Walter H. Lenhard, CFA — Senior Investment StrategistVanguard Quantitative Equity Group

The evolution of indexing: An active / passive discussionMarch 9, 2011

> 2

Indexing philosophy

> 3

• The success of index investing does not depend on market efficiency

• Beating the market is extremely difficult

• Costs matter

• By consistently earning the return of the broad market,

you have the potential to outperform most investors

Indexing philosophy

> 4

The zero sum game means that after cost, a majority of dollars will underperform the costless market benchmark

• The holdings of all investors aggregate to form a market

• Outperformance by one, necessarily means underperformance by another

• The key to increasing the likelihood of remaining on the winning side is by lowering costs (but maintaining skill)

Source: Vanguard.

Distribution of fund returns

Tax impact

Expense ratio impact

After all costs, fewer dollars exceed the benchmark

> 5

Most equity funds lagged the broad market over 15 years

General equity funds versus the Dow Jones Wilshire 5000 Composite Index over 15 years

Sources: Lipper Analytical Services, Wilshire Associates, and Vanguard.Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.As of December 31, 2010.

103

10

43

111

183

236

165

135

71

4838 26

<-6 -5 to -6 -4 to -5 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2 2 to 3 3 to 4 4 to 5 > 5

45% Better (483 funds)55% Worse (596 funds)

Wilshire 5000

> 6

Most large-cap funds lagged the S&P 500 over 15 years

Large-cap funds versus S&P 500 over 15 years

Sources: Lipper Analytical Services, S&P, and Vanguard.As of December 31, 2010.

3 1 2 13

47

104110

79

41

15 5

< - 6 -5 to -6 -4 to -5 -3 to -4 -2 to -3 -1 to -2 0 to -1 0 to 1 1 to 2 2 to 3 > 3

S&P 500

33% Better (140 funds)67% Worse (280 funds)

> 7

Large-cap funds vs. the S&P 500 Index

Percentage of large-cap funds outperformed by the S&P 500 Index

65% 67% 65%61%

71%

51%

43%

54%

46%

78%

85%

73%

88%

63%

50%

42%

66% 67%

73%76%

48%

71%

41%

61%

42%

70%

57% 57% 58%

Sources: Lipper Analytical Services, S&P, and Vanguard.Number of funds for each time period: 1–year, 2,391; 5–year, 1,767; 10–year, 1,044; 20–year, 173.As of ended December 31, 2010.

> 8

Index fund history

> 9

12

25

35

47

62

26 2725

35

40

28

33

61

34

56

0

10

20

30

40

50

60

70

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Investment Company Institute.

Net flow to index funds in billions of dollars from 1995 to 2009

Index fund history: Net flow to index funds

> 10

4.0

5.1

6.5

8.28.9 9.0

9.710.5

10.911.3 11.1 11.2 11.5

13.013.7

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Percentage of equity mutual fund total net assets from 1995 to 2009

Equity index funds’ share continued to rise

Source: Investment Company Institute.

> 11

Index fund management

> 12

Replication versus Optimization

Key factors to consider:

• Portfolio size

• Index characteristics— number of securities, length of “tail”

• Transaction costs and other market-specific issues

• Nature and size of cash flow profile

• Index-effect in relevant market

Investment process: Which indexing technique

> 13

Investment process: Equity indexing process

Reconciliation

Cash flow projection

Index updates

Optimizer generatestrade lists

Executetrades

Monitor performancePerformance attribution

Overnight compliance reporting

Pre-trade compliance

engine

> 14

Weighted Median Market Cap $59.2B $59.2BDividend Yield 1.8% 1.8%Price/Earnings Ratio (1-year forward) 17.0x 17.0xPrice/Book Ratio 2.9x 2.9xEstimated 3–5 Years EPS Growth Rate 12.4% 12.4%Return on Equity 19.9% 19.9%Long-Term Debt/Capital 33.9% 33.9%Number of Securities 500 500

Portfolio Characteristics S&P 500 Index Fund

0%

5%

10%

15%

20%

25%

Consu

mer dis

cretio

nary

Consu

mer sta

ples

Energy

Financia

lsHea

lth ca

reIndus

trials

Techno

logy

Materials

Tele-co

mmunicatio

n

Utilities

Large-Cap Equity S&P 500 Index

Sector Weights

1Individual stock level

2Factor level• Sector weights• Market capitalization• Volatility• Style

Replication: Maximum overweight/underweight < 0.5 bpOptimization: Maximum overweight/underweight < 1.0 bp

Index Fund

3Portfolio level

Three levels of risk control:Goal is to minimize risk to avoid unintended bets

> 15

Index methodology

> 16

Clearly defined market segmentation

Sources: MSCI, Russell, and S&P. MSCI, Russell, and S&P market-capitalization ranges calculated by FactSet as of December 301,2 009.

> 17

+ More Style Purity

- High Turnover

- Higher Cost

- Less Tax Efficient

- Less Style Purity

+ Lower Turnover

+ Lower Cost

+ More Tax Efficient

Lower Frequency Rebalancing

Higher Frequency Rebalancing

Index construction philosophy

> 18

Timely and efficient construction

Source: MSCI.

Buffer zones for managing turnover

Buffer zones

> 19

Sector weight

Source: FactSet as of June 30, 2010.

MSCI US Broad Russell S&P CompositeGICS Sector Market Index 3000 Index 1500 Index

Consumer discretionary

Consumer staples

Energy

Financials

Health care

Industrials

Materials

Information technology

Telecommunication services

Utilities

Total 100.0 100.0 100.0

11.0%

9.9

10.4

16.4

11.6

11.4

3.9

18.8

2.8

3.8

11.1%

9.7

10.2

17.1

11.6

11.5

4.0

18.4

2.8

3.7

10.7%

10.5

10.2

16.9

11.4

11.2

3.8

18.5

2.8

3.9

> 20

Performance Convergence

S&P 500 2.24%

Russell 1000 2.51%

MSCI US Large Cap

3002.49%

5-year average annual returns through January 31, 2011

Large-Cap Indexes Growth Indexes Value Indexes

Source: Vanguard

S&P 500 Growth 3.44%

Russell 1000 Growth 3.91%

MSCI US Large Cap 300 Growth

3.81%

S&P 500 Value 0.92%

Russell 1000 Value 0.96%

MSCI US Large Cap 300 Value

1.05%

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

> 21

Fair-value pricing

> 22

• Vanguard funds employ fair-value pricing to reflect events after the close of a stock’s primary market or exchange

• But it can cause a temporary pricing discrepancy that’s normally corrected by the following day

• Fair-value pricing ensures NAV reflects true value, discourages market timing, and protects shareholders

U.S. markets closeEuropean markets close11:30 a.m. ET

Nestle

$55

4:00 p.m. ET

Nestle

$53

Fair-value pricing protects shareholders

> 23

$45 FVP

Tokyo market closes 1 a.m., EST

London market closes 11:30 a.m., EST

New York market closes 4 p.m., EST

15-hour gap

4.5-hour gap

$50 $55 $40 FVP

Lehman declares

bankruptcy

Share price for British bank:

Much can happen in a few hours…

Fair-value pricing example

> 24

Indexing in a client portfolio

> 25

Indexed strategies can benefit clients and advisors

• The difficulty of active management

• The role of indexing in a client portfolio

• Combining active and passive strategies

> 26

Data: 8,775 hiring decisions by 3,417 plan sponsors delegating $627 billion in assets. 869 firing decisions by 482 plan sponsors withdrawing $105 billion in assets. Analysis covers the period 1996 through 2003.

Excess Return Persistence

Institutional investment manager hire/fire decisions from 1996 to 2003

Amount of excess return

Years before manager change Years after manager change3 2 1 1 2 3

Fired firm 2.27 (2.06) (0.74) 0.98 1.47 3.30

Hired firm 10.39 7.04 3.42 0.42 1.12 1.88

Difference 8.12 9.10 4.16 (0.56) (0.35) (1.42)

Source: The Selection and Termination of Investment Management Firms by Plan Sponsors Amit Goyal, Sunil Wahal (Journal of Finance Volume 63, Issue 4, printed August 2008)

> 27

Rankings of semiannual returns, 1982–2009

Worst

Best

Analysis of five possible portfolios in 56 semiannual periods during 1982–2009. A spliced index—the Dow Jones Wilshire 5000 Index through April 22, 2005, and the MSCI US Broad Market Index thereafter— was used as a proxy for a broad-market index portfolio. (Index performance does not reflect real-world operating costs, which could alter the results.) The active portfolios were combinations of Lipper fund category averages roughly approximating the market capitalization of the broad market. Past performance is no guarantee of future results. These hypothetical examples are not representative of any particular investment, as you cannot invest directly in an index or a fund-group average.

Sources: Vanguard and Lipper Inc.

Combining active portfolios with indexed portfolios combines risk control with the opportunity to outperform

The returns of active/passive combinations fell between those of all active and all indexed portfolios

> 28

Clie

nt p

ulls

mos

t ass

ets

Upd

ate

resu

me US Stock

Market Return

On average this portfolio has added alpha for a client

But the advisor faces a risk of losing clients

Portfolio’s periodic returns

Clie

nt p

ulls

som

e as

sets

Clie

nt a

sks

ques

tions

How will clients react when a strategy is out of favor?

• No strategy works consistently year over year

• It’s during those periods where a strategy is out of favor where clients may not appreciate the long-term track record

• This is where indexing can help

> 29

Adding a broad market index fund dilutes alpha, but can temper the drawdown

• Combining index and active strategies, maintains positive alpha, but truncates the extreme downside risk of active management

On average this portfolio has still added alpha

But the advisor faces a lesser risk of losing

clients

Portfolio’s periodic returns

US Stock Market Return

Clie

nt a

sks

ques

tions

Clie

nt p

ulls

som

e as

sets

Clie

nt p

ulls

mos

t ass

ets

Upd

ate

resu

me

> 30

Indexing offers additional benefits in portfolio construction

• Greater control of asset class risks

• Diversification

• Style consistency

• Tax advantages

> 31

Conclusion

• On average active management has not met investor expectations

• Index funds derive their long-term performance advantage from lower costs, style purity and the relative efficiency of the capital markets

• Despite the averages, opportunities do exist for active management to add value

• Combining index and active strategies can truncate downside risk and lead to improved client retention

> 32

Disclosures

• All investing is subject to risk. Diversification does not ensure a profit or protect against a loss in a declining market. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

• © 2011 The Vanguard Group, Inc. All rights reserved.