Mud at the end of the rainbow

Individually, each color of the rainbow is vibrant and unique. Mix them all together and you get a color that looks like mud.

The same thing can happen in building a portfolio with a lot of different investment managers.

For proof, one need look no further than Vanguard Explorer, which muddied its management situation recently when it announced it was bringing a new subadviser into the fold, giving the fund seven bosses — one for each main color in the rainbow.

Vanguard isn’t just the biggest manager in the fund business. It’s a shareholderfriendly company with lowcost funds that typically give investors what they expect.

That’s what makes Vanguard Explorer (VEXPX) an interesting case study. It’s a small-cap growth fund with over $11 billion in assets — huge for a fund in that asset class — that hires out the money management to outside experts.

The fund has long had at least five sub-advisers. In adding Stephens Investment Management Group last week, the money in Explorer is again spread among seven managers.

The problem is that countless studies show that once an investor has four actively managed funds in an asset class, they have something called a “closet index fund,” where they are never likely to get performance that beats the index, but they will pay higher prices to get that disappointing performance. If it applies to four separate funds, then why not seven?

“There’s something to be said for the multi-manager or rotation of managers, where if someone falters you fire him and bring in someone else whose style is cresting,” said Geoff Bobroff of Bobroff Consulting in East Greenwich, R.I. “But running new managers in and out hasn’t worked terribly well.”

Dan Newhall, a Vanguard principal involved in selecting outside money managers, says the performance has not been that of a “closet index,” because it hasn’t tracked the bench- mark particularly closely.

That’s true, but something of a technicality; in truth, Explorer has lagged Vanguard Small Cap Growth over the last decade by an average of more than 1.5 percent per year. So while Explorer checks out with three stars and a neutral rating from Morningstar Inc., the company’s index fund in the same space delivers four stars and gets a silver analysts’ rating.

Morningstar’s Russel Kinnel noted that investors aren’t taking much extra risk in the fund — since the expenses are low for an actively managed issue.

Newhall said that while some experts may prefer to have fewer managers, Vanguard is looking for idiosyncratic risk — for each manager to take different risks to try to generate results in the small-cap space. He noted the fund has beaten the Lipper Small-Cap Growth Fund Index, meaning it has done better than a lot of funds that rely on simply one manager.

Maybe, but every performance measure that suggests Explorer is OK is countered by one that says investors aren’t getting what they pay for. That doesn’t make the fund bad, but it doesn’t make it great, either.