that if it ain't broke, don't fix it. And for some reason, Vanguard has decided to try to fix what ain't broke.

Vanguard has spent decades establishing itself as the leader in low-cost investing. Ever since it founded the first readily available stock index fund 35 years ago, Vanguard has offered investors efficient, low-cost alternatives to more pricey actively managed funds.

Yet with its most recent move, Vanguard is trying to be all things to all investors. That's not a road the fund giant should travel down.

The king of emerging markets goes active
Late last month, Vanguard announced that it will open a new mutual fund aimed at investing in emerging-market stocks. The fund employs a four-manager approach, splitting its assets among investment managers Wellington, Pzena, Oaktree Capital, and M&G.

Perhaps the most ironic thing about Vanguard's announcement is that it comes so closely on the heels of its emerging-market index ETF, Vanguard MSCI Emerging Markets (NYSE: VWO  ) , surpassing rival iShares MSCI Emerging Markets (NYSE: EEM  ) as the largest ETF in its space. Investors have flocked to the Vanguard ETF's lower annual expenses, which at 0.22% are about a third what the iShares ETF charges.

In other words, having declared victory on the index approach to emerging markets, Vanguard is now setting itself a difficult task: how to beat its own index with an actively managed fund that charges close to 1% in annual fees.

What were you thinking?
Granted, this certainly won't be the first actively managed fund that Vanguard has started. The firm's illustrious history begins with Vanguard Wellington, which has survived the decades despite coming to market just before the 1929 stock market crash. But in recent years, almost all of the new funds that Vanguard has opened have either been based on indexes, incorporated new gimmicks such as managed payouts, or been additions to existing series like its target retirement funds.

Moreover, it's easy to understand the higher profit potential from actively managed funds. AllianceBernstein (NYSE: AB  ) , for instance, generated $159 million in revenue over the past 12 months, and with a stellar profit margin of more than 80%, $130 million of that fell to the bottom line in net income.

But with Vanguard's recent success, especially in the ETF realm, the new active fund can only serve as a distraction. Consider: In 2010, Vanguard was the fastest-growing ETF provider, bringing in more than $40 billion in new assets and firing a warning shot against larger competitors BlackRock (NYSE: BLK  ) and State Street (NYSE: STT  ) . Its decision to offer its brokerage customers free access to Vanguard ETFs gave it a competitive advantage not only against those ETF providers but also rival brokers like Schwab (NYSE: SCHW  ) and Fidelity, which have more limited sets of free ETFs, and E*Trade Financial (Nasdaq: ETFC  ) , which doesn't offer free ETFs. In combination with falling expense ratios for ETFs across the market, Vanguard has essentially done everything right to make investing easier for its shareholders -- along with its unique structure of investor ownership of its funds.

A no-win scenario
Of course, Vanguard must think that its new active emerging-markets fund can do what many other funds haven't: beat the returns of its index. But the strategy is fraught with peril. If the active fund loses to its index, then Vanguard will have to face accusations of hypocrisy from its largely index-based investors.

Still worse, though, would be if the actively managed fund actually does manage to beat the index ETF. With so much of its asset base secure in the belief that all index funds are more efficient than any active fund, having an outperformer could well push current index-fund shareholders to look for better options -- and not all of those options will be Vanguard funds.

Growth for growth's sake often seems like a good idea. But in this case, Vanguard is jeopardizing a long streak of success with this detour into the cul-de-sac of actively managed funds. No matter how the new emerging-markets stock fund performs, Vanguard will probably rue the day it decided to steer away from its winning ways.

Vanguard plays a prominent role among the three promising ETFs that the Fool has identified to help make you richer. Check out our free special report to learn more.

Fool contributor Dan Caplinger has been a closet Boglehead for years. You can follow him on Twitter. He owns shares of both emerging-market ETFs listed above. The Motley Fool owns shares of Vanguard MSCI Emerging Markets ETF. Motley Fool newsletter services have recommended buying shares of BlackRock and Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy was our best move ever.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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