-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QWsOsXef+SYGJc2Wirf3+EOwzdJ4bynq4tDxauekOQsvutP7q5KqsyoUFbCcq4ea Xo7vrMLcmB6SrXUedwQUlA== 0000893220-98-001874.txt : 19981221 0000893220-98-001874.hdr.sgml : 19981221 ACCESSION NUMBER: 0000893220-98-001874 CONFORMED SUBMISSION TYPE: N-30D PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19981031 FILED AS OF DATE: 19981218 FILER: COMPANY DATA: COMPANY CONFORMED NAME: VANGUARD/WINDSOR FUNDS INC CENTRAL INDEX KEY: 0000107606 STANDARD INDUSTRIAL CLASSIFICATION: [] IRS NUMBER: 510082711 STATE OF INCORPORATION: DE FISCAL YEAR END: 1031 FILING VALUES: FORM TYPE: N-30D SEC ACT: SEC FILE NUMBER: 811-00834 FILM NUMBER: 98771816 BUSINESS ADDRESS: STREET 1: PO BOX 2600 STREET 2: V37 CITY: VALLEY FORGE STATE: PA ZIP: 19482 BUSINESS PHONE: 6106696289 MAIL ADDRESS: STREET 1: PO BOX 2600 STREET 2: V37 CITY: VALLEY FORGE STATE: PA ZIP: 19482 FORMER COMPANY: FORMER CONFORMED NAME: WINDSOR FUNDS INC DATE OF NAME CHANGE: 19920703 FORMER COMPANY: FORMER CONFORMED NAME: WINDSOR FUNDS DATE OF NAME CHANGE: 19851031 FORMER COMPANY: FORMER CONFORMED NAME: WINDSOR FUND INC DATE OF NAME CHANGE: 19850424 N-30D 1 WINDSOR AND WINDSOR II ANNUAL REPORT 1 VANGUARD WINDSOR FUND ANNUAL REPORT OCTOBER 31, 1998 [PHOTO] [THE VANGUARD GROUP LOGO] 2 AT VANGUARD, WE BELIEVE THAT TRADITION MATTERS Our 8,000 crew members embrace the traditional values on which our success is built, including integrity, hard work, thrift, teamwork, and fair dealing on behalf of our clients. This year, our report cover pays homage to three anniversaries, each of great significance to The Vanguard Group: - - The 200th anniversary of the Battle of the Nile, which commenced on August 1, 1798. HMS Vanguard, the victorious British flagship at the Nile, is our namesake. And its motto--"Leading the way"--serves as a guiding principle for our company. - - The 100th birthday, on July 23, of Walter L. Morgan, founder of Wellington Fund, the oldest member of what became The Vanguard Group. Mr. Morgan was friend and mentor to Vanguard founder John C. Bogle, and helped to shape the standards and business principles that Mr. Bogle laid down for Vanguard at its beginning nearly 25 years ago: a stress on balanced, diversified investments; insistence on fair dealing and candor with clients; and a focus on long-term investing. To our great regret, Mr. Morgan died on September 2. - - The 70th anniversary, on December 28, of the incorporation of Vanguard Wellington Fund. It was the nation's first balanced mutual fund, and is one of only a handful of funds created in the 1920s that are still in operation. Although Vanguard constantly tackles new challenges, adopts new technology, and develops new services, we treasure the traditions and values that set us apart in a crowded, competitive industry. And we salute our shareholders, whose support and trust we strive to earn each and every day. [LOGO] CONTENTS A Message to Our Shareholders 1 The Markets in Perspective 5 Report From the Adviser 7 Fund Profile 10 Performance Summary 12 Financial Statements 13 Report of Independent Accountants 21 All comparative mutual fund data are from Lipper Analytical Services, Inc., or Morningstar unless otherwise noted. 3 FELLOW SHAREHOLDER, [PHOTO] [PHOTO] John J. Brennan John C. Bogle Chairman & CEO Senior Chairman Vanguard Windsor Fund's performance suffered badly during the fiscal year ended October 31, 1998. Our return of -0.8% was some 12 percentage points behind that of the average value (growth and income) mutual fund, which itself trailed by about 11 percentage points the superb gains achieved by the Standard & Poor's 500 Composite Stock Price Index.
- ------------------------------------------------------ TOTAL RETURNS FISCAL YEAR ENDED OCTOBER 31, 1998 - ------------------------------------------------------ Vanguard Windsor Fund - 0.8% - ------------------------------------------------------ Average Value Fund +11.1% - ------------------------------------------------------ S&P 500 Index +22.0% - ------------------------------------------------------
Clearly, we were very disappointed in the fund's performance. However, while no one is pleased with the fund's results versus its benchmarks, we believe there are sound reasons for the fund's investment stance. As we mentioned six months ago in our semiannual report to you, Windsor Fund's longstanding emphasis on a fairly concentrated list of value stocks has always resulted in a portfolio that can behave very differently from the stock market as a whole. We have seen other periods when Windsor's returns diverged significantly--sometimes positively and other times negatively--from those of the overall market. The table above presents the fiscal-year total returns (capital change plus reinvested dividends) for Windsor Fund, its average peer, and the unmanaged S&P 500 Index. Our fund's return is based on a decrease in its net asset value from $19.55 per share on October 31, 1997, to $16.34 per share on October 31, 1998, with the ending net asset value adjusted for dividends totaling $0.24 per share paid from net investment income and distributions totaling $2.88 per share paid from net capital gains realized during 1997. FINANCIAL MARKETS IN REVIEW Through the first two-thirds of the fiscal year that ended October 31, the U.S. stock market continued the remarkable rise that began in August 1982. By mid-July, the S&P 500 Index had gained +31.2%. However, most of that gain evaporated during a six-week slump that lasted through August 31. But stock prices then rebounded, so that for the full twelve months ended October 31 the S&P 500 Index earned a +22.0% return--twice the long-term average return of +11% a year for stocks. The performance of the S&P 500 Index--which is dominated by large-capitalization stocks--was remarkably different from that of the rest of the market. The Wilshire 4500 Equity Index, representing stocks outside of the S&P 500, actually fell by -3.4% for the fiscal year. And small-cap stocks, as measured by the Russell 2000 Index, lost -11.8%. Even within the S&P 500 there was an unusually wide gap between returns for growth and value stocks. The value stocks within the S&P 500 earned +11.7% as a group, trailing by a remarkable 20.3 percentage points the +32.0% return of the growth component of the index. Interest rates declined significantly during the year, providing some support for stock prices and elevating prices for bonds. The yield on the benchmark 30-year U.S. Treasury bond began the year at 6.15%, dwindled to a low of 4.72% on October 5 amid 1 4 concerns about a slowing economy, then rebounded to end the fiscal year at 5.16%. For bonds, of course, lower yields translate into higher prices. The Lehman Brothers Aggregate Bond Index, a benchmark for taxable bonds of all maturities, returned +9.3% during the fiscal year, as a price rise of about 2.5% augmented income of about 6.8%. Wide and abrupt shifts in investor sentiment buffeted financial markets during the year despite a generally positive economic environment. Inflation stayed in check: Consumer prices rose just 1.5% during the twelve months ended October 31, 1998. The U.S. economy grew by more than 3%, although the pace of growth appeared to slow late in the period. The economy's expansion was fueled by strong consumer spending encouraged by a strong job market (unemployment as low as 4.3%) and rising wages (up about 4%). The summer slump in stock prices sent broad market indexes lower by roughly - -20% or more, technically a "bear market," one of only four in the past 20 years. Analysts cited a number of reasons for investors' skittishness, including a continuing slump in Asian economies. Many investors had assumed that Asia's troubles--and the resulting drag on U.S. exports and corporate profits--would be short-lived. But as the problems lingered, investors worried that the "Asian contagion" would spread worldwide, crimping trade and denting investor and consumer confidence. Whatever the causes, investors grew more risk-averse, at least for a time. There was a decided movement toward the "safe haven" of U.S. Treasury securities, and away from corporate bonds and U.S. and international stocks. By October, however, many investors appeared to regain their appetite for risk, and stock prices shot up +8.1% for the month. FISCAL 1998 PERFORMANCE OVERVIEW For more than 30 years, Windsor Fund's investment strategy has been to identify out-of-favor stocks whose share prices are low in relation to their past and potential earnings. Typically, this strategy has resulted in relatively large positions in companies and industry sectors for which growth expectations are low. Thus, as we mentioned at the outset of this letter, Windsor often performs quite differently from the market as a whole. Clearly, the divergence in fiscal 1998 was exceptionally unfavorable. As noted earlier, our total return of -0.8% placed us some 12 percentage points behind the average growth-and-income fund and nearly 23 percentage points behind the S&P 500 Index. Much of our shortfall versus the index can be attributed to the market's bias toward large-cap growth stocks and our lack of representation in those stocks. In a fiscal year when growth stocks within the S&P 500 outperformed value stocks by some 20 percentage points, value investors had a tough row to hoe. Also, as we noted, stocks outside the S&P 500 registered a collective decline of -3.4%. Our advisory team at Wellington Management Company continues to believe that despite the market's current ardor for large "household name" stocks, there are better buys to be found now among midsized companies. As a result, Windsor's median market capitalization is only about one-fifth that of the S&P 500 Index: $10.8 billion versus $53.3 billion. In a "bigger is better" environment, this disparity worked against us. Of course, the market's tilt toward large growth stocks isn't the sole explanation for Windsor's subpar performance. A number of our stock selections performed poorly, even when the market's growth-stock bias is accounted for. We note that while the divergences in performance between growth and value stocks and between mid- and large-cap stocks were unusually wide in fiscal 1998, they are not unprecedented. And the differences have at times favored value stocks and mid-cap stocks. For example, as recently as fiscal year 1993, value stocks within the S&P 500 2 5 outperformed growth stocks by 18.4 percentage points. And smaller stocks outpaced the S&P 500 Index significantly during the early 1990s. There have always been wide swings in relative returns, at times lasting a decade or more, but they have typically evened out over the very long run. LONG-TERM PERFORMANCE OVERVIEW The table below presents the returns over the past ten years for Windsor Fund and its comparative standards, the average value fund and the S&P 500 Index. The table also shows the results for hypothetical $10,000 investments made in each, assuming the reinvestment of income and capital gains distributions. Bluntly put, over the past decade we have fallen significantly short of our goal of providing returns superior to our peers. However, we remain committed to that goal, and to our belief that Windsor Fund--which was our first pure stock fund, and which reached its 40th anniversary on October 23--is a sound vehicle for long-term investors. We add our customary caution about the usefulness of historic returns: They are not a guide to the future. The past decade's returns--especially the +17.9% average annual return achieved by the unmanaged index--were well above the long-term average of +11% annually from common stocks. It would be rash to expect such high absolute returns to continue indefinitely. That said, we hope to significantly improve our relative returns in the future and to surpass the results of our comparative benchmarks. Our shortfall in comparison with the average value fund during the past decade is largely the result of our poor showing during two fiscal years--1998 and 1990--that were the fund's worst in four decades of operation. (At last year's fiscal year-end, our 10-year average annual return was slightly ahead of that of the average value fund.) We note that while the stock market has provided rich returns for stocks during the past decade, results were generally less favorable for value funds in comparison with the S&P 500 Index, whose performance has been led by its growth-stock component. This growth segment earned an average annual return of +19.7% during the decade, versus a +15.7% average annual return for the index's value component. Over the very long haul, again, returns from growth and value stocks have been similar. We expect value stocks to have their day in the sun again. In its own comeback effort, Windsor Fund should be aided by its very low expense ratio: Our operating costs amounted to 0.27% of average net assets during fiscal 1998, a fraction of the 1.20% expense ratio charged by the average value fund. Our expense ratio in the past year was even lower than usual, reflecting the fact that our adviser is receiving about one-third of the base advisory fee due to our contractual penalty for the fund's underperformance.
- ---------------------------------------------------------------------- TOTAL RETURNS 10 YEARS ENDED OCTOBER 31, 1998 -------------------------------- AVERAGE FINAL VALUE OF ANNUAL A $10,000 RATE INITIAL INVESTMENT - ---------------------------------------------------------------------- Vanguard Windsor Fund +12.8% $33,285 - ---------------------------------------------------------------------- Average Value Fund +14.7% $39,571 - ---------------------------------------------------------------------- S&P 500 Index +17.9% $51,825 - ----------------------------------------------------------------------
IN SUMMARY It is a truism that to profit from the long-term rewards of the stock market, investors must be willing and able to endure discomforting declines, an ever-present risk of owning stocks. Both the risks and rewards of stocks were on display during the past fiscal year, for the market in general and specifically for Windsor Fund. But the mettle of an investment strategy is not proven in a year or even in a period of several years. 3 6 We urge our fellow shareholders in Windsor Fund to maintain a long-term focus. Our strategy of taking significant positions in companies that are out of favor with the crowd requires patience. And we believe that Windsor will continue to be a sound choice as part of a balanced portfolio of other stock funds, bond funds, and reserves, chosen in proportions suited to your goals, time horizon, and tolerance for the ups and downs of the markets. In short, we believe in thoughtfully constructing an investment plan and sticking with it. /S/ JOHN C. BOGLE /S/ JOHN J. BRENNAN John C. Bogle John J. Brennan Senior Chairman Chairman and Chief Executive Officer November 12, 1998 4 7 THE MARKETS IN PERSPECTIVE YEAR ENDED OCTOBER 31, 1998 [LOGO] U.S. financial markets encountered strong turbulence yet produced solid overall gains during the fiscal year ended October 31. The S&P 500 Index gained 22.0%, overcoming a sharp six-week setback in July and August. Bond prices rose as interest rates declined over the course of the year. Overseas, returns varied widely, with big gains on European bourses and sharp losses in Pacific and most emerging stock markets. U.S. STOCK MARKETS Large-capitalization stocks--especially large growth stocks--overwhelmingly led the market during the year. While the S&P 500 Index, which is dominated by large-cap stocks, was rising 22.0%, the rest of the market was down 3.4%, more than 25 percentage points behind the S&P. Results were even worse--a negative return of 11.8%--for small-cap stocks, as represented by the Russell 2000 Index. The Wilshire 5000 Equity Index, a measure of the entire U.S. market, gained 14.9%. Even large-cap investors endured sharp fluctuations during the year. After vaulting to a record high on July 17, the S&P 500 fell by 19.2% during the following six weeks, just shy of the 20% mark generally considered the "boundary" between a bear market and a mere "correction." However, declines were certifiably bearish for most smaller stocks. The Russell 2000 Index fell more than 30% from its peak in April before recovering somewhat during the final two months of the fiscal year.
- -------------------------------------------------------------------------------- AVERAGE ANNUALIZED RETURNS PERIODS ENDED OCTOBER 31, 1998 -------------------------------------- 1 YEAR 3 YEARS 5 YEARS - -------------------------------------------------------------------------------- STOCKS S&P 500 Index 22.0% 26.0% 21.3% Russell 2000 Index -11.8 10.0 9.4 MSCI EAFE Index 10.0 8.5 7.1 - -------------------------------------------------------------------------------- BONDS Lehman Aggregate Bond Index 9.3% 8.0% 7.0% Lehman 10-Year Municipal Bond Index 8.3 7.3 6.5 Salomon Smith Barney 3-Month U.S. Treasury Bill Index 5.2 5.2 5.1 - -------------------------------------------------------------------------------- OTHER Consumer Price Index 1.5% 2.2% 2.4% - --------------------------------------------------------------------------------
The July-August tumble in stock prices reflected a number of factors that collectively raised the anxiety level for many investors. Among these factors were deteriorating corporate earnings reports and forecasts, Russia's default on its debts, and a murkier global economic picture. Asia's economic troubles--which surfaced in mid-1997--persisted and began to look like a significant threat to continued expansions in the U.S. and European economies. But after steadying during September, stock prices bounced back strongly in October. Although many of the risk factors remained--for example, securities analysts continued to trim their estimates of corporate earnings--stock prices got a lift from falling interest rates, which dropped to levels last seen in the 1960s. (Low inflation and low interest rates help stock prices by raising the estimated value of future dividends and earnings.) Three forces clearly shaped the performance of industry sectors within the overall market. They could be summarized as faith (the buoyant confidence of consumers), fear (related to the effects of financial troubles abroad), and fortresses (companies somewhat protected from competition). U.S. consumers played the role of Atlas during fiscal 1998, 5 8 propping up the economic world with their strong spending. Feeling flush because of plentiful jobs (the nation's unemployment rate was as low as 4.3%) and rising wages, consumers spent a record proportion of their income. Not surprisingly, then, two big gainers among sectors of the S&P 500 Index were consumer staples (+26%) and consumer discretionary firms, such as retailers (+23%). Fear was a factor in the lagging returns from industry groups that were perceived by investors to be vulnerable to slowing global growth, falling commodity prices, and heightened price competition from foreign suppliers. Among these were exploration and services firms in the "other energy" category (-34%); chemical, metals, and other materials & processing firms (-3%); and makers of producer durables such as airplanes and machinery (-0.3%). Conversely, the utilities sector was the year's top performer (+45%) in part because utilities are seen as relatively insulated from foreign competition or economic troubles. Fortresses are companies perceived as relatively safe from competitors because of patented products, brands, or services. Such companies dominated the health-care (+41%) and technology (+37%) groups. U.S. BOND MARKETS Interest rates declined during the fiscal year, especially for U.S. Treasury securities, which benefited from greater aversion to risk among investors and from a slight decrease in supply, thanks to a $70 billion federal budget surplus. The Federal Reserve Board twice trimmed short-term rates by 0.25 percentage point, first on September 29 and then on October 15. Inflation, the bane of bond investors, was remarkably tame--consumer prices were up just 1.5% for the 12 months ended October 31. In this friendly environment, yields on long-term Treasury bonds fell by roughly 1 to 1.25 percentage points, with the 30-year Treasury bond ending the fiscal year at 5.16%. Lower rates mean higher prices for bonds, and the Lehman Brothers Long U.S. Treasury Bond Index earned a return of 16.3%, an astounding margin of nearly 15 percentage points over the inflation rate. High-quality corporate bonds and mortgage-backed securities did not rise in price as far as Treasury securities. Mortgage bonds tend to lag Treasuries during periods of falling rates because increased refinancing activity by homeowners results in prepayments of principal to holders of mortgage-backed securities. The Lehman Aggregate Bond Index, which comprises high-quality corporate and mortgage-backed bonds, as well as Treasuries, and has an intermediate-term average maturity, earned 9.3%. Yields on long-term municipal bonds declined only modestly during the fiscal year, and by October 31 were only slightly lower than yields on comparable Treasury securities, even though interest on municipals is exempt from federal income tax. INTERNATIONAL STOCK MARKETS Europe's stock markets outshone even the S&P 500 Index, but big declines swept the markets of Asia and Latin America. As a group, European stocks earned 23.4% for U.S. investors, reflecting local returns of about 21% and a gain of about 2% from a slight strengthening of several currencies against the dollar. Reasons for Europe's bull market included continuing economic growth; increased corporate restructuring and merger activity; and optimism about the long-term impact of the euro, a common currency due to be adopted in 1999 by 11 nations. In Japan, the stock market declined 14.3% in U.S.-dollar terms, reflecting a severe recession and a shaky banking system. Declines elsewhere in the Pacific region ranged from about 1% in Hong Kong to more than 60% in Indonesia and Malaysia. Losses were steep in non-Asian emerging markets, too. Notable declines in our own hemisphere occurred in Mexico (-20%), Venezuela (-64%), Brazil (-30%), and Chile (-38%). 6 9 REPORT FROM THE ADVISER [LOGO] Performance for our fiscal year ended October 31 was very disappointing. Windsor Fund's total return was minus 0.8%, versus gains of 22.0% for the S&P 500 Index and 9.9% for the average growth-and-income fund (excluding S&P 500 Index funds). Over the last 12 months, the portfolio mix we have been running with for a good while--i.e., way underweighted in the high-flying large-capitalization stocks, overweighted in cyclicals, and way overweighted in mid- and small-caps--has worked against us. In the atmosphere of global economic crisis that prevailed during the period, the market flocked toward the big household-name stocks and turned its back on the cyclicals and smaller stocks that we have featured. In short, mid-cap, deep-value was the wrong place to be during the last 12 months. This was typified by the result for Morningstar's average mid-cap value fund, whose 2.1% decline was very similar to our own. Another way to characterize the market of the last twelve months is to say that it was very narrow. Within the S&P 500 Index, the 50 largest stocks, by market cap, were up 37%, while the other 450 stocks were up only 5.5%. To look at this another way, the capitalization-weighted S&P 500--i.e., the index as we know it--appreciated 20%, while the equal-weighted S&P, with all 500 stocks counting the same, was up only 9%. Fiscal 1998 was the fourth year in a row for such narrow leadership of the market, an unusually long stretch. Over the last 30 years, 80% of the time Windsor Fund has underperformed in such narrowing markets, and outperformed in broadening markets, i.e., when the equal-weighted S&P 500 beats the cap-weighted S&P 500. Given our low P/E style, we are always underweighted in the big-cap stocks--because they are mostly too rich for our blood. By definition, these are the stocks that dominate in narrowing markets and lag in broadening markets. Our portfolio continues to be pointed toward a different kind of market--one that is broader, less dominated by large-caps and more receptive to other stocks, including our merchandise. We think we will see an inflection point, with this broader market ensuing, but not until the market gets more comfortable with the economic landscape. Our view is that world economic growth will be on the order of 11/2%-2% next year, and will go back in 2000 to the 3% pace that we saw in 1996 and 1997. This view assumes that Japan's economy flattens out in 1999 after this year's sharp decline; the rest of Asia shows a mild bounce; Latin America decelerates; and the United States and Europe grow about 2%-21/2% each. The United States and Europe are key, in that they account for over half of world economic output. The stock market is worried that world economic growth will be worse than our "soft landing" scenario, and maybe even negative. We think this is unlikely; we hang our hat on the still-solid domestic economies of the United States and Europe. For now, the market is very uncertain about the world and it continues to cling to its security blanket--the big-caps. The 50 largest stocks in the 7 10 S&P 500--the "nifties"--now account for fully 54% of its total value. We own only six of these stocks--ours are among the cheapest at that--and they represent only 19% of the fund. On average, the nifties sell at a stunning 311/2 times this year's earnings, about twice the P/E ratio of the other 450. The nifties include many excellent companies, but twice the P/E of everything else, for the group as a whole, seems overdone to us. We think there is a large safety premium built into that average P/E of 311/2; investors for some time now have run to the nifties in this period of uncertainty because they are so relatively "safe." But this thesis has been found somewhat wanting, as 12 of the 50 biggest caps have suffered significant earnings shortfalls this year--Coke, Royal Dutch, Gillette, Procter & Gamble, DuPont, Disney, McDonald's, Hewlett-Packard, Pfizer, and the three big money-center banks. For the most part, emerging-market issues lay behind the shortfalls of these stocks; so as it turned out, emerging markets were a problem not just for obvious casualties, such as the Alcoas, the Caterpillars, and other of our holdings, but even for the rarefied likes of Coke and P&G. We expect the list of earnings casualties among the nifties to expand through the rest of 1998 and into 1999. Not that earnings shortfalls so far seem to have had much lasting impact on the nifties--Coke still trades at 47 times earnings, and Gillette, P&G, and Disney at 30 to 35 times. The big stocks get hit when there's bad news, but then they recover, as money keeps pouring into the nifties. As you can see in our traditional report card on page 9, the global economic crisis atmosphere that has prevailed in the last 12 months has hit our financial, energy, and other cyclical stocks hard, and, again, has bulled the big caps. This pattern is history repeating itself. Historically, when we have seen this nervous narrowing of investor interest, the market is discounting an economic slowdown or downturn. But history also shows that the market's focus inevitably turns, at some point, from discounting the slowdown to looking to recovery. We have had a narrowing market for four years now, and the economic slowdown is at hand. We think the market, once it gets a sense of a bottom, will start discounting the recovery. We expect this inflection point to occur not too far down the road. Recent events--the Fed's rate cuts; Japan's $500 billion banking bill; Brazil's austere new fiscal plan--have served to calm the fear of global meltdown we saw during the summer. Sentiment has improved. Once the classic inflection point occurs, we should see a broader market that is receptive to all kinds of stocks, not just a few. Such times are, historically, when Windsor Fund shines. We are working very hard to make sure that we have a portfolio that will fully participate in such a market. We think that the unappreciated value in the portfolio is manifest in our portfolio P/E of only 16 times this year's earnings, versus a P/E of 23 for the S&P as a whole and 31 1/2 for the nifties. Charles T. Freeman, Portfolio Manager Wellington Management Company, LLP November 19, 1998 INVESTMENT PHILOSOPHY The adviser believes that superior long-term investment results can be achieved by emphasizing common stocks that are generally misunderstood, out of favor, or undervalued by fundamental measures such as price/earnings ratio or dividend yield. The adviser will concentrate a large portion of the fund's assets in those securities it believes offer the best return potential. 8 11
WINDSOR 1998 REPORT CARD - ------------------------------------------------------------------------------------------------------------------------------------ FISCAL YEAR 1998* 10/31/1998 ---------------------------- MEANINGFUL INDUSTRY GROUPS PERCENT WEIGHTED RELATIVE TO WINDSOR POSITIONS (5% OR MORE OF OF NET AVERAGE S&P 500 (IN ORDER OF SIZE) NET ASSETS) ASSETS APPRECIATION INDEX AT YEAR-END GRADE CRITIQUE - ------------------------------------------------------------------------------------------------------------------------------------ Basic Materials 14% -8% -23% Alcoa, Reynolds F Very poor result, despite (aluminum, Metals, Bowater, Abitibi- biggest bet being aluminum, chemicals, paper, Consolidated, Lyondell the best of a bad lot; Alcoa, and steel) Chemical, AK Steel, our biggest single holding, Stone Container, actually matched S&P 500; Jefferson Smurfit Group paper, chemicals, AK Steel all terrible, but have substantial upside. - ------------------------------------------------------------------------------------------------------------------------------------ Capital Goods 5% -8% -18% Caterpillar, Eaton Corp. D- Weakness was all Caterpillar, whose earnings have held up well despite the Asian crisis; it should be a good stock in 1999. - ------------------------------------------------------------------------------------------------------------------------------------ Communication 7% 37% 25% AT&T, Comcast, MCI WorldCom A+ Comcast and Cox were homeruns; Services MCI WorldCom and AT&T were also big winners. - ------------------------------------------------------------------------------------------------------------------------------------ Energy 14% -12% -22% Burlington Resources, F Our concentration on natural USX-Marathon Group, gas, deep-water drilling, and Transocean Offshore, refining--all areas that can Union Pacific Resources, work fundamentally even with Ultramar Diamond low oil prices--didn't do us Shamrock, Anadarko much good, as stubbornly Petroleum, Valero low oil prices cast a shadow Energy, Apache Corp. over the entire oil patch, as far as the stock market concerned; we have oil at $18 a barrel in 1999. - ------------------------------------------------------------------------------------------------------------------------------------ Financials 23% 2% -12% Citigroup, First Union, D+ Summer sell-off in money- BankAmerica Corp., center banks and S&Ls, Golden West Financial, related to emerging markets Allstate Corp., crisis, did in our financials; Washington Mutual, these stocks are cheap and National City Corp., undervalued. PartnerRe, PMI Group - ------------------------------------------------------------------------------------------------------------------------------- Health Care 15% 4% -13% Rhone-Poulenc, D+ Pharmacia & Upjohn a winner; Columbia/HCA Healthcare, Rhone-Poulenc so-so this year; CIGNA Corp., Aetna, HMOs mixed; Columbia/HCA Pharmacia & Upjohn. terrible, but has substantial PacifiCare Health B, value to be realized once it Foundation Health, settles government Medicare PacifiCare Health A fraud case. - ------------------------------------------------------------------------------------------------------------------------------------ Technology 5% 13% 1% General Instrument, A- General Instrument big winner, Arrow Electronics, though offset by Scientific Scientific Atlanta, Atlanta, Seagate, Advanced Quantum Corp., Avnet Micro Devices, and Tektronix. - ------------------------------------------------------------------------------------------------------------------------------------
* Capital change only. For stocks purchased and sold during the year, absolute appreciation is measured from the date of purchase or to the date of sale, and then relative to the S&P 500 Index for the same period. 9 12 FUND PROFILE WINDSOR FUND This Profile provides a snapshot of the fund's characteristics as of October 31, 1998, compared where appropriate to an unmanaged index. Key elements of this Profile are defined on page 11.
PORTFOLIO CHARACTERISTICS - ---------------------------------------------------------- WINDSOR S&P 500 - ---------------------------------------------------------- Number of Stocks 117 500 Median Market Cap $10.8B $53.3B Price/Earnings Ratio 15.7x 25.0x Price/Book Ratio 2.1x 4.3x Yield 1.4% 1.5% Return on Equity 13.9% 22.2% Earnings Growth Rate 14.7% 16.5% Foreign Holdings 11.8% 1.7% Turnover Rate 48% -- Expense Ratio 0.27% -- Cash Reserves 0.0% --
INVESTMENT FOCUS - ---------------------------------------------------------- [GRAPH]
VOLATILITY MEASURES - ---------------------------------------------------------- WINDSOR S&P 500 - ---------------------------------------------------------- R-Squared 0.83 1.00 Beta 1.06 1.00
TEN LARGEST HOLDINGS (% OF TOTAL NET ASSETS) - ---------------------------------------------------------- Citigroup, Inc. 6.5% Aluminum Co. of America 5.1 Rhone-Poulenc SA ADR 4.7 First Union Corp. 4.6 Burlington Resources, Inc. 3.6 BankAmerica Corp. 3.2 Caterpillar, Inc. 3.1 Columbia/HCA Healthcare Corp. 2.8 AT&T Corp. 2.8 Golden West Financial Corp. 2.6 - ---------------------------------------------------------- Top Ten 39.0%
SECTOR DIVERSIFICATION (% OF COMMON STOCKS) - ----------------------------------------------------------------------------------------------------------------- OCTOBER 31, 1997 OCTOBER 31, 1998 ---------------------------------------------------------- WINDSOR WINDSOR S&P 500 ---------------------------------------------------------- Auto & Transportation 12.2% 8.1% 3.0% Consumer Discretionary 0.9 0.3 10.7 Consumer Staples 0.0 0.0 10.2 Financial Services 19.2 28.9 16.8 Health Care 7.9 11.8 12.7 Integrated Oils 4.5 3.5 6.4 Other Energy 4.6 10.5 1.2 Materials & Processing 24.3 15.5 4.2 Producer Durables 11.9 5.8 3.3 Technology 5.2 5.4 14.5 Utilities 7.8 7.3 11.4 Other 1.5 2.9 5.6 - -----------------------------------------------------------------------------------------------------------------
10 13 BETA. A measure of the magnitude of a fund's past share-price fluctuations in relation to the ups and downs of the overall market (or appropriate market index). The market (or index) is assigned a beta of 1.00, so a fund with a beta of 1.20 would have seen its share price rise or fall by 12% when the overall market rose or fell by 10%. CASH RESERVES. The percentage of a fund's net assets invested in "cash equivalents"--highly liquid, short-term, interest-bearing securities. This figure does not include cash invested in futures contracts to simulate stock investment. EARNINGS GROWTH RATE. The average annual rate of growth in earnings over the past five years for the stocks now in a fund. EXPENSE RATIO. The percentage of a fund's average net assets used to pay its annual administrative and advisory expenses. These expenses directly reduce returns to investors. FOREIGN HOLDINGS. The percentage of a fund's equity assets represented by stocks or American Depositary Receipts of companies based outside the United States. INVESTMENT FOCUS. This grid indicates the focus of a fund in terms of two attributes: market capitalization (large, medium, or small) and relative valuation (growth, value, or a blend). MEDIAN MARKET CAP. An indicator of the size of companies in which a fund invests; the midpoint of market capitalization (market price x shares outstanding) of a fund's stocks, weighted by the proportion of the fund's assets invested in each stock. Stocks representing half of the fund's assets have market capitalizations above the median, and the rest are below it. NUMBER OF STOCKS. An indicator of diversification. The more stocks a fund holds, the more diversified it is and the more likely to perform in line with the overall stock market. PRICE/BOOK RATIO. The share price of a stock divided by its net worth, or book value, per share. For a fund, the weighted average price/book ratio of the stocks it holds. PRICE/EARNINGS RATIO. The ratio of a stock's current price to its per-share earnings over the past year. For a fund, the weighted average P/E of the stocks it holds. P/E is an indicator of market expectations about corporate prospects; the higher the P/E, the greater the expectations for a company's future growth. R-SQUARED. A measure of how much of a fund's past returns can be explained by the returns from the overall market (or its benchmark index). If a fund's total return were precisely synchronized with the overall market's return, its R-squared would be 1.00. If a fund's returns bore no relationship to the market's returns, its R-squared would be 0. RETURN ON EQUITY. The annual average rate of return generated by a company during the past five years for each dollar of shareholder's equity (net income divided by shareholder's equity). For a fund, the weighted average return on equity for the companies whose stocks it holds. SECTOR DIVERSIFICATION. The percentages of a fund's common stocks that come from each of the major industry groups that compose the stock market. TEN LARGEST HOLDINGS. The percentage of net assets that a fund has invested in its ten largest holdings. (The average for stock mutual funds is about 30%.) As this percentage rises, a fund's returns are likely to be more volatile because they are more dependent on the fortunes of a few companies. TURNOVER RATE. An indication of trading activity during the past year. Funds with high turnover rates incur higher transaction costs and are more likely to distribute capital gains (which are taxable to investors). YIELD. A snapshot of a fund's income from interest and dividends. The yield, expressed as a percentage of the fund's net asset value, is based on income earned over the past 30 days and is annualized, or projected forward for the coming year. The index yield is based on the current annualized rate of dividends paid on stocks in the index. 11 14 PERFORMANCE SUMMARY WINDSOR FUND All of the data on this page represent past performance, which cannot be used to predict future returns that may be achieved by the fund. Note, too, that both share price and return can fluctuate widely, so an investment in the fund could lose money.
TOTAL INVESTMENT RETURNS: OCTOBER 31, 1978-OCTOBER 31, 1998 - ------------------------------------------------------- WINDSOR FUND S&P 500 FISCAL CAPITAL INCOME TOTAL TOTAL YEAR RETURN RETURN RETURN RETURN - ------------------------------------------------------- 1979 13.5% 6.0% 19.5% 15.3% 1980 17.2 7.0 24.2 32.1 1981 11.1 6.9 18.0 0.6 1982 14.2 7.0 21.2 16.3 1983 25.3 7.3 32.6 27.8 1984 9.6 6.9 16.5 6.3 1985 16.6 6.7 23.3 19.4 1986 22.8 6.5 29.3 33.2 1987 2.7 1.9 4.6 6.4 1988 18.9 8.1 27.0 14.8 1989 11.9 5.2 17.1 26.4 1990 -31.8 3.9 -27.9 -7.5 1991 35.7 9.0 44.7 33.5 1992 4.3 5.0 9.3 10.0 1993 24.6 3.7 28.3 14.9 1994 3.7 2.6 6.3 3.9 1995 14.2 3.6 17.8 26.4 1996 19.6 3.6 23.2 24.1 1997 24.3 2.7 27.0 32.1 1998 -2.0 1.2 -0.8 22.0 - -------------------------------------------------------
See Financial Highlights table on page 18 for dividend and capital gains information for the past five years.
CUMULATIVE PERFORMANCE: OCTOBER 31, 1988-OCTOBER 31, 1998 - -------------------------------------------- Average Windsor Value 5&P 500 Fund Fund Index - -------------------------------------------- 1988 10 10000 10000 10000 1989 01 10721 10613 10764 1989 04 10895 10990 11298 1989 07 11883 12090 12744 1989 10 11705 12083 12640 1990 01 10579 11564 12321 1990 04 10537 11669 12491 1990 07 10840 12475 13572 1990 10 8436 10904 11695 1991 01 10316 12268 13355 1991 04 11443 13376 14691 1991 07 11758 13895 15304 1991 10 12207 14531 15612 1992 01 12623 15071 16385 1992 04 13363 15243 16752 1992 07 13827 15571 17262 1992 10 13342 15830 17166 1993 01 15186 16591 18119 1993 04 15581 16746 18300 1993 07 16360 17240 18769 1993 10 17116 18442 19731 1994 01 18207 18828 20452 1994 04 16985 17763 19273 1994 07 17964 18090 19737 1994 10 18202 18924 20494 1995 01 17473 18406 20560 1995 04 19283 19981 22639 1995 07 21497 21885 24890 1995 10 21442 22849 25913 1996 01 22942 24467 28510 1996 04 24399 25404 29479 1996 07 23766 24803 29014 1996 10 26409 27736 32157 1997 01 29924 30072 36020 1997 04 29992 30073 36889 1997 07 35093 35852 44141 1997 10 33548 35627 42483 1998 01 34346 36766 45713 1998 04 39466 41059 52038 1998 07 35954 40194 52654 1998 10 33285 39571 51825 - --------------------------------------------
AVERAGE ANNUAL TOTAL RETURNS PERIODS ENDED OCTOBER 31, 1998 ----------------------------------- FINAL VALUE OF A 1 YEAR 5 YEARS 10 YEARS $10,000 INVESTMENT - --------------------------------------------------------------------------------------------------- Windsor Fund -0.78% 14.23% 12.78% $33,285 Average Value Fund 11.07 16.50 14.75 39,571 S&P 500 Index 21.99 21.30 17.88 51,825 - ---------------------------------------------------------------------------------------------------
AVERAGE ANNUAL TOTAL RETURNS: PERIODS ENDED SEPTEMBER 30, 1998* - --------------------------------------------------------------------------------------------------------------------- 10 YEARS INCEPTION ----------------------------- DATE 1 YEAR 5 YEARS CAPITAL INCOME TOTAL - --------------------------------------------------------------------------------------------------------------------- Windsor Fund 10/23/1958 -14.10% 12.40% 8.11% 3.99% 12.10% - ---------------------------------------------------------------------------------------------------------------------
*SEC rules require that we provide this average annual total return information through the latest calendar quarter. 12 15 FINANCIAL STATEMENTS OCTOBER 31, 1998 STATEMENT OF NET ASSETS This Statement provides a detailed list of the fund's holdings, including each security's market value on the last day of the reporting period. Securities are grouped and subtotaled by asset type (common stocks, bonds, etc.) and by industry sector. Other assets are added to, and liabilities are subtracted from, the value of Total Investments to calculate the fund's Net Assets. Finally, Net Assets are divided by the outstanding shares of the fund to arrive at its share price, or Net Asset Value (NAV) Per Share. At the end of the Statement of Net Assets, you will find a table displaying the composition of the fund's net assets on both a dollar and per-share basis. Because all income and any realized gains must be distributed to shareholders each year, the bulk of net assets consists of Paid in Capital (money invested by shareholders). The amounts shown for Undistributed Net Investment Income and Accumulated Net Realized Gains usually approximate the sums the fund had available to distribute to shareholders as income dividends or capital gains as of the statement date. Any Accumulated Net Realized Losses, and any cumulative excess of distributions over net income or net realized gains, will appear as negative balances. Unrealized Appreciation (Depreciation) is the difference between the market value of the fund's investments and their cost, and reflects the gains (losses) that would be realized if the fund were to sell all of its investments at their statement-date values.
- ----------------------------------------------------------- MARKET VALUE* WINDSOR FUND SHARES (000) - ----------------------------------------------------------- COMMON STOCKS (97.9%) - ----------------------------------------------------------- AUTO & TRANSPORTATION (7.9%) - - (1)America West Holdings Corp. Class B 4,476,100 $ 68,820 Canadian National Railway Co. 1,227,700 61,922 Compagnie Generale des Establissements Michelin Class B shares 7,684,136 316,665 - - (1)Continental Airlines, Inc. Class B 2,681,300 106,247 (1)Delta Air Lines, Inc. 3,910,261 412,777 (1)Eaton Corp. 3,856,300 261,023 Ford Motor Co. 4,266,353 231,450 ----------- 1,458,904 ----------- CONSUMER DISCRETIONARY (0.3%) - - BJ's Wholesale Club, Inc. 881,700 31,686 - - (1)HomeBase, Inc. 2,362,900 15,950 ----------- 47,636 ----------- FINANCIAL SERVICES (28.3%) BANKS--OUTSIDE NEW YORK CITY (8.4%) BankAmerica Corp. 10,123,372 581,461 First Union Corp. 14,402,698 835,356 National City Corp. 1,887,800 121,409 DIVERSIFIED FINANCIAL SERVICES (6.5%) Citigroup, Inc. 25,329,000 1,192,046 INSURANCE--MULTILINE (4.6%) Allstate Corp. 9,621,800 414,339 CIGNA Corp. 5,827,100 425,014 INSURANCE--PROPERTY-CASUALTY (1.1%) (1)The PMI Group Inc. 1,570,600 79,217 (1)IPC Holdings Ltd. 1,689,700 39,286 PartnerRe Ltd. 2,116,200 84,119 REAL ESTATE INVESTMENT TRUSTS (3.3%) Archstone Communities Trust REIT 6,202,200 124,819 Avalonbay Communities, Inc. REIT 2,257,436 72,520 (1)Camden Property Trust REIT 2,519,300 67,706 CarrAmerica Realty Corp. REIT 1,748,600 39,344 Equity Residential Properties Trust REIT 3,549,100 149,062 (1)Liberty Property Trust REIT 4,746,100 109,160 Spieker Properties, Inc. REIT 1,307,000 45,092 SAVINGS & LOAN (4.4%) (1)Golden West Financial Corp. 5,221,100 473,489 Washington Federal Inc. 143,220 3,822 Washington Mutual, Inc. 8,783,564 328,835 ----------- 5,186,096 ----------- HEALTH CARE (11.4%) Aetna Inc. 3,038,100 226,718 Columbia/HCA Healthcare Corp. 24,726,000 519,246 - - (1)Foundation Health Systems Class A 7,267,660 85,395 - - (1)PacifiCare Health Systems, Inc. Class A 1,126,300 81,798 - - PacifiCare Health Systems, Inc. Class B 1,957,500 154,153
13 16
- --------------------------------------------------------------- MARKET VALUE* WINDSOR FUND SHARES (000) - --------------------------------------------------------------- Pharmacia & Upjohn, Inc. 3,471,400 $ 183,767 Rhone-Poulenc SA ADR 18,416,350 859,813 Rhone-Poulenc SA Class A 102,071 4,666 ----------- 2,115,556 ----------- INTEGRATED OILS (3.4%) (1)Cabot Oil & Gas Corp. Class A 2,255,200 38,338 (1)Lyondell Chemical Co. 6,659,903 112,386 Murphy Oil Corp. 1,573,200 64,993 USX-Marathon Group 12,690,700 414,827 ----------- 630,544 ----------- OTHER ENERGY (10.3%) Alberta Energy Co. Ltd. 2,233,300 51,972 Anadarko Petroleum Corp. 4,072,500 137,956 Apache Corp. 4,193,500 118,728 (1)Burlington Resources, Inc. 15,904,000 655,046 Diamond Offshore Drilling, Inc. 1,296,000 39,771 - - (1)EEX Corp. 9,420,297 36,504 Noble Affiliates, Inc. 690,800 22,624 - - Noble Drilling Corp. 1,603,400 27,558 (1)Transocean Offshore, Inc. 8,707,300 321,626 (1)Ultramar Diamond Shamrock Corp. 5,611,200 151,152 (1)Union Pacific Resources Group, Inc. 15,510,600 201,638 (1)Valero Energy Corp. 5,113,300 127,833 ----------- 1,892,408 ----------- MATERIALS & PROCESSING (15.2%) (1)AK Steel Corp. 6,199,352 107,326 Abitibi-Consolidated, Inc. 12,439,500 117,398 (1)Albany International Corp. 2,424,060 44,239 (1)Aluminum Co. of America 11,820,217 936,752 Anderson Exploration Ltd. 5,890,000 59,777 (1)Bowater Inc. 4,748,980 193,818 - - (1)Burlington Industries, Inc. 3,986,700 36,877 (1)Century Aluminum Co. 2,000,000 19,750 Champion International Corp. 1,718,500 54,885 Deltic Timber Corp. 549,471 13,393 (1)Geon Co. 2,480,000 53,785 (1)Georgia Gulf Corp. 3,705,300 63,222 (1)IMC Global Inc. 11,042,280 287,099 - - IMC Global Warrants Exp. 12/22/2000 644,066 805 Jefferson Smurfit Group PLC ADR 4,527,341 73,852 - - (1)Kaiser Aluminum & Chemical Corp. 5,929,334 37,429 Lafarge Corp. 1,961,300 66,071 (1)Mississippi Chemical Corp. 1,738,700 25,102 Pechiney SA ADR A 2,831,628 49,553 (1)Phosphate Resources Partners Ltd. 8,973,200 92,536 (1)Reynolds Metals Co. 5,702,548 341,796 - - (1)Ryerson Tull, Inc. Class A 1,378,600 15,595 - - (1)Stone Container Corp. 9,470,000 90,557 ----------- 2,781,617 ----------- PRODUCER DURABLES (5.7%) - - Beazer Homes USA, Inc. 171,900 3,040 (1)Case Corp. 7,415,000 163,130 Caterpillar, Inc. 12,846,200 578,079 - - (1)General Semiconductor, Inc. 2,352,500 18,673 Kaufman & Broad Home Corp. 1,595,000 45,557 Lincoln Electric Holdings 962,600 21,117 (1)MDC Holdings, Inc. 1,156,300 20,308 New Holland NV 5,689,700 71,832 Tektronix, Inc. 690,800 12,348 - - (1)Toll Brothers, Inc. 3,227,566 74,839 - - (1)U.S. Home Corp. 1,196,795 37,849 ----------- 1,046,772 ----------- TECHNOLOGY (5.3%) - - Advanced Micro Devices, Inc. 800,000 18,050 - - (1)Arrow Electronics, Inc. 6,893,700 150,369 Avnet, Inc. 1,632,000 81,192 - - (1)General Instrument Corp. 13,513,400 347,125 - - Maxtor Corp. 1,929,100 20,497 - - Quantum Corp. 4,867,800 85,187 (1)Scientific-Atlanta, Inc. 7,866,400 117,504 - - Seagate Technology 5,496,916 144,981 ----------- 964,905 ----------- UTILITIES (7.2%) AT&T Corp. 8,265,000 514,496 (1)Comcast Corp. Class A 2,784,900 136,808 (1)Comcast Corp. Class A Special 5,321,200 262,734 - - MCI WorldCom, Inc. 3,493,493 193,015 - - Tele-Communications, Inc. Class A 4,400,600 185,375 Telecom Corp. of New Zealand Ltd. 1,604,350 24,567 ----------- 1,316,995 ----------- OTHER (2.9%) Kemira Oy ADR 3,833,000 62,286 Miscellaneous (2.6%) 468,581 ----------- 530,867 ----------- - --------------------------------------------------------------- TOTAL COMMON STOCKS (COST $16,013,660) 17,972,300 - --------------------------------------------------------------- PREFERRED STOCKS (2.4%) - --------------------------------------------------------------- News Corp. Ltd. ADR 16,858,475 407,764 Petroleo Brasileiro SA ADR 2,983,400 37,293 - --------------------------------------------------------------- TOTAL PREFERRED STOCKS (COST $380,731) 445,057 - --------------------------------------------------------------- CONVERTIBLE PREFERRED STOCKS (0.1%) - --------------------------------------------------------------- Beazer Homes USA, Inc. 8.00% 370,000 9,713 Continental Airlines, Inc. Finance Trust 8.50% Cvt. Pfd. 175,000 14,416 - --------------------------------------------------------------- TOTAL CONVERTIBLE PREFERRED STOCKS (COST $20,527) 24,129 - --------------------------------------------------------------- FACE AMOUNT (000) - --------------------------------------------------------------- TEMPORARY CASH INVESTMENT (0.2%) - --------------------------------------------------------------- REPURCHASE AGREEMENT Collateralized by U.S. Government Obligations in a Pooled Cash Account 5.41%, 11/2/1998--Note F (COST $42,181) $42,181 42,181 - --------------------------------------------------------------- TOTAL INVESTMENTS (100.6%) (COST $16,457,099) 18,483,667 - ---------------------------------------------------------------
14 17
- ----------------------------------------------------------- MARKET* VALUE (000) - ----------------------------------------------------------- OTHER ASSETS AND LIABILITIES (-0.6%) - ----------------------------------------------------------- Other Assets--Note C $ 87,324 Liabilities--Note F (215,593) ----------- (128,269) - ----------------------------------------------------------- NET ASSETS (100%) - ----------------------------------------------------------- Applicable to 1,123,024,263 outstanding $.001 par value shares of beneficial interest (unlimited authorization) $18,355,398 =========================================================== NET ASSET VALUE PER SHARE $16.34 ===========================================================
* See Note A in Notes to Financial Statements. - - Non-Income-Producing Security. (1)Considered an affiliated company as the fund owns more than 5% of the outstanding voting securities of such company. The total market value of investments in affiliated companies was $7,120,613,000. ADR--American Depositary Receipt.
- ----------------------------------------------------------- AMOUNT PER (000) SHARE - ----------------------------------------------------------- AT OCTOBER 31, 1998, NET ASSETS CONSISTED OF: - ----------------------------------------------------------- Paid in Capital $14,915,527 $13.28 Undistributed Net Investment Income 71,199 .06 Accumulated Net Realized Gains 1,342,104 1.20 Unrealized Appreciation-- Note E 2,026,568 1.80 =========================================================== NET ASSETS $18,355,398 $16.34 ===========================================================
15 18 STATEMENT OF OPERATIONS This Statement shows dividend and interest income earned by the fund during the reporting period, and details the operating expenses charged to the fund. These expenses directly reduce the amount of investment income available to pay to shareholders as dividends. This Statement also shows any Net Gain (Loss) realized on the sale of investments, and the increase or decrease in the Unrealized Appreciation (Depreciation) on investments during the period.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR FUND YEAR ENDED OCTOBER 31, 1998 (000) - ------------------------------------------------------------------------------------------------------------------------ INVESTMENT INCOME INCOME Dividends* $ 293,508 Interest 26,319 Security Lending 1,533 ---------- Total Income 321,360 ---------- EXPENSES Investment Advisory Fees--Note B Basic Fee 24,971 Performance Adjustment (15,501) The Vanguard Group--Note C Management and Administrative 40,520 Marketing and Distribution 4,218 Taxes (other than income taxes) 1,073 Custodian Fees 293 Auditing Fees 17 Shareholders' Reports 311 Annual Meeting and Proxy Costs 179 Trustees' Fees and Expenses 39 ---------- Total Expenses 56,120 Expenses Paid Indirectly--Note C (4,859) ---------- Net Expenses 51,261 - ------------------------------------------------------------------------------------------------------------------------ NET INVESTMENT INCOME 270,099 - ------------------------------------------------------------------------------------------------------------------------ REALIZED NET GAIN ON INVESTMENT SECURITIES SOLD* 1,346,037 - ------------------------------------------------------------------------------------------------------------------------ CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) OF INVESTMENT SECURITIES (1,700,942) - ------------------------------------------------------------------------------------------------------------------------ NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS (84,806) ========================================================================================================================
*Dividend income and realized net gain from affiliated companies were $89,952,000 and $5,156,000, respectively. 16 19 STATEMENT OF CHANGES IN NET ASSETS This Statement shows how the fund's total net assets changed during the two most recent reporting periods. The Operations section summarizes information detailed in the Statement of Operations. The amounts shown as Distributions to shareholders from the fund's net income and capital gains may not match the amounts shown in the Operations section, because distributions are determined on a tax basis and may be made in a period different from the one in which the income was earned or the gains were realized on the financial statements. The Capital Share Transactions section shows the amount shareholders invested in the fund, either by purchasing shares or by reinvesting distributions, as well as the amounts redeemed. The corresponding numbers of Shares Issued and Redeemed are shown at the end of the Statement.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR FUND YEAR ENDED OCTOBER 31, -------------------------------- 1998 1997 (000) (000) - ------------------------------------------------------------------------------------------------------------------------ INCREASE (DECREASE) IN NET ASSETS OPERATIONS Net Investment Income $ 270,099 $ 357,653 Realized Net Gain 1,346,037 3,052,726 Change in Unrealized Appreciation (Depreciation) (1,700,942) 887,426 -------------------------------- Net Increase (Decrease) in Net Assets Resulting from Operations (84,806) 4,297,805 -------------------------------- DISTRIBUTIONS Net Investment Income (268,858) (402,197) Realized Capital Gain (3,045,000) (1,237,831) -------------------------------- Total Distributions (3,313,858) (1,640,028) -------------------------------- CAPITAL SHARE TRANSACTIONS(1) Issued 1,632,455 2,267,286 Issued in Lieu of Cash Distributions 3,148,447 1,562,364 Issued in Exchange for Net Assets of Gemini II--Note G -- 263,239 Redeemed (3,704,909) (1,913,647) -------------------------------- Net Increase from Capital Share Transactions 1,075,993 2,179,242 - ------------------------------------------------------------------------------------------------------------------------ Total Increase (Decrease) (2,322,671) 4,837,019 - ------------------------------------------------------------------------------------------------------------------------ NET ASSETS Beginning of Year 20,678,069 15,841,050 -------------------------------- End of Year $18,355,398 $20,678,069 ======================================================================================================================== (1)Shares Issued (Redeemed) Issued 92,583 123,045 Issued in Lieu of Cash Distributions 187,538 92,396 Issued in Exchange for Net Assets of Gemini II--Note G -- 13,730 Redeemed (214,952) (103,790) -------------------------------- Net Increase in Shares Outstanding 65,169 125,381 ========================================================================================================================
17 20 FINANCIAL HIGHLIGHTS This table summarizes the fund's investment results and distributions to shareholders on a per-share basis. It also presents the fund's Total Return and shows net investment income and expenses as percentages of average net assets. These data will help you assess: the variability of the fund's net income and total returns from year to year; the relative contributions of net income and capital gains to the fund's total return; how much it costs to operate the fund; and the extent to which the fund tends to distribute capital gains. The table also shows the Portfolio Turnover Rate, a measure of trading activity. A turnover rate of 100% means that the average security is held in the fund for one year.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR FUND YEAR ENDED OCTOBER 31, ---------------------------------------------------------- FOR A SHARE OUTSTANDING THROUGHOUT EACH YEAR 1998 1997 1996 1995 1994 - ------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF YEAR $19.55 $16.99 $15.55 $14.55 $14.95 - ------------------------------------------------------------------------------------------------------------------------ INVESTMENT OPERATIONS Net Investment Income .23 .36 .43 .44 .44 Net Realized and Unrealized Gain (Loss) on Investments (.32) 3.94 2.85 1.86 .42 ---------------------------------------------------------- Total from Investment Operations (.09) 4.30 3.28 2.30 .86 ---------------------------------------------------------- DISTRIBUTIONS Dividends from Net Investment Income (.24) (.41) (.46) (.44) (.37) Distributions from Realized Capital Gains (2.88) (1.33) (1.38) (.86) (.89) ---------------------------------------------------------- Total Distributions (3.12) (1.74) (1.84) (1.30) (1.26) - ------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF YEAR $16.34 $19.55 $16.99 $15.55 $14.55 ======================================================================================================================== TOTAL RETURN -0.78% 27.04% 23.16% 17.80% 6.35% ======================================================================================================================== RATIOS/SUPPLEMENTAL DATA Net Assets, End of Year (Millions) $18,355 $20,678 $15,841 $13,008 $11,406 Ratio of Total Expenses to Average Net Assets 0.27% 0.27% 0.31% 0.45% 0.45% Ratio of Net Investment Income to Average Net Assets 1.31% 1.89% 2.75% 3.01% 3.11% Portfolio Turnover Rate 48% 61% 34% 32% 34% ========================================================================================================================
18 21 NOTES TO FINANCIAL STATEMENTS Vanguard Windsor Fund is registered under the Investment Company Act of 1940 as a diversified open-end investment company, or mutual fund. A. The following significant accounting policies conform to generally accepted accounting principles for mutual funds. The fund consistently follows such policies in preparing its financial statements. 1. SECURITY VALUATION: Equity securities are valued at the latest quoted sales prices as of the close of trading on the New York Stock Exchange (generally 4:00 p.m. Eastern time) on the valuation date; such securities not traded on the valuation date are valued at the mean of the latest quoted bid and asked prices. Prices are taken from the primary market in which each security trades. Temporary cash investments acquired over 60 days to maturity are valued using the latest bid prices or using valuations based on a matrix system (which considers such factors as security prices, yields, maturities, and ratings), both as furnished by independent pricing services. Other temporary cash investments are valued at amortized cost, which approximates market value. Securities for which market quotations are not readily available are valued by methods deemed by the Board of Trustees to represent fair value. 2. FEDERAL INCOME TAXES: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. Accordingly, no provision for federal income taxes is required in the financial statements. 3. REPURCHASE AGREEMENTS: The fund, along with other members of The Vanguard Group, transfers uninvested cash balances to a Pooled Cash Account, which is invested in repurchase agreements secured by U.S. government securities. Securities pledged as collateral for repurchase agreements are held by a custodian bank until the agreements mature. Each agreement requires that the market value of the collateral be sufficient to cover payments of interest and principal; however, in the event of default or bankruptcy by the other party to the agreement, retention of the collateral may be subject to legal proceedings. 4. DISTRIBUTIONS: Distributions to shareholders are recorded on the ex-dividend date. Distributions are determined on a tax basis and may differ from net investment income and realized capital gains for financial reporting purposes. 5. OTHER: Dividend income is recorded on the ex-dividend date. Security transactions are accounted for on the date securities are bought or sold. Costs used to determine realized gains (losses) on the sale of investment securities are those of the specific securities sold. B. Wellington Management Company, LLP provides investment advisory services to the fund for a fee calculated at an annual percentage rate of average net assets. The basic fee is subject to quarterly adjustments based on performance relative to the S&P 500 Index. For the year ended October 31, 1998, the advisory fee represented an effective annual basic rate of 0.12% of the fund's average net assets before a decrease of $15,501,000 (0.08%) based on performance. C. The Vanguard Group furnishes at cost corporate management, administrative, marketing, and distribution services. The costs of such services are allocated to the fund under methods approved by the Board of Trustees. The fund has committed to provide up to 0.40% of its net assets in capital contributions to Vanguard. At October 31, 1998, the fund had contributed capital of $3,375,000 to Vanguard (included in Other Assets), representing 0.02% of net assets and 4.8% of Vanguard's capitalization. The fund's Trustees and officers are also Directors and officers of Vanguard. Vanguard has asked the fund's investment adviser to direct certain portfolio trades, subject to obtaining the best price and execution, to brokers who have agreed to rebate to the fund part of the commissions generated. Such rebates are used solely to reduce the fund's administrative expenses. For the year ended October 31, 1998, directed brokerage arrangements reduced the fund's expenses by $4,859,000 (an annual rate of 0.02% of average net assets). 19 22 NOTES TO FINANCIAL STATEMENTS (continued) D. During the year ended October 31, 1998, the fund purchased $9,642,670,000 of investment securities and sold $10,958,700,000 of investment securities, other than temporary cash investments. E. At October 31, 1998, net unrealized appreciation of investment securities for financial reporting and federal income tax purposes was $2,026,568,000, consisting of unrealized gains of $3,844,518,000 on securities that had risen in value since their purchase and $1,817,950,000 in unrealized losses on securities that had fallen in value since their purchase. F. The market value of securities on loan to broker/dealers at October 31, 1998, was $41,476,000, for which the fund held cash collateral of $42,181,000. Cash collateral received is invested in repurchase agreements. G. On June 19, 1997, the fund acquired Gemini II Fund's net assets pursuant to an agreement approved by Gemini II Fund's shareholders on June 18, 1997. The acquisition was accomplished by a tax-free exchange of 13,730,319 of the fund's capital shares for the 9,232,207 outstanding Gemini II Fund shares on June 19, 1997. Gemini II Fund's net assets of $263,239,000, including $57,791,000 of unrealized appreciation, were combined with Windsor Fund's net assets of $19,820,772,000, resulting in combined net assets of $20,084,011,000 on the merger date. 20 23 REPORT OF INDEPENDENT ACCOUNTANTS [LOGO] To the Shareholders and Board of Trustees of Vanguard Windsor Fund In our opinion, the accompanying statement of net assets and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Vanguard Windsor Fund (the "Fund") at October 31, 1998, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the five years in the period then ended, in conformity with generally accepted accounting principles. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at October 31, 1998 by correspondence with the custodian, provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 November 30, 1998 21 24 SPECIAL 1998 TAX INFORMATION (UNAUDITED) FOR VANGUARD WINDSOR FUND This information for the fiscal year ended October 31, 1998, is included pursuant to provisions of the Internal Revenue Code. The fund distributed $2,135,730,000 as capital gain dividends (from net long-term capital gains) to shareholders in December 1997. Of the $2,135,730,000 capital gain dividends, the fund designates $939,076,000 as a 20% rate gain distribution. For corporate shareholders, 89.7% of investment income (dividend income plus short-term gains, if any) qualifies for the dividends-received deduction. 22 25 TRUSTEES AND OFFICERS JOHN C. BOGLE Founder, Senior Chairman of the Board, and Director/Trustee of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. JOHN J. BRENNAN Chairman, Chief Executive Officer, and Director/Trustee of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. BARBARA BARNES HAUPTFUHRER Director of The Great Atlantic and Pacific Tea Co., IKON Office Solutions, Inc., Raytheon Co., Knight-Ridder, Inc., Massachusetts Mutual Life Insurance Co., and Ladies Professional Golf Association; Trustee Emerita of Wellesley College. JOANN HEFFERNAN HEISEN Vice President, Chief Information Officer, and a member of the Executive Committee of Johnson & Johnson; Director of Johnson & JohnsonoMerck Consumer Pharmaceuticals Co., Women First HealthCare, Inc., Recording for the Blind and Dyslexic, The Medical Center at Princeton, and Women's Research and Education Institute. BRUCE K. MACLAURY President Emeritus of The Brookings Institution; Director of American Express Bank Ltd., The St. Paul Companies, Inc., and National Steel Corp. BURTON G. MALKIEL Chemical Bank Chairman's Professor of Economics, Princeton University; Director of Prudential Insurance Co. of America, Banco Bilbao Gestinova, Baker Fentress & Co., The Jeffrey Co., and Southern New England Telecommunications Co. ALFRED M. RANKIN, JR. Chairman, President, and Chief Executive Officer of NACCO Industries, Inc.; Director of NACCO Industries, The BFGoodrich Co., and The Standard Products Co. JOHN C. SAWHILL President and Chief Executive Officer of The Nature Conservancy; formerly, Director and Senior Partner of McKinsey & Co. and President of New York University; Director of Pacific Gas and Electric Co., Procter & Gamble Co., NACCO Industries, and Newfield Exploration Co. JAMES O. WELCH, JR. Retired Chairman of Nabisco Brands, Inc.; retired Vice Chairman and Director of RJR Nabisco; Director of TECO Energy, Inc., and Kmart Corp. J. LAWRENCE WILSON Chairman and Chief Executive Officer of Rohm & Haas Co.; Director of Cummins Engine Co. and The Mead Corp.; Trustee of Vanderbilt University. OTHER FUND OFFICERS RAYMOND J. KLAPINSKY Secretary; Managing Director and Secretary of The Vanguard Group, Inc.; Secretary of each of the investment companies in The Vanguard Group. THOMAS J. HIGGINS Treasurer; Principal of The Vanguard Group, Inc.; Treasurer of each of the investment companies in The Vanguard Group. KAREN E. WEST Controller; Principal of The Vanguard Group, Inc.; Controller of each of the investment companies in The Vanguard Group. OTHER VANGUARD OFFICERS R. GREGORY BARTON Managing Director, Legal Department. ROBERT A. DISTEFANO Managing Director, Information Technology. JAMES H. GATELY Managing Director, Individual Investor Group. KATHLEEN C. GUBANICH Managing Director, Human Resources. IAN A. MACKINNON Managing Director, Fixed Income Group. F. WILLIAM MCNABB, III Managing Director, Institutional Investor Group. MICHAEL S. MILLER Managing Director, Planning and Development. RALPH K. PACKARD Managing Director and Chief Financial Officer. GEORGE U. SAUTER Managing Director, Core Management Group. "Standard & Poor's(R)," "S&P(R)," "S&P 500(R)," "Standard & Poor's 500," and "500" are trademarks of The McGraw-Hill Companies, Inc. Frank Russell Company is the owner of trademarks and copyrights relating to the Russell Indexes. "Wilshire 4500" and "Wilshire 5000" are trademarks of Wilshire Associates. 26 VANGUARD MILESTONES [LOGO] The Vanguard Group is named for HMS Vanguard, Admiral Horatio Nelson's flagship at the Battle of the Nile on August 1, 1798. Our founder, John C. Bogle, chose the name after reading Nelson's inspiring tribute to his fleet: "Nothing could withstand the squadron . . . with the judgment of the captains, together with their valour, and that of the officers and men of every description, it was absolutely irresistible." [LOGO] Walter L. Morgan, founder of Wellington Fund, the nation's first balanced mutual fund and forerunner of today's family of some 100 Vanguard funds, celebrated his 100th birthday on July 23, 1998. Mr. Morgan, a true investment pioneer, died six weeks later on September 2. [LOGO] Wellington Fund, The Vanguard Group's oldest fund, was incorporated by Mr. Morgan 70 years ago, on December 28, 1928. The fund was named after the Duke of Wellington, whose forces defeated Napoleon Bonaparte at the Battle of Waterloo in 1815. [THE VANGUARD GROUP LOGO] Post Office Box 2600 Valley Forge, Pennsylvania 19482 FUND INFORMATION 1-800-662-7447 INDIVIDUAL ACCOUNT SERVICES 1-800-662-2739 INSTITUTIONAL INVESTOR SERVICES 1-800-523-1036 www.vanguard.com online@vanguard.com All Vanguard funds are offered by prospectus only. Prospectuses contain more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before you invest or send money. Prospectuses can be obtained directly from The Vanguard Group. Q220-12/10/1998 (C) 1998 Vanguard Marketing Corporation, Distributor. All rights reserved. 27 VANGUARD WINDSOR II FUND ANNUAL REPORT OCTOBER 31, 1998 [PHOTO] [THE VANGUARD GROUP LOGO] 28 AT VANGUARD, WE BELIEVE THAT TRADITION MATTERS Our 8,000 crew members embrace the traditional values on which our success is built, including integrity, hard work, thrift, teamwork, and fair dealing on behalf of our clients. This year, our report cover pays homage to three anniversaries, each of great significance to The Vanguard Group: - - The 200th anniversary of the Battle of the Nile, which commenced on August 1, 1798. HMS Vanguard, the victorious British flagship at the Nile, is our namesake. And its motto--"Leading the way"--serves as a guiding principle for our company. - - The 100th birthday, on July 23, of Walter L. Morgan, founder of Wellington Fund, the oldest member of what became The Vanguard Group. Mr. Morgan was friend and mentor to Vanguard founder John C. Bogle, and helped to shape the standards and business principles that Mr. Bogle laid down for Vanguard at its beginning nearly 25 years ago: a stress on balanced, diversified investments; insistence on fair dealing and candor with clients; and a focus on long-term investing. To our great regret, Mr. Morgan died on September 2. - - The 70th anniversary, on December 28, of the incorporation of Vanguard Wellington Fund. It was the nation's first balanced mutual fund, and is one of only a handful of funds created in the 1920s that are still in operation. Although Vanguard constantly tackles new challenges, adopts new technology, and develops new services, we treasure the traditions and values that set us apart in a crowded, competitive industry. And we salute our shareholders, whose support and trust we strive to earn each and every day. [LOGO] CONTENTS A Message to Our Shareholders 1 The Markets in Perspective 4 Adviser's Report 6 Fund Profile 8 Performance Summary 10 Financial Statements 11 Report of Independent Accountants 20 All comparative mutual fund data are from Lipper Analytical Services, Inc. or Morningstar unless otherwise noted. 29 FELLOW SHAREHOLDER, [PHOTO] [PHOTO] JOHN J. BRENNAN JOHN C. BOGLE Chairman & CEO Senior Chairman During the fiscal year ended October 31, 1998, the U.S. stock market roared ahead, took a violent two-month tumble, and then advanced strongly again. In this frenetic but ultimately rewarding environment, Vanguard Windsor II Fund gave a fine account of itself, earning a return of +16.5% and easily outpacing its average competitor. Our shortfall against the Standard & Poor's 500 Composite Stock Price Index was explained simply by the fact that it was growth stocks, not value stocks, that led the way during the year.
- ---------------------------------------------------------- TOTAL RETURNS FISCAL YEAR ENDED OCTOBER 31, 1998 - ---------------------------------------------------------- Vanguard Windsor II Fund +16.5% - ---------------------------------------------------------- Average Value Fund +11.1% - ---------------------------------------------------------- S&P 500 Index +22.0% - ----------------------------------------------------------
The table at right compares Windsor II's total return (capital change plus reinvested dividends) for the fiscal year with those of the average value (growth and income) mutual fund and the unmanaged S&P 500 Index, which is dominated by large blue chip stocks. The fund's total return is based on net asset values of $29.36 per share on October 31, 1997, and $31.07 per share on October 31, 1998, adjusted for dividends totaling $0.66 per share paid from net investment income and a distribution of $2.19 per share paid from net realized capital gains. FINANCIAL MARKETS IN REVIEW Through the first two-thirds of the fiscal year that ended October 31, the U.S. stock market--led by large blue chip issues--continued the remarkable rise that began in August 1982. By mid-July, the S&P 500 Index had gained +31.2%. However, most of that gain evaporated during an unnerving six-week slump that lasted through August 31. But stock prices then rebounded, and for the full twelve months ended October 31 the S&P 500 Index earned a +22.0% return--twice the long-term annualized average of +11% a year. Within the stock market, unusually strong crosscurrents prevailed. While the S&P 500 Index, which is dominated by large-capitalization stocks, generated awesome returns, the rest of the market was down. Stocks outside of the S&P 500 (represented by the Wilshire 4500 Equity Index) fell -3.4%, and small-cap stocks (as measured by the Russell 2000 Index) lost -11.8%. Within the S&P 500, value stocks, which performed well, lagged the returns on growth stocks by a wide margin. Interest rates declined significantly during the year, providing a significant lift to stock prices and elevating prices for bonds. The yield on the benchmark 30-year U.S. Treasury bond began the year at 6.15%, dwindled to a low of 4.72% on October 5 amid concerns about a slowing economy, then rebounded to end the fiscal year at 5.16%. For bonds, of course, lower yields translate into higher prices. The Lehman Brothers Aggregate Bond Index, a benchmark for the overall taxable bond market, returned +9.3% during the fiscal year, as a price rise of about 2.5% augmented income of about 6.8%. Wide and abrupt shifts in investor sentiment buffeted financial markets during the fiscal year, despite a generally positive economic environment. Inflation stayed in check: Consumer prices rose just 1.5% during the twelve months ended October 31. The U.S. 1 30 economy grew by more than 3%, although the pace of growth appeared to slow late in the period. The economy's expansion was fueled by strong consumer spending encouraged by a strong job market (unemployment as low as 4.3%) and rising wages (up about 4%). The summer slump in stock prices sent broad market indexes lower by approximately -20% or more, technically a "bear market," one of only four in the past 20 years. Analysts cited a number of reasons for investors' skittishness, including Asia's continuing economic distress. Many investors had assumed that the region's troubles would be short-lived. But as the problems lingered, investors worried that the "Asian contagion" would spread worldwide. Whatever the causes, investors grew more risk-averse. There was a decided movement toward the "safe haven" of U.S. Treasury securities, and away from corporate bonds and U.S. and international stocks. By October, however, many investors appeared to regain their appetite for risk, and stock prices shot up +8.1% for the month. FISCAL 1998 PERFORMANCE OVERVIEW Windsor II's return for the 1998 fiscal year was outstanding both in absolute terms and relative to the average value mutual fund. Our +16.5% return was 5.4 percentage points better than the +11.1% return of our average peer. A big part of that advantage can be explained by the size of the companies in which our team of advisers invests. Overall, our stocks are much larger than those held by competing mutual funds; the median market capitalization of Windsor II's stocks as of October 31 was $25.8 billion, compared with $16 billion for our average peer. In fiscal 1998, bigger was better on Wall Street. With respect to the unmanaged S&P 500 Index, which returned a remarkable +22.0% during the year, our shortfall was based entirely on investment style. The value component of the index returned +11.7%, while its growth component returned a truly astounding +32.0%. Relative to the index's value component--a better benchmark for the stocks Windsor II emphasizes--our return was superior by 4.8 percentage points (+16.5% versus +11.7%). As our previous reports have explained, the swings between the returns of value stocks and growth stocks often vary widely from one year to another. While the value shortfall of 20 percentage points during the past twelve months was one of the largest on record, it wasn't too many years ago that value stocks trounced growth stocks. During calendar year 1993, value stocks gained +18.6%, versus +1.7% for growth stocks--a margin of 16.9 percentage points in favor of the value segment. Our favorable margin versus the value index during the fiscal year was, in part, the result of our relatively large stake in the top-performing utilities sector--where we often find the higher income we seek. Our strong relative performance also came from our portfolio managers' terrific stock selection among auto & transportation and consumer staples. However, our minimal commitment to the strong-performing health-care sector (about 2% of assets versus 12% for the index) and our higher stake (6% versus 1%) in the dismal "other energy" sector, which includes drilling and mining companies, hurt us in comparison with the index.
- ----------------------------------------------------------------- TOTAL ASSETS MANAGED ---------------------- $ MILLION PERCENT - ----------------------------------------------------------------- Barrow, Hanley, Mewhinney & Strauss, Inc. $20,030 68% Equinox Capital Management, Inc. 3,292 11 Tukman Capital Management, Inc. 3,166 11 Vanguard Core Management Group 1,573 5 Cash Reserve* 1,578 5 - ----------------------------------------------------------------- Total $29,639 100% - -----------------------------------------------------------------
*This cash reserve is invested in equity index futures to simulate investment in stocks; each adviser may also maintain a modest cash reserve. Each of our four investment advisers bested the return of the average value 2 31 fund. The table at the bottom of the previous page presents the share of assets supervised by each adviser at the end of the fiscal year. LONG-TERM PERFORMANCE OVERVIEW The performance of Vanguard Windsor II Fund has also been excellent over a longer time frame. For the ten years ended October 31, our annualized return of +16.5% outpaced the +14.7% return of the average peer by 1.8 percentage points. An initial $10,000 investment in Windsor II would have grown to $46,247 over the decade. That's $6,676 more than would have accumulated in the average peer mutual fund--a margin of advantage that amounts to 67% of the original investment. Of course, part of our performance advantage comes from our much lower costs. Windsor II's expense ratio of 0.41% of average net assets is about one-third of the 1.20% charged by the average value mutual fund, an advantage that can be especially powerful over the long run.
- -------------------------------------------------------------- TOTAL RETURNS 10 YEARS ENDED OCTOBER 31, 1998 ------------------------------- AVERAGE FINAL VALUE OF ANNUAL A $10,000 RATE INITIAL INVESTMENT - -------------------------------------------------------------- Vanguard Windsor II Fund +16.5% $46,247 - -------------------------------------------------------------- Average Value Fund +14.7% $39,571 - -------------------------------------------------------------- S&P 500 Index +17.9% $51,825 - --------------------------------------------------------------
While our annual rate of return lagged the S&P 500 Index by a margin of 1.4 percentage points, we should note that we outpaced the index's value stocks, which returned an annualized +15.7% during the period. While value stocks happened to have a lower return than growth stocks during the decade, we would also note that value stocks have carried less risk, in the form of lower price volatility. Though ten-year returns provide a long-term perspective on performance, they tell us nothing about what's to come over the next ten years--or even the next ten months or ten days. However, we must note that returns from stocks over the past decade have been exceptional--more than 11/2 times the long-term average of +11%. To expect a repeat performance over the next ten years would be imprudent, and to build an investment program around such an expectation could be downright hazardous. IN SUMMARY In our report six months ago, we warned investors to expect to "encounter downturns--possibly severe ones--from time to time." Our suggestion for the most appropriate way to reap the markets' rewards while weathering these risks was for investors to hold balanced portfolios of stock funds, bond funds, and reserves in proportion to each person's financial situation, investment goals, and tolerance for risk. In the wake of just such a downturn in July and August, our recommendation, needless to say, remains unchanged. We believe that thoughtfully constructing a balanced portfolio and then sticking with it, whatever the markets may throw your way, is an approach that is as sensible as it is simple. /S/ JOHN C. BOGLE /S/ JOHN J. BRENNAN John C. Bogle John J. Brennan Senior Chairman Chairman and Chief Executive Officer November 18, 1998 3 32 THE MARKETS IN PERSPECTIVE YEAR ENDED OCTOBER 31, 1998 [LOGO] U.S. financial markets encountered strong turbulence yet produced solid overall gains during the fiscal year ended October 31. The S&P 500 Index gained 22.0%, overcoming a sharp six-week setback in July and August. Bond prices rose as interest rates declined over the course of the year. Overseas, returns varied widely, with big gains on European bourses and sharp losses in Pacific and most emerging stock markets. U.S. STOCK MARKETS Large-capitalization stocks--especially large growth stocks--overwhelmingly led the market during the year. While the S&P 500 Index, which is dominated by large-cap stocks, was rising 22.0%, the rest of the market was down 3.4%, more than 25 percentage points behind the S&P. Results were even worse--a negative return of 11.8%--for small-cap stocks, as represented by the Russell 2000 Index. The Wilshire 5000 Equity Index, a measure of the entire U.S. market, gained 14.9%. Even large-cap investors endured sharp fluctuations during the year. After vaulting to a record high on July 17, the S&P 500 fell by 19.2% during the following six weeks, just shy of the 20% mark generally considered the "boundary" between a bear market and a mere "correction." However, declines were certifiably bearish for most smaller stocks. The Russell 2000 Index fell more than 30% from its peak in April before recovering somewhat during the final two months of the fiscal year.
- ----------------------------------------------------------------------------- AVERAGE ANNUALIZED RETURNS PERIODS ENDED OCTOBER 31, 1998 --------------------------------- 1 YEAR 3 YEARS 5 YEARS - ----------------------------------------------------------------------------- STOCKS S&P 500 Index 22.0% 26.0% 21.3% Russell 2000 Index -11.8 10.0 9.4 MSCI EAFE Index 10.0 8.5 7.1 - ----------------------------------------------------------------------------- BONDS Lehman Aggregate Bond Index 9.3% 8.0% 7.0% Lehman 10-Year Municipal Bond Index 8.3 7.3 6.5 Salomon Smith Barney 3-Month U.S. Treasury Bill Index 5.2 5.2 5.1 - ----------------------------------------------------------------------------- OTHER Consumer Price Index 1.5% 2.2% 2.4% - -----------------------------------------------------------------------------
The July-August tumble in stock prices reflected a number of factors that collectively raised the anxiety level for many investors. Among these factors were deteriorating corporate earnings reports and forecasts, Russia's default on its debts, and a murkier global economic picture. Asia's economic troubles--which surfaced in mid-1997--persisted and began to look like a significant threat to continued expansions in the U.S. and European economies. But after steadying during September, stock prices bounced back strongly in October. Although many of the risk factors remained--for example, securities analysts continued to trim their estimates of corporate earnings--stock prices got a lift from falling interest rates, which dropped to levels last seen in the 1960s. (Low inflation and low interest rates help stock prices by raising the estimated value of future dividends and earnings.) Three forces clearly shaped the performance of industry sectors within the overall market. They could be summarized as faith (the buoyant confidence of consumers), fear (related to the effects of financial troubles abroad), and fortresses (companies somewhat protected from competition). U.S. consumers played the role of Atlas during fiscal 1998, 4 33 propping up the economic world with their strong spending. Feeling flush because of plentiful jobs (the nation's unemployment rate was as low as 4.3%) and rising wages, consumers spent a record proportion of their income. Not surprisingly, then, two big gainers among sectors of the S&P 500 Index were consumer staples (+26%) and consumer discretionary firms, such as retailers (+23%). Fear was a factor in the lagging returns from industry groups that were perceived by investors to be vulnerable to slowing global growth, falling commodity prices, and heightened price competition from foreign suppliers. Among these were exploration and services firms in the "other energy" category (-34%); chemical, metals, and other materials & processing firms (-3%); and makers of producer durables such as airplanes and machinery (-0.3%). Conversely, the utilities sector was the year's top performer (+45%) in part because utilities are seen as relatively insulated from foreign competition or economic troubles. Fortresses are companies perceived as relatively safe from competitors because of patented products, brands, or services. Such companies dominated the health-care (+41%) and technology (+37%) groups. U.S. BOND MARKETS Interest rates declined during the fiscal year, especially for U.S. Treasury securities, which benefited from greater aversion to risk among investors and from a slight decrease in supply, thanks to a $70 billion federal budget surplus. The Federal Reserve Board twice trimmed short-term rates by 0.25 percentage point, first on September 29 and then on October 15. Inflation, the bane of bond investors, was remarkably tame--consumer prices were up just 1.5% for the 12 months ended October 31. In this friendly environment, yields on long-term Treasury bonds fell by roughly 1 to 1.25 percentage points, with the 30-year Treasury bond ending the fiscal year at 5.16%. Lower rates mean higher prices for bonds, and the Lehman Brothers Long U.S. Treasury Bond Index earned a return of 16.3%, an astounding margin of nearly 15 percentage points over the inflation rate. High-quality corporate bonds and mortgage-backed securities did not rise in price as far as Treasury securities. Mortgage bonds tend to lag Treasuries during periods of falling rates because increased refinancing activity by homeowners results in prepayments of principal to holders of mortgage-backed securities. The Lehman Aggregate Bond Index, which comprises high-quality corporate and mortgage-backed bonds, as well as Treasuries, and has an intermediate-term average maturity, earned 9.3%. Yields on long-term municipal bonds declined only modestly during the fiscal year, and by October 31 were only slightly lower than yields on comparable Treasury securities, even though interest on municipals is exempt from federal income tax. INTERNATIONAL STOCK MARKETS Europe's stock markets outshone even the S&P 500 Index, but big declines swept the markets of Asia and Latin America. As a group, European stocks earned 23.4% for U.S. investors, reflecting local returns of about 21% and a gain of about 2% from a slight strengthening of several currencies against the dollar. Reasons for Europe's bull market included continuing economic growth; increased corporate restructuring and merger activity; and optimism about the long-term impact of the euro, a common currency due to be adopted in 1999 by 11 nations. In Japan, the stock market declined 14.3% in U.S.-dollar terms, reflecting a severe recession and a shaky banking system. Declines elsewhere in the Pacific region ranged from about 1% in Hong Kong to more than 60% in Indonesia and Malaysia. Losses were steep in non-Asian emerging markets, too. Notable declines in our own hemisphere occurred in Mexico (-20%), Venezuela (-64%), Brazil (-30%), and Chile (-38%). 5 34 ADVISER'S REPORT [LOGO] Fiscal 1998 was a rewarding year for your fund, though the second half handed investors a challenge. For the full fiscal year, Vanguard Windsor II Fund's total return was an excellent 16.5%. Results for the last six months, however, were most disappointing, as our return declined 4.4%. The S&P 500 Index fell 0.4% during the final six months of the fiscal year, and the value component of the S&P was down 6.7%. The real story of the year was the second-half decline of smaller companies. For more details about Windsor II's performance, see the Message to Shareholders beginning on page 1. More than a year ago, a cycle of currency devaluation and credit correction began in Asia. Slowly this grew in importance and moved west. By spring, the disruption it caused put significant downward pressure on demand for many goods and services and on commodity prices. Larger Asian economies began to react, and in several cases the result was political upheaval. As the trend continued westward, it was exacerbated by Russia's inability to honor its bonds, which took a real toll on investors. While the U.S. stock market suffered during this period, markets in many other countries were hit even harder. We would guess that spreading investments among various countries wasn't especially helpful during the fiscal year. Out of this turmoil came an unexpected dislocation. Some large "hedge funds"--a misnomer for highly leveraged, focused investment schemes--found it almost impossible to shed unsuccessful holdings and had to either give up or get others to take over. The big surprise was the amount of money that these funds had borrowed. Pressures from the hedge-fund troubles continue to have a negative impact on lower-quality securities. The resulting illiquidity has made it difficult for businesses with low credit quality to obtain financing, a trend that, in turn, is affecting U.S. economic activity. An example of this weakness is the decline in commercial real estate prices, a natural by-product of the tight credit environment now facing developers and real estate investment trusts. As a result, construction activity may well slow. Corporate profits have also begun to experience weakness. Lower earnings expectations appeared to be a factor in the decline in stock prices during late summer, and particularly in the fall from grace of financial companies, whose third-quarter results were especially awful. The international concern for the fortunes of developing countries seems well founded, but manageable. Leadership at the Federal Reserve and the Treasury Department is experienced and focused, and has congressional backing. For this we are grateful. Windsor II has significant holdings among utilities--both electric and telephone company stocks. We emphasize that this is not a defensive strategy, but rather an attempt to take advantage of the low price/earnings (P/E) ratios and high yields in the sector. Should overall earnings growth decline, stable demand in the utilities should provide relatively predictable profits. The same could be said for retailers, defense contractors, and consumer-staples companies. 6 35 Though oil prices fell during the fiscal year, stocks of large integrated-oil companies did quite well. We took the opportunity to significantly lower our exposure to big oil stocks and to divert a portion of the proceeds to the oil services industry, where returns were off 50% despite what we believe are solid fundamentals. With our commitment to stocks that feature low P/Es, low price/book ratios, and high current dividend yields, we feel that our portfolio will do well in fiscal 1999. Barrow, Hanley, Mewhinney & Strauss, Inc. November 12, 1998 INVESTMENT PHILOSOPHY The fund reflects a belief that superior long-term investment results can be achieved by holding a diversified portfolio of out-of-favor stocks with below-average price/earnings ratios, above-average dividend yields, and the prospect of above-average total return. 7 36 FUND PROFILE WINDSOR II FUND This Profile provides a snapshot of the fund's characteristics as of October 31, 1998, compared where appropriate to an unmanaged index. Key elements of this Profile are defined on page 9.
PORTFOLIO CHARACTERISTICS - ---------------------------------------------------------- WINDSOR II S&P 500 - ---------------------------------------------------------- Number of Stocks 274 500 Median Market Cap $25.8B $53.3B Price/Earnings Ratio 19.9x 25.0x Price/Book Ratio 2.9x 4.3x Yield 2.1% 1.5% Return on Equity 17.8% 22.2% Earnings Growth Rate 12.3% 16.5% Foreign Holdings 0.6% 1.7% Turnover Rate 31% -- Expense Ratio 0.41% -- Cash Reserves 1.6% --
INVESTMENT FOCUS - ---------------------------------------------------------- [GRAPH]
VOLATILITY MEASURES - ---------------------------------------------------------- WINDSOR II S&P 500 - ---------------------------------------------------------- R-Squared 0.95 1.00 Beta 0.91 1.00
TEN LARGEST HOLDINGS (% OF TOTAL NET ASSETS) - ---------------------------------------------------------- Anheuser-Busch Cos., Inc. 3.5% The Chase Manhattan Corp. 3.0 BankAmerica Corp. 2.8 GTE Corp. 2.6 Washington Mutual, Inc. 2.5 U S West, Inc. 2.5 SBC Communications Inc. 2.4 Sears, Roebuck & Co. 2.2 Philip Morris Cos., Inc. 2.2 International Business Machines Corp. 2.2 - ---------------------------------------------------------- Top Ten 25.9%
SECTOR DIVERSIFICATION (% OF COMMON STOCKS) - ------------------------------------------------------------------------------------------------------------------ OCTOBER 31, 1997 OCTOBER 31, 1998 --------------------------------------------------------- WINDSOR II WINDSOR II S&P 500 --------------------------------------------------------- Auto & Transportation 5.8% 4.8% 3.0% Consumer Discretionary 9.9 11.0 10.7 Consumer Staples 6.3 8.4 10.2 Financial Services 23.9 23.9 16.8 Health Care 1.8 1.8 12.7 Integrated Oils 9.6 3.6 6.4 Other Energy 4.9 7.9 1.2 Materials & Processing 3.4 3.7 4.2 Producer Durables 4.1 4.8 3.3 Technology 3.8 3.6 14.5 Utilities 15.7 18.5 11.4 Other 10.8 8.0 5.6 - ------------------------------------------------------------------------------------------------------------------
8 37 BETA. A measure of the magnitude of a fund's past share-price fluctuations in relation to the ups and downs of the overall market (or appropriate market index). The market (or index) is assigned a beta of 1.00, so a fund with a beta of 1.20 would have seen its share price rise or fall by 12% when the overall market rose or fell by 10%. CASH RESERVES. The percentage of a fund's net assets invested in "cash equivalents"--highly liquid, short-term, interest-bearing securities. This figure does not include cash invested in futures contracts to simulate stock investment. EARNINGS GROWTH RATE. The average annual rate of growth in earnings over the past five years for the stocks now in a fund. EXPENSE RATIO. The percentage of a fund's average net assets used to pay its annual administrative and advisory expenses. These expenses directly reduce returns to investors. FOREIGN HOLDINGS. The percentage of a fund's equity assets represented by stocks or American Depositary Receipts of companies based outside the United States. INVESTMENT FOCUS. This grid indicates the focus of a fund in terms of two attributes: market capitalization (large, medium, or small) and relative valuation (growth, value, or a blend). MEDIAN MARKET CAP. An indicator of the size of companies in which a fund invests; the midpoint of market capitalization (market price x shares outstanding) of a fund's stocks, weighted by the proportion of the fund's assets invested in each stock. Stocks representing half of the fund's assets have market capitalizations above the median, and the rest are below it. NUMBER OF STOCKS. An indicator of diversification. The more stocks a fund holds, the more diversified it is and the more likely to perform in line with the overall stock market. PRICE/BOOK RATIO. The share price of a stock divided by its net worth, or book value, per share. For a fund, the weighted average price/book ratio of the stocks it holds. PRICE/EARNINGS RATIO. The ratio of a stock's current price to its per-share earnings over the past year. For a fund, the weighted average P/E of the stocks it holds. P/E is an indicator of market expectations about corporate prospects; the higher the P/E, the greater the expectations for a company's future growth. R-SQUARED. A measure of how much of a fund's past returns can be explained by the returns from the overall market (or its benchmark index). If a fund's total return were precisely synchronized with the overall market's return, its R-squared would be 1.00. If a fund's returns bore no relationship to the market's returns, its R-squared would be 0. RETURN ON EQUITY. The annual average rate of return generated by a company during the past five years for each dollar of shareholder's equity (net income divided by shareholder's equity). For a fund, the weighted average return on equity for the companies whose stocks it holds. SECTOR DIVERSIFICATION. The percentages of a fund's common stocks that come from each of the major industry groups that compose the stock market. TEN LARGEST HOLDINGS. The percentage of net assets that a fund has invested in its ten largest holdings. (The average for stock mutual funds is about 30%.) As this percentage rises, a fund's returns are likely to be more volatile because they are more dependent on the fortunes of a few companies. TURNOVER RATE. An indication of trading activity during the past year. Funds with high turnover rates incur higher transaction costs and are more likely to distribute capital gains (which are taxable to investors). YIELD. A snapshot of a fund's income from interest and dividends. The yield, expressed as a percentage of the fund's net asset value, is based on income earned over the past 30 days and is annualized, or projected forward for the coming year. The index yield is based on the current annualized rate of dividends paid on stocks in the index. 9 38 PERFORMANCE SUMMARY WINDSOR II FUND All of the data on this page represent past performance, which cannot be used to predict future returns that may be achieved by the fund. Note, too, that both share price and return can fluctuate widely, so an investment in the fund could lose money.
TOTAL INVESTMENT RETURNS: JUNE 24, 1985-OCTOBER 31, 1998 - -------------------------------------------------------- WINDSOR II FUND S&P 500 FISCAL CAPITAL INCOME TOTAL TOTAL YEAR RETURN RETURN RETURN RETURN - -------------------------------------------------------- 1985 -0.9% 1.1% 0.2% 1.8% 1986 31.2 4.4 35.6 33.2 1987 -0.6 1.5 0.9 6.4 1988 14.5 6.0 20.5 14.8 1989 19.5 5.2 24.7 26.4 1990 -21.5 4.0 -17.5 -7.5 1991 29.4 7.2 36.6 33.5 1992 7.9 4.6 12.5 10.0 1993 15.8 3.7 19.5 14.9 1994 -0.8 3.0 2.2 3.9 1995 19.2 3.9 23.1 26.4 1996 23.8 3.4 27.2 24.1 1997 28.1 3.2 31.3 32.1 1998 14.1 2.4 16.5 22.0 - --------------------------------------------------------
See Financial Highlights table on page 17 for dividend and capital gains information for the past five years.
CUMULATIVE PERFORMANCE: OCTOBER 31, 1988-OCTOBER 31, 1998 - ------------------------------------------- Windsor Average S&P 500 II Fund Value Fund Index - ------------------------------------------- 1988 10 10000 10000 10000 1989 01 10617 10613 10764 1989 04 11293 10990 11298 1989 07 12815 12090 12744 1989 10 12468 12083 12640 1990 01 11987 11564 12321 1990 04 11697 11669 12491 1990 07 12172 12475 13572 1990 10 10289 10904 11695 1991 01 12136 12268 13355 1991 04 13440 13376 14691 1991 07 13925 13895 15304 1991 10 14056 14531 15612 1992 01 14694 15071 16385 1992 04 15231 15243 16752 1992 07 15893 15571 17262 1992 10 15813 15830 17166 1993 01 16865 16591 18119 1993 04 17281 16746 18300 1993 07 18015 17240 18769 1993 10 18898 18442 19731 1994 01 19409 18828 20452 1994 04 18407 17763 19273 1994 07 18827 18090 19737 1994 10 19317 18924 20494 1995 01 19197 18406 20560 1995 04 21085 19981 22639 1995 07 22697 21885 24890 1995 10 23776 22849 25913 1996 01 26691 24467 28510 1996 04 27826 25404 29479 1996 07 27331 24803 29014 1996 10 30236 27736 32157 1997 01 33475 30072 36020 1997 04 33837 30073 36889 1997 07 39841 35852 44141 1997 10 39693 35627 42483 1998 01 41792 36766 45713 1998 04 48361 41059 52038 1998 07 47155 40194 52654 1998 10 46247 39571 51825 - -------------------------------------------
AVERAGE ANNUAL TOTAL RETURNS PERIODS ENDED OCTOBER 31, 1998 ------------------------------------- FINAL VALUE OF A 1 YEAR 5 YEARS 10 YEARS $10,000 INVESTMENT - ------------------------------------------------------------------------------------------------------------------------- Windsor II Fund 16.51% 19.60% 16.55% $46,247 Average Value Fund 11.07 16.50 14.75 39,571 S&P 500 Index 21.99 21.30 17.88 51,825 - -------------------------------------------------------------------------------------------------------------------------
AVERAGE ANNUAL TOTAL RETURNS: PERIODS ENDED SEPTEMBER 30, 1998* - ----------------------------------------------------------------------------------------------------------------------- 10 YEARS INCEPTION ------------------------------- DATE 1 YEAR 5 YEARS CAPITAL INCOME TOTAL - ----------------------------------------------------------------------------------------------------------------------- Windsor II Fund 6/24/1985 5.45% 18.01% 11.93% 4.04% 15.97% - -----------------------------------------------------------------------------------------------------------------------
*SEC rules require that we provide this average annual total return information through the latest calendar quarter. 10 39 FINANCIAL STATEMENTS OCTOBER 31, 1998 [LOGO] STATEMENT OF NET ASSETS This Statement provides a detailed list of the fund's holdings, including each security's market value on the last day of the reporting period. Securities are grouped and subtotaled by asset type (common stocks, bonds, etc.) and by industry sector. Other assets are added to, and liabilities are subtracted from, the value of Total Investments to calculate the fund's Net Assets. Finally, Net Assets are divided by the outstanding shares of the fund to arrive at its share price, or Net Asset Value (NAV) Per Share. At the end of the Statement of Net Assets, you will find a table displaying the composition of the fund's net assets on both a dollar and per-share basis. Because all income and any realized gains must be distributed to shareholders each year, the bulk of net assets consists of Paid in Capital (money invested by shareholders). The amounts shown for Undistributed Net Investment Income and Accumulated Net Realized Gains usually approximate the sums the fund had available to distribute to shareholders as income dividends or capital gains as of the statement date. Any Accumulated Net Realized Losses, and any cumulative excess of distributions over net income or net realized gains, will appear as negative balances. Unrealized Appreciation (Depreciation) is the difference between the market value of the fund's investments and their cost, and reflects the gains (losses) that would be realized if the fund were to sell all of its investments at their statement-date values.
- ---------------------------------------------------------- MARKET VALUE* WINDSOR II FUND SHARES (000) - ---------------------------------------------------------- COMMON STOCKS (92.9%)+ - ---------------------------------------------------------- AUTO & TRANSPORTATION (4.4%) - - AMR Corp. 134,500 $ 9,012 Autoliv, Inc. 100,970 3,338 Burlington Northern Santa Fe Corp. 333,300 10,291 CSX Corp. 1,993,600 78,249 Chrysler Corp. 7,094,200 341,408 - - Continental Airlines, Inc. Class B 33,200 1,316 Ford Motor Co. 11,344,000 615,412 General Motors Corp. 3,660,700 230,853 - - Navistar International Corp. 15,000 313 Norfolk Southern Corp. 144,500 4,759 PACCAR, Inc. 140,000 6,108 Tidewater Inc. 245,800 6,959 - - UAL Corp. 82,600 5,364 ------------ 1,313,382 ------------ CONSUMER DISCRETIONARY (10.2%) - - Boise Cascade Office Products Corp. 16,700 153 - - Borders Group, Inc. 56,400 1,431 Browning-Ferris 1,964,900 69,631 Industries, Inc. CKE Restaurants Inc. 189,900 4,997 - - Circus Circus Enterprises Inc. 397,600 4,448 Cracker Barrel Old Country Stores, Inc. 106,200 2,748 Darden Restaurants Inc. 264,000 4,356 Dayton Hudson Corp. 171,800 7,280 Deluxe Corp. 6,300 204 Dillard's Inc. 68,800 2,137 The Walt Disney Co. 5,620,432 151,400 R.H. Donnelley Corp. 14,760 207 R.R. Donnelley & Sons Co. 109,400 4,718 Eastman Kodak Co. 1,938,000 150,195 Gannett Co., Inc. 4,009,400 248,082 - - Harrah's Entertainment, Inc. 367,100 5,185 - -(1)Kmart Corp. 38,159,100 538,997 Kimberly-Clark Corp. 2,356,500 113,701 Knight Ridder 23,000 1,172 May Department Stores Co. 49,358 3,011 Maytag Corp. 135,200 6,684 The McGraw-Hill Cos., Inc. 28,600 2,572 - - Neiman Marcus Group Inc. 231,900 5,131 New York Times Co. Class A 38,400 1,085 - - Office Depot, Inc. 193,700 4,843 - - OfficeMax, Inc. 322,000 2,938 Premark International, Inc. 85,700 2,716 - - Promus Hotel Corp. 21,300 679 Sears, Roebuck & Co. 14,669,200 659,197 The Stanley Works 9,900 297 Time Warner, Inc. 1,502,600 139,460 - - Toys R Us, Inc. 294,800 5,767 Tribune Co. 4,600 265 - - Venator Group, Inc. 294,100 2,481 - - Viacom Inc. Class B 152,600 9,137 Wal-Mart Stores, Inc. 3,254,400 224,554 The Warnaco Group, Inc. Class A 201,000 5,138 Washington Post Co. Class B 2,800 1,487
11 40
- ---------------------------------------------------------- MARKET VALUE* WINDSOR II FUND SHARES (000) - ---------------------------------------------------------- Waste Management, Inc. 13,121,997 $ 592,130 Whirlpool Corp. 1,041,900 53,397 ----------- 3,034,011 ----------- CONSUMER STAPLES (7.8%) Anheuser-Busch Cos., Inc. 17,398,700 1,034,135 Brown-Forman Corp. Class B 15,100 1,026 General Mills, Inc. 16,500 1,213 H.J. Heinz Co. 2,757,700 160,291 Imperial Tobacco Group ADR 12,448,100 245,850 Kellogg Co. 154,600 5,102 - - The Kroger Co. 16,300 905 PepsiCo, Inc. 4,212,900 142,185 Philip Morris Cos., Inc. 12,705,500 649,569 Sara Lee Corp. 1,370,400 81,796 ----------- 2,322,072 ----------- FINANCIAL SERVICES (22.3%) Allmerica Financial Corp. 126,000 6,300 Allstate Corp. 14,731,244 634,364 AMBAC Financial Group Inc. 95,900 5,580 American Express Co. 3,794,208 335,313 American General Corp. 17,000 1,165 American International Group, Inc. 4,075,630 347,447 American National Insurance Co. 4,700 395 AmSouth Bancorp 207,300 8,305 Aon Corp. 6,070,975 376,400 Associates First Capital Corp. 1,551,052 109,349 BB&T Corp. 58,600 2,091 The Bank of New York Co., Inc. 111,600 3,522 BankAmerica Corp. 14,680,074 843,187 BankBoston Corp. 236,900 8,721 Bank One Corp. 7,448,883 364,064 Bankers Trust Corp. 78,500 4,931 CIGNA Corp. 7,500 547 The CIT Group, Inc. 203,400 5,555 The Chase Manhattan Corp. 15,793,756 897,283 The Chubb Corp. 1,369,000 84,194 Citigroup, Inc. 6,884,187 323,987 City National Corp. 163,200 5,579 Colonial BancGroup, Inc. 402,800 5,262 Comerica, Inc. 130,950 8,446 Commerce Bancshares, Inc. 33,200 1,446 Conseco Inc. 146,600 5,085 Countrywide Credit Industries, Inc. 36,300 1,568 - - DST Systems, Inc. 110,000 5,500 Duke Realty Investments, Inc. REIT 78,975 1,886 Dun & Bradstreet Corp. 73,800 2,094 A.G. Edwards & Sons, Inc. 186,350 6,441 The Equitable Cos. 123,200 6,037 Everest Reinsurance Holdings, Inc. 92,400 3,182 Fannie Mae 5,549,800 392,995 FINOVA Group, Inc. 82,900 4,041 First Data Corp. 217,800 5,772 First Security Corp. 180,300 3,685 First Union Corp. 229,402 13,305 - - FIRSTPLUS Financial Group, Inc. 927,700 4,117 Fleet Financial Group, Inc. 324,200 12,948 General Re Corp. 5,700 1,252 - - Golden State Bancorp Inc. 332,300 6,376 Green Point Financial Corp. 152,800 5,014 The Hartford Financial Services Group Inc. 185,600 9,860 Hartford Life, Inc. 122,000 5,643 KeyCorp 25,500 773 Lehman Brothers Holdings, Inc. 8,200 311 M & T Bank Corp. 5,300 2,642 MBIA, Inc. 106,200 6,491 Mellon Bank Corp. 16,500 992 Mercantile Bancorp, Inc. 56,500 2,581 Mercury General Corp. 12,100 514 Merrill Lynch & Co., Inc. 183,600 10,878 J.P. Morgan & Co., Inc. 27,000 2,545 Morgan Stanley Dean Witter & Co. 1,688,500 109,330 National City Corp. 172,800 11,113 Nationwide Financial Services, Inc. 134,400 5,578 Norwest Corp. 247,400 9,200 Old Republic International Corp. 267,100 5,075 The PMI Group Inc. 72,900 3,677 PNC Bank Corp. 9,709,200 485,460 Peoples Bank Bridgeport 47,000 1,201 Popular, Inc. 21,200 644 Provident Cos., Inc. 159,900 4,647 Provident Financial Group, Inc. 84,900 3,271 Regions Financial Corp. 24,800 918 Reliance Group Holdings 224,100 3,123 Republic New York Corp. 118,500 4,955 Summit Bancorp. 64,900 2,462 Transamerica Corp. 66,300 6,895 Travelers Property Casualty Corp. 173,900 5,337 UnionBanCal Corp. 61,426 5,682 Valley National Bancorp 63,875 1,725 Wachovia Corp. 16,100 1,463 Washington Mutual, Inc. 19,696,134 737,374 Wells Fargo & Co. 748,000 276,760 Zions Bancorp 62,600 3,322 ----------- 6,597,173 ----------- HEALTH CARE (1.7%) Abbott Laboratories 157,600 7,397 Aetna Inc. 1,752,000 130,743 American Home Products Corp. 4,630,800 225,752 - - Beverly Enterprises, Inc. 209,900 1,417 Bristol-Myers Squibb Co. 1,062,000 117,417 Pharmacia & Upjohn, Inc. 63,100 3,340 - - Tenet Healthcare Corp. 251,900 7,037 United Healthcare Corp. 119,300 5,197 - - Wellpoint Health Networks Inc. Class A 76,500 5,632 ----------- 503,932 ----------- INTEGRATED OILS (3.4%) Amoco Corp. 250,800 14,076 Ashland, Inc. 122,700 5,905 Atlantic Richfield Co. 1,250,700 86,142
12 41
- ---------------------------------------------------------- MARKET VALUE* SHARES (000) - ---------------------------------------------------------- Chevron Corp. 177,200 $ 14,442 - - Conoco Inc. 2,446,600 60,859 Enron Corp. 2,704,100 142,641 Exxon Corp. 2,622,600 186,860 Mobil Corp. 2,027,500 153,456 Murphy Oil Corp. 42,500 1,756 Phillips Petroleum Co. 7,350,800 317,922 Sun Co., Inc. 159,000 5,456 Texaco Inc. 111,200 6,596 USX-Marathon Group 163,100 5,331 ----------- 1,001,442 ----------- OTHER ENERGY (7.4%) - - BJ Services Co. 23,000 470 (1)Baker Hughes, Inc. 21,857,620 482,234 - - CalEnergy Co. 184,900 5,062 Halliburton Co. 13,482,500 484,527 - - Noble Drilling Corp. 25,200 433 (1)Occidental Petroleum Corp. 20,069,300 398,877 Schlumberger Ltd. 4,851,200 254,688 Tosco Corp. 257,600 7,229 Williams Cos., Inc. 20,273,646 556,258 ----------- 2,189,778 ----------- MATERIALS & PROCESSING (3.4%) Aluminum Co. of America 57,199 4,533 Archer-Daniels-Midland Co. 429,975 7,175 Bowater Inc. 136,500 5,571 Dow Chemical Co. 116,000 10,861 E.I. du Pont de Nemours & Co. 386,200 22,207 Engelhard Corp. 190,100 3,992 Fluor Corp. 150,000 5,822 (1)Fort James Corp. 15,453,300 622,961 The BFGoodrich Co. 122,600 4,414 IMC Global Inc. 263,300 6,846 International Paper Co. 12,400 576 Johns Manville Corp. 111,500 1,463 Lafarge Corp. 169,800 5,720 Louisiana-Pacific Corp. 195,300 3,467 The Mead Corp. 179,500 5,677 (1)Millennium Chemicals, Inc. 7,933,742 193,385 - - Owens-Illinois, Inc. 68,700 2,100 Solutia, Inc. 9,200 202 The Timber Co. 258,000 5,724 USG Corp. 35,000 1,669 USX-U.S. Steel Group 110,300 2,564 (1)Witco Chemical Corp. 5,431,800 102,186 ----------- 1,019,115 ----------- PRODUCER DURABLES (4.5%) AGCO Corp. 712,900 6,773 Aeroquip-Vickers Inc. 171,100 5,390 Case Corp. 102,100 2,246 Caterpillar, Inc. 252,600 11,367 Centex Corp. 40,800 1,367 Cordant Technologies, Inc. 141,700 5,765 Deere & Co. 161,700 5,720 Emerson Electric Co. 37,100 2,449 - - General Semiconductor, Inc. 61,100 485 (1)Honeywell, Inc. 7,898,400 630,885 Lockheed Martin Corp. 99,900 11,126 Pentair, Inc. 144,000 5,418 Pitney Bowes, Inc. 130,900 7,208 Sundstrand Corp. 7,700 361 Tecumseh Products Co. Class A 61,560 3,201 Tektronix, Inc. 66,300 1,185 Thomas & Betts Corp. 84,200 3,763 United Technologies Corp. 70,400 6,706 Xerox Corp. 6,463,421 626,144 ----------- 1,337,559 ----------- TECHNOLOGY (3.3%) - - Apple Computer, Inc. 129,800 4,819 Electronic Data Systems Corp. 7,544,600 306,971 International Business Machines Corp. 4,300,700 638,385 - - NCR Corp. 68,800 2,313 Rockwell International Corp. 179,700 7,379 - - The SABRE Group Holdings, Inc. 77,400 2,917 - - Storage Technology Corp. 195,000 6,520 - - Tech Data Corp. 40,300 1,587 Texas Instruments, Inc. 119,400 7,634 ----------- 978,525 ----------- UTILITIES (17.2%) AT&T Corp. 3,023,200 188,194 Allegheny Energy, Inc. 52,600 1,617 ALLTEL Corp. 64,600 3,024 Ameren Corp. 179,100 7,153 American Electric Power Co., Inc. 9,090,300 444,857 Ameritech Corp. 520,700 28,085 BEC Energy 117,700 4,671 Baltimore Gas & Electric Co. 195,600 6,137 Bell Atlantic Corp. 414,636 22,028 BellSouth Corp. 393,000 31,366 - - Cablevision Systems Corp. Class B 5,500 265 (1)Central & South West Corp. 11,943,000 332,165 Century Telephone Enterprises, Inc. 120,300 6,835 DTE Energy Co. 187,100 7,975 Duke Energy Corp. 2,008,200 129,905 Edison International 283,200 7,469 Energy East Corp. 152,900 7,473 (1)Entergy Corp. 21,267,400 611,438 FPL Group, Inc. 59,500 3,722 FirstEnergy Corp. 9,885,877 296,576 GPU, Inc. 188,300 8,120 GTE Corp. 12,893,200 756,670 Houston Industries, Inc. 10,869,900 337,646 Kansas City Power & Light Co. 13,700 395 - - MCI WorldCom, Inc. 2,975,448 164,394 - - MediaOne Group, Inc. 87,300 3,694 PG&E Corp. 161,200 4,907 PP&L Resources Inc. 222,288 6,030 Pinnacle West Capital Corp. 109,000 4,776 Public Service Enterprise Group, Inc. 4,527,500 172,045 Puget Sound Energy Inc. 41,800 1,129 SBC Communications Inc. 15,583,098 721,692 Southern Co. 442,500 12,473 Sprint Corp. 52,700 4,045 Texas Utilities Co. 232,200 10,159 - - U.S. Cellular Corp. 200,900 7,358
13 42
- ---------------------------------------------------------- MARKET VALUE* WINDSOR II FUND SHARES (000) - ---------------------------------------------------------- U S West, Inc. 12,733,484 $ 730,584 UtiliCorp United, Inc. 147,200 5,290 ----------- 5,092,362 ----------- OTHER (7.3%) AlliedSignal Inc. 5,441,800 211,890 Brunswick Corp. 98,600 1,917 Crane Co. 91,950 2,649 General Electric Co. 2,768,700 242,261 Hanson PLC ADR 4,671,150 164,950 (1)ITT Industries, Inc. 9,282,100 331,835 Lancaster Colony Corp. 39,500 1,185 Loews Corp. 63,000 5,918 Minnesota Mining & Manufacturing Co. 1,358,600 108,688 National Service Industries, Inc. 1,800 65 Raytheon Co. Class B 9,978,400 579,371 (1)Tenneco, Inc. 16,365,800 497,111 - - Thermo Electron Corp. 25,000 498 Trinity Industries, Inc. 158,200 5,873 U.S. Industries, Inc. 227,700 3,714 ----------- 2,157,925 ----------- - ---------------------------------------------------------- TOTAL COMMON STOCKS (COST $20,285,994) 27,547,276 - ---------------------------------------------------------- FACE AMOUNT (000) - ---------------------------------------------------------- TEMPORARY CASH INVESTMENTS (7.2%) - ---------------------------------------------------------- U.S. TREASURY BILLS (2)3.885%, 1/14/1999 $ 24,200 23,996 (2)3.892%, 1/21/1999 63,000 62,391 (2)4.03%, 1/7/1999 9,500 9,428 (2)5.118%, 1/7/1999 5,000 4,962 REPURCHASE AGREEMENTS Collateralized by U.S. Government Obligations in a Pooled Cash Account 5.41%, 11/2/1998 2,020,967 2,020,967 5.41%, 11/2/1998--Note F 9,320 9,320 - ---------------------------------------------------------- TOTAL TEMPORARY CASH INVESTMENTS (COST $2,131,135) 2,131,064 - ---------------------------------------------------------- TOTAL INVESTMENTS (100.1%) (COST $22,417,129) 29,678,340 - ---------------------------------------------------------- OTHER ASSETS AND LIABILITIES (-0.1%) - ---------------------------------------------------------- Other Assets--Note C 111,388 Liabilities--Note F (151,067) (39,679) - ---------------------------------------------------------- NET ASSETS (100%) - ---------------------------------------------------------- Applicable to 953,894,747 outstanding $.001 par value shares of beneficial interest (unlimited authorization) $29,638,661 ========================================================== NET ASSET VALUE PER SHARE $31.07 ==========================================================
* See Note A in Notes to Financial Statements. - - Non-Income-Producing Security. + The combined market value of common stocks and index futures contracts represents 98.4% of net assets. See Note E in Notes to Financial Statements. (1)Considered an affiliated company as the fund owns more than 5% of the outstanding voting securities of such company. The total market value of investments in affiliated companies was $4,742,074,000. (2)Security segregated as initial margin for open futures contracts. ADR--American Depositary Receipt. REIT--Real Estate Investment Trust.
- ---------------------------------------------------------- AT OCTOBER 31, 1998, NET ASSETS CONSISTED OF: - ---------------------------------------------------------- AMOUNT PER (000) SHARE - ---------------------------------------------------------- Paid in Capital $19,526,890 $20.47 Undistributed Net Investment Income 294,824 .31 Accumulated Net Realized Gains 2,458,251 2.58 Unrealized Appreciation-- Note E Investment Securities 7,261,211 7.61 Futures Contracts 97,485 .10 ========================================================== NET ASSETS $29,638,661 $31.07 ==========================================================
14 43 STATEMENT OF OPERATIONS This Statement shows dividend and interest income earned by the fund during the reporting period, and details the operating expenses charged to the fund. These expenses directly reduce the amount of investment income available to pay to shareholders as dividends. This Statement also shows any Net Gain (Loss) realized on the sale of investments, and the increase or decrease in the Unrealized Appreciation (Depreciation) on investments during the period. If the fund invested in futures contracts during the period, the results of these investments are shown separately.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR II FUND YEAR ENDED OCTOBER 31, 1998 (000) - ------------------------------------------------------------------------------------------------------------------------ INVESTMENT INCOME INCOME Dividends* $ 577,026 Interest 119,513 Security Lending 477 ------------ Total Income 697,016 ------------ EXPENSES Investment Advisory Fees--Note B Basic Fee 33,584 Performance Adjustment 5,749 The Vanguard Group--Note C Management and Administrative 62,788 Marketing and Distribution 6,017 Taxes (other than income taxes) 1,298 Custodian Fees 69 Auditing Fees 27 Shareholders' Reports 493 Annual Meeting and Proxy Costs 267 Trustees' Fees and Expenses 52 ------------ Total Expenses 110,344 Expenses Paid Indirectly--Note C (2,549) ------------ Net Expenses 107,795 - ------------------------------------------------------------------------------------------------------------------------ NET INVESTMENT INCOME 589,221 - ------------------------------------------------------------------------------------------------------------------------ REALIZED NET GAIN Investment Securities Sold* 2,447,364 Futures Contracts 10,264 - ------------------------------------------------------------------------------------------------------------------------ REALIZED NET GAIN 2,457,628 - ------------------------------------------------------------------------------------------------------------------------ CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) Investment Securities 596,164 Futures Contracts 98,670 - ------------------------------------------------------------------------------------------------------------------------ CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) 694,834 - ------------------------------------------------------------------------------------------------------------------------ NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $3,741,683 ========================================================================================================================
*Dividend income and realized net gain from affiliated companies were $123,686,000 and $116,894,000, respectively. 15 44 STATEMENT OF CHANGES IN NET ASSETS This statement shows how the fund's total net assets changed during the two most recent reporting periods. The Operations section summarizes information detailed in the Statement of Operations. The amounts shown as Distributions to shareholders from the fund's net income and capital gains may not match the amounts shown in the Operations section, because distributions are determined on a tax basis and may be made in a period different from the one in which the income was earned or the gains were realized on the financial statements. The Capital Share Transactions section shows the amount shareholders invested in the fund, either by purchasing shares or by reinvesting distributions, as well as the amounts redeemed. The corresponding numbers of shares Issued and Redeemed are shown at the end of the Statement.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR II FUND YEAR ENDED OCTOBER 31, --------------------------------- 1998 1997 (000) (000) - ------------------------------------------------------------------------------------------------------------------------ INCREASE IN NET ASSETS OPERATIONS Net Investment Income $ 589,221 $ 465,699 Realized Net Gain 2,457,628 1,698,039 Change In Unrealized Appreciation (Depreciation) 694,834 2,753,749 ---------------------------------- Net Increase in Net Assets Resulting From Operations 3,741,683 4,917,487 ---------------------------------- DISTRIBUTIONS Net Investment Income (541,835) (410,609) Realized Capital Gain (1,694,611) (716,881) ---------------------------------- Total Distributions (2,236,446) (1,127,490) ---------------------------------- CAPITAL SHARE TRANSACTIONS(1) Issued 7,469,255 5,466,998 Issued in Lieu of Cash Distributions 2,144,820 1,087,312 Redeemed (4,048,511) (2,534,333) ---------------------------------- Net Increase from Captial Share Transactions 5,565,564 4,019,977 - ------------------------------------------------------------------------------------------------------------------------ Total Increase 7,070,801 7,809,974 - ------------------------------------------------------------------------------------------------------------------------ NET ASSETS Beginning of Year 22,567,860 14,757,886 ---------------------------------- End of Year $29,638,661 $22,567,860 ======================================================================================================================== (1)Shares Issued (Redeemed) Issued 243,421 205,712 Issued in Lieu of Cash Distributions 75,460 45,084 Redeemed (133,672) (95,875) ---------------------------------- Net Increase in Shares Outstanding 185,209 154,921 ========================================================================================================================
16 45 FINANCIAL HIGHLIGHTS This table summarizes the fund's investment results and distributions to shareholders on a per-share basis. It also presents the fund's Total Return and shows net investment income and expenses as percentages of average net assets. These data will help you assess: the variability of the fund's net income and total returns from year to year; the relative contributions of net income and capital gains to the fund's total return; how much it costs to operate the fund; and the extent to which the fund tends to distribute capital gains. The table also shows the Portfolio Turnover Rate, a measure of trading activity. A turnover rate of 100% means that the average security is held in the fund for one year.
- ------------------------------------------------------------------------------------------------------------------------ WINDSOR II FUND YEAR ENDED OCTOBER 31, ----------------------------------------------------------- FOR A SHARE OUTSTANDING THROUGHOUT EACH YEAR 1998 1997 1996 1995 1994 - ------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, BEGINNING OF YEAR $29.36 $24.04 $20.06 $17.33 $17.98 - ------------------------------------------------------------------------------------------------------------------------ INVESTMENT OPERATIONS Net Investment Income .65 .64 .62 .58 .55 Net Realized and Unrealized Gain (Loss) on Investments 3.91 6.47 4.63 3.17 (.19) ----------------------------------------------------------- Total from Investment Operations 4.56 7.11 5.25 3.75 .36 ----------------------------------------------------------- DISTRIBUTIONS Dividends from Net Investment Income (.66) (.63) (.58) (.55) (.51) Distributions from Realized Capital Gains (2.19) (1.16) (.69) (.47) (.50) ----------------------------------------------------------- Total Distributions (2.85) (1.79) (1.27) (1.02) (1.01) - ------------------------------------------------------------------------------------------------------------------------ NET ASSET VALUE, END OF YEAR $31.07 $29.36 $24.04 $20.06 $17.33 ======================================================================================================================== TOTAL RETURN 16.51% 31.27% 27.17% 23.08% 2.22% ======================================================================================================================== RATIOS/SUPPLEMENTAL DATA Net Assets, End of Year (Millions) $29,639 $22,568 $14,758 $10,272 $8,246 Ratio of Total Expenses to Average Net Assets 0.41% 0.37% 0.39% 0.40% 0.39% Ratio of Net Investment Income to Average Net Assets 2.16% 2.49% 2.92% 3.27% 3.26% Portfolio Turnover Rate 31% 30% 32% 30% 24% ========================================================================================================================
17 46 NOTES TO FINANCIAL STATEMENTS Vanguard Windsor II Fund is registered under the Investment Company Act of 1940 as a diversified open-end investment company, or mutual fund. A. The following significant accounting policies conform to generally accepted accounting principles for mutual funds. The fund consistently follows such policies in preparing its financial statements. 1. SECURITY VALUATION: Equity securities are valued at the latest quoted sales prices as of the close of trading on the New York Stock Exchange (generally 4:00 p.m. Eastern time) on the valuation date; such securities not traded on the valuation date are valued at the mean of the latest quoted bid and asked prices. Prices are taken from the primary market in which each security trades. Temporary cash investments acquired over 60 days to maturity are valued using the latest bid prices or using valuations based on a matrix system (which considers such factors as security prices, yields, maturities, and ratings), both as furnished by independent pricing services. other temporary cash investments are valued at amortized cost, which approximates market value. Securities for which market quotations are not readily available are valued by methods deemed by the Board of Trustees to represent fair value. 2. FEDERAL INCOME TAXES: The fund intends to continue to qualify as a regulated investment company and distribute all of its taxable income. accordingly, no provision for federal income taxes is required in the financial statements. 3. REPURCHASE AGREEMENTS: The fund, along with other members of The Vanguard Group, transfers uninvested cash balances to a Pooled Cash Account, which is invested in repurchase agreements secured by u.s. government securities. Securities pledged as collateral for repurchase agreements are held by a custodian bank until the agreements mature. Each agreement requires that the market value of the collateral be sufficient to cover payments of interest and principal; however, in the event of default or bankruptcy by the other party to the agreement, retention of the collateral may be subject to legal proceedings. 4. FUTURES: The fund uses S&P 500 Index and S&P MidCap 400 Index futures contracts to a limited extent, with the objective of maintaining full exposure to the stock market while maintaining liquidity. The fund may purchase or sell futures contracts to achieve a desired level of investment, whether to accommodate portfolio turnover or cash flows from capital shares transactions. The primary risks associated with the use of futures contracts are imperfect correlation between changes in market values of stocks held by the fund and the prices of futures contracts, and the possibility of an illiquid market. Futures contracts are valued at their quoted daily settlement prices. The aggregate principal amounts of the contracts are not recorded in the financial statements. Fluctuations in the value of the contracts are recorded in the Statement of Net Assets as an asset (liability) and in the Statement of Operations as unrealized appreciation (depreciation) until the contracts are closed, when they are recorded as realized futures gains (losses). 5. DISTRIBUTIONS: Distributions to shareholders are recorded on the ex-dividend date. distributions are determined on a tax basis and may differ from net investment income and realized capital gains for financial reporting purposes. 6. OTHER: Dividend income is recorded on the ex-dividend date. Security transactions are accounted for on the date securities are bought or sold. Costs used to determine realized gains (losses) on the sale of investment securities are those of the specific securities sold. B. Barrow, Hanley, Mewhinney & Strauss, Inc.; Equinox Capital Management, Inc.; and Tukman Capital Management, Inc., provide investment advisory services to the fund for fees calculated at an annual percentage rate of average net assets. the basic fees thus computed for Barrow, Hanley, Mewhinney & Strauss, Inc., are subject to quarterly adjustments based on performance relative to the S&P/BARRA Value Index; such fees for Equinox Capital Management, Inc., are subject to quarterly adjustments based on performance relative to the Russell 1000 value Index; such fees for Tukman Capital Management, Inc., are subject to quarterly adjustments based on performance relative to the S&P 500 Index. 18 47 The Vanguard Group provides investment advisory services to a portion of the fund on an at-cost basis; the fund paid Vanguard advisory fees of $287,000 for the year ended October 31, 1998. For the year ended October 31, 1998, the aggregate investment advisory fee represented an effective annual basic rate of 0.12% of average net assets before an increase of $5,749,000 (0.02%) based on performance. C. The Vanguard Group furnishes at cost corporate management, administrative, marketing, and distribution services. the costs of such services are allocated to the fund under methods approved by the Board of Trustees. The fund has committed to provide up to 0.40% of its net assets in capital contributions to Vanguard. At October 31, 1998, the fund had contributed capital of $5,440,000 to Vanguard (Included in Other Assets), representing 0.02% of the fund's net assets and 7.8% of Vanguard's Capitalization. The Fund's Trustees and officers are also Directors and officers of Vanguard. Vanguard has asked the fund's investment advisers to direct certain portfolio trades, subject to obtaining the best price and execution, to brokers who have agreed to rebate to the fund part of the commissions generated. Such rebates are used solely to reduce the fund's administrative expenses. For the year ended October 31, 1998, these arrangements reduced the fund's expenses by $2,549,000 (an annual rate of 0.01% of average net assets). D. During the year ended October 31, 1998, the fund purchased $11,250,884,000 of investment securities and sold $7,665,012,000 of investment securities, other than temporary cash investments. E. At October 31, 1998, net unrealized appreciation of investment securities for financial reporting and federal income tax purposes was $7,261,211,000, consisting of unrealized gains of $8,287,236,000 on securities that had risen in value since their purchase and $1,026,025,000 in unrealized losses on securities that had fallen in value since their purchase. At October 31, 1998, the aggregate settlement value of open futures contracts expiring in December 1998 and the related unrealized appreciation were:
- ---------------------------------------------------------------------------------------------------------- (000) ---------------------------------- AGGREGATE NUMBER OF SETTLEMENT UNREALIZED FUTURES CONTRACTS LONG CONTRACTS VALUE APPRECIATION - ---------------------------------------------------------------------------------------------------------- S&P 500 Index 5,228 $1,444,496 $84,812 S&P Midcap 400 Index 951 159,958 12,673 - ----------------------------------------------------------------------------------------------------------
Unrealized appreciation on open futures contracts is required to be treated as realized gain for tax purposes. F. The market value of securities on loan to broker/dealers at October 31, 1998, was $6,842,000, for which the fund held cash collateral of $9,320,000. Cash collateral received is invested in repurchase agreements. 19 48 REPORT OF INDEPENDENT ACCOUNTANTS [LOGO] To the Shareholders and Board of Trustees of Vanguard Windsor II Fund In our opinion, the accompanying statement of net assets and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Vanguard Windsor II Fund (the "Fund") at October 31, 1998, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the five years in the period then ended, in conformity with generally accepted accounting principles. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at October 31, 1998 by correspondence with the custodian, provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 November 30, 1998 SPECIAL 1998 TAX INFORMATION (UNAUDITED) FOR VANGUARD WINDSOR II FUND This information for the fiscal year ended October 31, 1998, is included pursuant to provisions of the Internal Revenue Code. The fund distributed $1,427,652,000 as capital gain dividends (from net long-term capital gains) to shareholders in December 1997. Of the $1,427,652,000 capital gain dividends, the fund designates $622,316,000 as a 20% rate gain distribution. For corporate shareholders, 56.7% of investment income (dividend income plus short-term gains, if any) qualifies for the dividends-received deduction. 20 49 TRUSTEES AND OFFICERS JOHN C. BOGLE Founder, Senior Chairman of the Board, and Director/Trustee of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. JOHN J. BRENNAN Chairman of the Board, Chief Executive Officer, and Director/Trustee of The Vanguard Group, Inc., and each of the investment companies in The Vanguard Group. BARBARA BARNES HAUPTFUHRER Director of The Great Atlantic and Pacific Tea Co., IKON Office Solutions, Inc., Raytheon Co., Knight-Ridder, Inc., Massachusetts Mutual Life Insurance Co., and Ladies Professional Golf Association; Trustee Emerita of Wellesley College. JOANN HEFFERNAN HEISEN Vice President, Chief Information Officer, and a member of the Executive Committee of Johnson & Johnson; Director of Johnson & JohnsonoMerck Consumer Pharmaceuticals Co., Women First HealthCare, Inc., Recording for the Blind and Dyslexic, The Medical Center at Princeton, and Women's Research and Education Institute. BRUCE K. MACLAURY President Emeritus of The Brookings Institution; Director of American Express Bank Ltd., The St. Paul Companies, Inc., and National Steel Corp. BURTON G. MALKIEL Chemical Bank Chairman's Professor of Economics, Princeton University; Director of Prudential Insurance Co. of America, Banco Bilbao Gestinova, Baker Fentress & Co., The Jeffrey Co., and Southern New England Telecommunications Co. ALFRED M. RANKIN, JR. Chairman, President, and Chief Executive Officer of NACCO Industries, Inc.; Director of NACCO Industries, The BFGoodrich Co., and The Standard Products Co. JOHN C. SAWHILL President and Chief Executive Officer of The Nature Conservancy; formerly, Director and Senior Partner of McKinsey & Co. and President of New York University; Director of Pacific Gas and Electric Co., Procter & Gamble Co., NACCO Industries, and Newfield Exploration Co. JAMES O. WELCH, JR. Retired Chairman of Nabisco Brands, Inc.; retired Vice Chairman and Director of RJR Nabisco; Director of TECO Energy, Inc., and Kmart Corp. J. LAWRENCE WILSON Chairman and Chief Executive Officer of Rohm & Haas Co.; Director of Cummins Engine Co. and The Mead Corp.; Trustee of Vanderbilt University. OTHER FUND OFFICERS RAYMOND J. KLAPINSKY Secretary; Managing Director and Secretary of The Vanguard Group, Inc.; Secretary of each of the investment companies in The Vanguard Group. THOMAS J. HIGGINS Treasurer; Principal of The Vanguard Group, Inc.; Treasurer of each of the investment companies in The Vanguard Group. KAREN E. WEST Controller; Principal of The Vanguard Group, Inc.; Controller of each of the investment companies in The Vanguard Group. OTHER VANGUARD OFFICERS R. GREGORY BARTON Managing Director, Legal Department. ROBERT A. DISTEFANO Managing Director, Information Technology. JAMES H. GATELY Managing Director, Individual Investor Group. KATHLEEN C. GUBANICH Managing Director, Human Resources. IAN A. MACKINNON Managing Director, Fixed Income Group. F. WILLIAM MCNABB, III Managing Director, Institutional Investor Group. MICHAEL S. MILLER Managing Director, Planning and Development. RALPH K. PACKARD Managing Director and Chief Financial Officer. GEORGE U. SAUTER Managing Director, Core Management Group. "Standard & Poor's(R)," "S&P(R)," "S&P 500(R)," "Standard & Poor's 500," and "500" are trademarks of The McGraw-Hill Companies, Inc. Frank Russell Company is the owner of trademarks and copyrights relating to the Russell Indexes. "Wilshire 4500" and "Wilshire 5000" are trademarks of Wilshire Associates. 50 VANGUARD MILESTONES [LOGO] The Vanguard Group is named for HMS Vanguard, Admiral Horatio Nelson's flagship at the Battle of the Nile on August 1, 1798. Our founder, John C. Bogle, chose the name after reading Nelson's inspiring tribute to his fleet: "Nothing could withstand the squadron . . . with the judgment of the captains, together with their valour, and that of the officers and men of every description, it was absolutely irresistible." [LOGO] Walter L. Morgan, founder of Wellington Fund, the nation's first balanced mutual fund and forerunner of today's family of some 100 Vanguard funds, celebrated his 100th birthday on July 23, 1998. Mr. Morgan, a true investment pioneer, died six weeks later on September 2. [LOGO] Wellington Fund, The Vanguard Group's oldest fund, was incorporated by Mr. Morgan 70 years ago, on December 28, 1928. The fund was named after the Duke of Wellington, whose forces defeated Napoleon Bonaparte at the Battle of Waterloo in 1815. [THE VANGUARD GROUP LOGO] Post Office Box 2600 Valley Forge, Pennsylvania 19482 FUND INFORMATION 1-800-662-7447 INDIVIDUAL ACCOUNT SERVICES 1-800-662-2739 INSTITUTIONAL INVESTOR SERVICES 1-800-523-1036 www.vanguard.com online@vanguard.com All Vanguard funds are offered by prospectus only. Prospectuses contain more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before you invest or send money. Prospectuses can be obtained directly from The Vanguard Group. Q730-12/14/1998 (C) 1998 Vanguard Marketing Corporation, Distributor. All rights reserved. -----END PRIVACY-ENHANCED MESSAGE-----