Of course, the index funds of this venerated family are legendary. But here are our favorite actively managed picks. iStock By Nellie S. Huang, Senior Associate Editor December 12, 2013 Vanguard is best-known for its index funds. But 69% of its mutual funds—80 out of 116—are actively managed. And lately, many of them have outpaced their benchmarks. “I can’t recall a better year for Vanguard’s active funds,” says Dan Newhall, a principal at Vanguard whose job it is to oversee the firm’s funds. “It’s striking to us how well they’ve done—and we have a healthy dose of skepticism” about active management. Indeed. See Also: The Best Fidelity Mutual Funds This year’s crop of Vanguard’s best actively managed funds includes a few from last year—three are members of the Kiplinger 25, the list of our favorite no-load mutual funds—as well as several new ones. (All returns are through December 10) Vanguard Dividend Growth (VDIGX). This isn’t your typical dividend fund, and that’s why we like it. At Dividend Growth, a member of the Kiplinger 25, manager Don Kilbride prefers to invest in companies that consistently raise their dividends instead of firms that pay the highest yields. So while he owns a fair share of the usual suspects—Johnson & Johnson, Procter & Gamble and Coca-Cola, to name a few—some not-so-usual dividend payers find a place in his portfolio, too. Take Nike, the sportswear apparel company. It yields just 1.1%, but it has raised its payout by an average of 10% annually over the past five years. Similarly, Diageo, the beverage and spirits company based in the U.K., and New Jersey-based payroll processor Automated Data Processing have each increased their payout 5% and 6% respectively a year, on average, over that time. Advertisement Over the past 12 months, Dividend Growth trailed the S&P 500 by 1.9 percentage point. But that doesn’t surprise us. Dividend stocks outpaced the market in 2010 and 2011 as investors sought stability during a volatile period that was marked by worries about a global meltdown, a struggling U.S. economy and a credit-rating downgrade for U.S. debt. As those fears have subsided, investors have shifted their attention from the solid dividend payers to other pockets of the market. Still, Kilbride does a solid job of homing in on quality companies. Over the past three years, his fund has been 28% less volatile than the S&P 500, and its three-year annualized return of 16.3% beats the index by an average of 0.5 percentage point per year. Vanguard Explorer Value (VEVFX). Vanguard never had an actively managed fund that focused on small and midsize companies until it launched Explorer Value in March 2010. (The average market value of the fund’s holdings is $2.2 billion.) Three firms—Cardinal Capital Management, in Greenwich, Conn.; Frontier Capital Management, in Boston; and Sterling Capital Management, in Charlotte, N.C.,—each manage an equal share of the fund’s assets. But there is little overlap in the portfolio among the three so-called sleeves. Of the 180 holdings in the fund, for example, only nine are held by more than one manager, and not one of the stocks is held by all three, says Vanguard’s Newhall. That is because each firm has its own strategy for picking stocks. Advertisement Timothy Beyer and Eduardo Brea at Sterling are value managers with a focus on traditional measures, such as price to book value (assets minus liabilities) and price to earnings. Eugene Fox, Robert Kirkpatrick and Amy Minella at Cardinal combine quantitative measures with dig-down-deep analysis to find companies with strong balance sheets and growing earnings that are trading at a discount. And Frontier’s Thomas Duncan and William Teichner favor companies that are growing but trading at reasonable prices. “Each manager screens for different characteristics, and that leads them to different kinds of companies,” says Newhall, who also heads up the division that searches for good outside fund managers. “We think that’s a good thing: You diversify the stock-selection risk.” So far, so good. The fund’s three-year annualized return of 16.2% beats the small-company Russell 2000 index by an average of 1.7 percentage points per year, and the S&P 400 Midcap index by an average of 1.2 points per year. It was less volatile than the benchmark over that period, too. One caveat: To keep a lid on assets, you can only buy shares in this fund through Vanguard. Unlike most other Vanguard mutual funds, Explorer Value isn’t available through other brokerage firms, such as Fidelity or Charles Schwab. Vanguard International Growth (VWIGX). One of International Growth’s five stewards left recently, but that shouldn’t be a problem. That’s because, as with Explorer, the fund is run by managers at three companies—and each firm works independently. Schroders (a U.K.-based investment bank that once managed the fund solely) manages about 35% of the fund’s $22 billion in assets. The Edinburgh, Scotland, firm Baillie Gifford, which Vanguard added in 2003, controls a bit more than half of the fund’s assets. And M&G Investment Management, a U.K.-based firm that joined in 2008, takes on 12%. What’s notable is that the manager who left held one of the longer tenures, Virginie Maisonneuve, formerly chief of global and international stocks at Schroders, had been a manager at International Growth since 2005. She left in October 2013 to join Pimco. But Simon Webber, her co-manager on the fund since 2009, remains at the fund. Advertisement Vanguard likes to parcel out portions of big funds to different firms. “It’s a better way to build portfolios versus taking on the risk of a single manager,” says Newhall. When we look at International Growth’s year-by-year performances, we’re inclined to agree with him. In five of the past seven years, including 2013, International Growth has ranked among the top 25% of its peer group—funds that focus on large, growing foreign companies. Vanguard Selected Value (VASVX)Two firms share management duties at this midsize-company fund, which is a member of the Kiplinger 25. Barrow, Hanley, Mewhinney & Strauss, in Dallas, takes on three-fourths of the fund’s assets. Jim Barrow has been a manager with Selected Value since 1999; Mark Giambrone has been a co-manager since 2002. Donald Smith and Richard Greenberg, of Donald Smith & Co., in New York City, who joined as managers in 2005, run the remaining 25%. Both firms troll for high-quality midsize companies that trade at bargain prices, but they go about it in different ways. At Barrow, Hanley, the managers tilt toward out-of-favor companies with a catalyst that will turn the business around. But the stock has to trade at a bargain level as measured by price to earnings, price to book value (assets minus liabilities) and dividend yield. In the end, Barrow and Giambrone typically invest in highly profitable companies with strong balance sheets and good cash flow (earnings plus depreciation and other noncash charges). Smith and Greenberg like high-quality companies, too. But they start with the universe of midsize firms—those with market values of $2 billion to $10 billion—that trade at the cheapest ratio of price to tangible book value. Smith believes tangible book value offers a clearer picture of a company’s net worth than traditional book value. It takes into account book value but also subtracts intangible assets, such as goodwill, leases, franchises, and export and import permits. Advertisement When Barrow, Hanley has struggled, Donald Smith has done well, and vice versa, says Vanguard’s Newhall (though results for each firm are not published). Together, they’ve outpaced their benchmark, the Russell Midcap Value index, albeit by the slimmest of margins. Since Smith and Greenberg joined the fund in 2005, Selected Value has returned 9.2% annualized, outpacing the Russell Midcap Value by an average of 0.4 percentage point per year. Vanguard Short-Term Investment-Grade (VFSTX). This fund, a member of the Kiplinger 25, has a simple mandate: deliver a higher yield than cash and short-term government bonds. Cash offers basically nil, and one-year and five-year Treasury notes were yielding 0.13% and 1.47%, respectively, in early December. Short-Term Investment Grade currently yields 1.5%. The fund holds a mix of short-term corporate bonds (60% of the fund’s assets at last report), asset- and commercial-mortgage-backed securities (19%), foreign sovereign debt (8%) and Treasury notes (8%). The portfolio has an average maturity of three years, and its average duration is two years. That implies that if interest rates were to rise by one percentage point, the fund would lose about 2%. In the five-plus years since he took the helm in mid 2008, manager Greg Nassour has returned 3.6% annualized, which outpaces the typical short-term bond fund by an average of 1.1 percentage points per year. Finally, a word about last year’s winners. Several of them failed to make the cut this year, and here’s why: Vanguard Wellington closed to new investors. And although they’re still superb at what they are supposed to do, we dropped two Vanguard bond funds—GNMA (VFIIX) and Intermediate-Term Investment Grade (VFICX)—because they are sensitive to interest-rate hikes, which are on the horizon. For the same reason, we also dropped Vanguard Wellesley Income (VFINX), a balanced fund that tilts more toward bonds than to stocks.