-----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, K60bu8ZVl8m7jP9zKYhp8SJNe0zyT6z2uM/lCFHY/U0VdOJsNBrepdPUGMUahOr7 MlbriT+xOsCo4MfowT/5tw== 0000932471-99-000521.txt : 19991217 0000932471-99-000521.hdr.sgml : 19991217 ACCESSION NUMBER: 0000932471-99-000521 CONFORMED SUBMISSION TYPE: N-30D PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19991209 FILED AS OF DATE: 19991216 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: 99776102 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 FUNDS ANNUAL REPORT 1999 VANGUARD WINDSOR FUND Annual Report October 31, 1999 [SHIP GRAPHIC] [A MEMBER OF THE VANGUARD GROUP(R) LOGO] [PHOTO OF JOHN C. BOGLE] JOHN C. BOGLE FELLOW SHAREHOLDERS: TWO ROADS DIVERGED IN A WOOD, AND I--I TOOK THE ONE LESS TRAVELED BY, AND THAT HAS MADE ALL THE DIFFERENCE. I can think of no better words than those of Robert Frost to begin this special letter to our shareholders, who have placed such extraordinary trust in me and in Vanguard over the past quarter century. When the firm was founded 25 years ago, we deliberately took a new road to managing a mutual fund enterprise. Instead of having the funds controlled by an outside management company with its own financial interests, the Vanguard funds--there were only 11 of them then--would be controlled by their own shareholders and operate solely in their financial interests. The outcome of our unprecedented decision was by no means certain. We described it then as "The Vanguard Experiment." Well, I guess it's fair to say it's an experiment no more. During the past 25 years, the assets we hold in stewardship for investors have grown from $1 billion to more than $500 billion, and I believe that our reputation for integrity, fair-dealing, and sound investment principles is second to none in this industry. Our staggering growth--which I never sought--has come in important part as a result of the simple investment ideas and basic human values that are the foundation of my personal philosophy. I have every confidence that they will long endure at Vanguard, for they are the right ideas and right values, unshakable and eternal. While Emerson believed that "an institution is the lengthened shadow of one man," Vanguard today is far greater than any individual. The Vanguard crew has splendidly implemented and enthusiastically supported our founding ideas and values, and deserves the credit for a vital role in forging our success over the years. It is a dedicated crew of fine human beings, working together in an organization that is well prepared to press on regardless long after I am gone. Creating and leading this enterprise has been an exhilarating run. Through it all, I've taken the kudos and the blows alike, enjoying every moment to the fullest, and even getting a second chance at life with a heart transplant three years ago. What more could a man ask? While I shall no longer be serving on the Vanguard Board, I want to assure you that I will remain vigorous and active in a newly created Vanguard unit, researching the financial markets, writing, and speaking. I'll continue to focus whatever intellectual power and ethical strength I possess on my mission to assure that mutual fund investors everywhere receive a fair shake. In the spirit of Robert Frost: BUT I HAVE PROMISES TO KEEP, AND MILES TO GO BEFORE I SLEEP, AND MILES TO GO BEFORE I SLEEP. You have given me your loyalty and friendship over these long years, and I deeply appreciate your thousands of letters of support. For my part, I will continue to keep an eagle eye on your interests, for you deserve no less. May God bless you all, always. /S/ JCB - -------------------------------------------------------------------------------- CONTENTS REPORT FROM THE CHAIRMAN ............1 PERFORMANCE SUMMARY ................11 AFTER-TAX RETURNS REPORT ............5 FUND PROFILE .......................12 THE MARKETS IN PERSPECTIVE ..........6 FINANCIAL STATEMENTS ...............14 REPORTS FROM THE ADVISERS ...........8 REPORT OF INDEPENDENT ACCOUNTANTS ..23 - -------------------------------------------------------------------------------- REPORT FROM THE CHAIRMAN [PHOTO OF JOHN J. BRENNAN] John J. Brennan Vanguard Windsor Fund posted a return of 13.7% during the fiscal year ended October 31, 1999. While this was a solid result that surpassed the 11.7% return of the average comparable fund, it was well behind the outstanding 25.7% advance of the Standard & Poor's 500 Index, which was propelled by a roaring market for large technology stocks. The table at right presents Windsor's fiscal year total return (capital change plus reinvested dividends). It also lists returns for the average multi-cap value fund (the category in which fund analyst Lipper Inc. has placed Windsor, which holds both large- and mid-capitalization stocks), as well as for the S&P 500 Index and its value-stock component. The fund's return is based on an increase in net asset value from $16.34 per share on October 31, 1998, to $16.91 per share on October 31, 1999. The return is adjusted for dividends totaling $0.24 per share paid from net investment income and a distribution of $1.23 per share paid in December 1998 from net realized capital gains. We estimate that the fund will make a distribution of approximately $1.88 from net realized capital gains in December 1999. - ------------------------------------------------------------ TOTAL RETURNS FISCAL YEAR ENDED OCTOBER 31, 1999 - ------------------------------------------------------------ Vanguard Windsor Fund 13.7% - ------------------------------------------------------------ Average Multi-Cap Value Fund* 11.7% - ------------------------------------------------------------ S&P 500 Index 25.7% - ------------------------------------------------------------ S&P 500/BARRA Value Index 19.0% - ------------------------------------------------------------ *Derived from data provided by Lipper Inc. FINANCIAL MARKETS IN REVIEW The fiscal year ended October 31 comprised two distinctly different halves. For most of the first half, stock prices worldwide were rebounding strongly from a slump in the summer of 1998 that had been prompted by economic crises in Asia, Russia, and parts of Latin America. The stock market's comeback was aided by a pickup in global economic activity and by interest rate reductions by the Federal Reserve Board that autumn. These developments--and the continued ebullience of the U.S. economy--erased investors' fears that the troubles abroad would depress business activity and profits at home. Even though interest rates rose during the six months from October 31 through April 30, the stock market, as measured by the Wilshire 5000 Total Market Index, gained 22.8% and the S&P 500 Index was up 22.3%. However, during the second half of our fiscal year, most stock prices stagnated or fell (with the notable exception of technology stocks). The Wilshire 5000 advanced 2.3%, bringing its full-year return to 25.7%. The S&P 500's second-half return of 2.7% brought it to an identical 25.7% return for our fiscal year. Large-cap growth stocks were the strongest market sector, led by simply stupendous gains for a number of dominant technology stocks, such as QUALCOMM (700%), Sun Microsystems (263%), Cisco Systems (135%), Microsoft (75%), and Intel (74%). The growth stocks within the S&P 500 gained 31.6%, while the index's value stocks, as measured by the S&P 500/BARRA Value Index, returned 19.0% as a group. Small-cap stocks were left in the wake of the big stocks: the Russell 2000 Index 1 of small stocks gained 14.9%. The growth/value split was even wider among the small-caps, as the Russell 2000 growth stocks gained 29.3% versus a paltry 0.7% return for the index's value stocks. One drag on the stock market in general was a strong uptrend in interest rates that began in February. The Federal Reserve encouraged this move, acting in late June and again in August to boost short-term interest rates by a total of 0.5 percentage point. Fears of a global economic slump were supplanted by worries that economic growth-- especially in the United States--was so strong that it would cause wages and commodity prices to surge, pushing up inflation. For the full year, yields on long-term U.S. Treasury bonds rose significantly. The yield on the 30-year Treasury increased exactly 1 percentage point (100 basis points) to 6.16% on October 31, 1999. Bond prices, which move in the opposite direction from interest rates, fell during the year. The Lehman Brothers Aggregate Bond Index, a benchmark for taxable bonds, eked out a return of 0.5% for the year, as its interest income of 6.2% only barely offset price declines of -5.7%. FISCAL 1999 PERFORMANCE OVERVIEW Windsor Fund's 13.7% return during the fiscal year was 2 percentage points ahead of that of the average multi-cap value fund--the category that Lipper--and Vanguard, for that matter--regards as the correct peer group. However, we trailed the S&P 500 Index's 25.7% return by 12 percentage points. Half of our performance gap versus the index can be explained by the simple fact that during fiscal 1999, growth stocks--whose relatively high price/earnings, price/book value, and price/dividend ratios reflect rosy expectations for future growth--ruled on Wall Street. As noted earlier, the return for growth stocks within the S&P 500 outdistanced that for value stocks by nearly 13 percentage points--31.6% versus 19.0%. Several large tech stocks are selling at prices of $50 or more per $1 of earnings, while large industrial companies are selling for $10 to $20 per $1 of earnings. Time will tell whether the great expectations for growth built into tech stock prices will be justified by actual earnings. Value stocks--particularly in such sectors as materials & processing, producer durables, big oil companies, and utilities--enjoyed a powerful rally in April and May, outperforming their growth stock competitors by 9.8 percentage points in those two months. But the resurgence was brief, and the market soon resumed its love affair with tech stocks. Within the S&P 500, technology stocks posted a 67% gain during our fiscal year. Windsor Fund's tech holdings earned a similar 66% return, but our stake in this group averaged about 4% of assets, a fraction of the 18% weighting for tech stocks in the S&P 500. Given the fund's value investing style and mandate to seek growth and income, it would be odd for it to emphasize technology stocks, with their high valuations and low dividend yields. (Only 19 of 52 tech stocks in the S&P 500 pay any dividend at all.) Another reason for our shortfall versus the broad index was poor performance of our holdings in several sectors, including "other energy," financial services, and health care. We were hurt, for example, by HMO and hospital stocks that suffered due to pricing pressures and concerns about legal and regulatory difficulties. One plus for your fund was our light stake in consumer-staples companies such as beverage and food makers. We held an average of just 0.5% of assets in this sector, which was the market's weakest. Interestingly, our light weighting in this sector stemmed from the same value disciplines that have kept us from investing heavily in technology. 2 As you know, during the year Sanford C. Bernstein & Co. began managing a portion of the fund's assets, joining our lead adviser, Wellington Management Company. The transition went smoothly. Careful planning and excellent cooperation between our advisers minimized the costs associated with the movement of some $4 billion in assets to Bernstein & Co. We estimate that these one-time transaction costs trimmed the fund's return by 0.10 to 0.20 percentage point. - ------------------------------------------------------------ TOTAL ASSETS MANAGED AS OF OCTOBER 31, 1999 ---------------------- $ MILLION PERCENT - ------------------------------------------------------------ Wellington Management Company, LLP $12,595 75% Sanford C. Bernstein & Co., Inc. 4,080 24 Cash Reserve* 149 1 - ------------------------------------------------------------ Total $16,824 100% - ------------------------------------------------------------ * This cash reserve is invested in equity index futures to simulate investment in stocks; each adviser may also maintain a modest cash reserve. The table above shows the share of assets supervised by each adviser at the end of the fiscal year. LONG-TERM PERFORMANCE OVERVIEW An annual review of a mutual fund's record should also include a look at its longer-term performance. The table below presents the average annual returns of Windsor Fund and its comparative benchmarks for the past ten years. It also presents the results of hypothetical $10,000 investments made a decade ago in the fund, the average fund in its peer group, the S&P 500 Index and the S&P 500/BARRA Value Index. Although Windsor Fund's 12.5% average annual return for the past decade was generous in comparison with long-term stock market returns, it was modestly short of the 13.4% return for its average peer, and well shy of the truly amazing 17.8% return chalked up by the unmanaged S&P 500 Index. In part, we trailed the index because the past ten years were a growth-stock decade: the growth stocks within the S&P 500 posted average returns of 19.9% a year, far ahead of the 15.4% return of the index's value stocks. However, even allowing for the disparity in growth and value stock returns, our performance has been subpar. All of us on the Windsor Fund team are focused on improving our performance relative to our primary benchmark, the S&P 500 Index. Our goal is to provide superior returns over the long term, and while we have fallen short of this goal of late, we continue to believe that our disciplined value-investing approach and low operating costs give us a good chance to accomplish it in the years ahead. Our annual expenses in fiscal 1999 amounted to a slender 0.28% of average assets, more than a full percentage point below the 1.38% expense ratio for the average multi-cap value fund, according to Lipper. We expect this advantage to aid us, year after year, in our effort to provide superior returns. - ------------------------------------------------------------ TOTAL RETURNS 10 YEARS ENDED OCTOBER 31, 1999 - ------------------------------------------------------------ AVERAGE FINAL VALUE OF ANNUAL A $10,000 RATE INITIAL INVESTMENT - ------------------------------------------------------------ Vanguard Windsor Fund 12.5% $32,344 - ------------------------------------------------------------ Average Multi-Cap Value Fund 13.4% $35,087 - ------------------------------------------------------------ S&P 500 Index 17.8% $51,526 - ------------------------------------------------------------ S&P 500/BARRA Value Index 15.4% $41,790 - ------------------------------------------------------------ Keep in mind that the returns earned by stocks--particularly large growth stocks--over the past decade were high by historical standards and will probably be lower in the future. This is not a prediction, but rather a prudent assumption that investors should 3 incorporate into their plans, given that the long-term average return from stocks is about 11% annually. It's worth noting that this long-term average includes lean years as well as the fabulous gains of the 1990s. IN SUMMARY The U.S. stock market provided another big gain for investors during the past 12 months, which marked the fifth fiscal year in a row during which the S&P 500 Index returned more than 20%. There has never been a streak like it in market history. Such outsized rewards have pushed stock valuations to very high levels, reflecting the superb economic and business conditions that have prevailed in recent years, as well as widespread expectations for more of the same. It's important to recognize, however, that such high valuations carry high risk, should future results fail to match expectations. Given the risk of wide short-term fluctuations in returns from the financial markets, I repeat our longstanding advice that investors should hold balanced portfolios of both value and growth stock funds, bond funds, and short-term reserves in proportions suitable to their own investment time horizon, goals, and financial situation. Such diversification can lessen some of the jolts you're sure to encounter on the road toward your financial goals. In short, I advise preparing an investment plan and sticking with it. /S/ John J. Brennan Chairman and Chief Executive Officer November 11, 1999 ================================================================================ A NOTE OF THANKS TO OUR FOUNDER ================================================================================ As you may have read on the inside cover of our report, our founder, John C. Bogle, is retiring December 31, 1999, as Senior Chairman of our Board after nearly 25 years of devoted service to Vanguard and our shareholders. Vanguard investors have Jack to thank for creating a truly mutual mutual fund company that operates solely in the interest of its fund shareholders. And mutual fund investors everywhere have benefited from his energetic efforts to improve this industry. Finally, on a personal note, I am forever grateful to Jack for giving me the opportunity to join this great company in 1982. 4 A REPORT ON YOUR FUND'S AFTER-TAX RETURNS Beginning with this annual report, Vanguard is pleased to provide a review of Windsor Fund's after-tax performance. The figures on this page demonstrate the considerable impact that federal income taxes can have on a fund's return--an important consideration for investors who own mutual funds in taxable accounts. While the pretax return is most often used to tally a fund's performance, the fund's after-tax return, which accounts for taxes on distributions of capital gains and income dividends, is a better representation of the return that many investors actually received. IF YOU OWN WINDSOR FUND IN A TAX-DEFERRED ACCOUNT SUCH AS AN INDIVIDUAL RETIREMENT ACCOUNT OR A 401(K), THIS INFORMATION DOES NOT APPLY TO YOU. SUCH ACCOUNTS ARE NOT SUBJECT TO CURRENT TAXES. The table below presents the pretax and after-tax returns for your fund and an appropriate peer group of mutual funds. Two things to keep in mind: o The after-tax return calculations use the top federal income tax rates in effect at the time of each distribution. The tax burden, therefore, would be somewhat less, and the after-tax return somewhat more, for those in lower tax brackets. o The peer funds' returns are based on data from Morningstar, Inc. (Elsewhere in this report, returns for comparable funds are based on data from Lipper Inc., which differ somewhat.) As you can see, Windsor Fund's pretax total return of 13.7% for the 12 months ended October 31, 1999, was reduced by taxes to 11.4%. In other words, for investors in the highest tax bracket, taxes cut the fund's pretax return by 2.3 percentage points. In comparison, the average mid-cap value fund earned a pretax return of 8.7% and an after-tax return of 6.6%, a difference of 2.1 percentage points. - -------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS: PRETAX AND AFTER-TAX PERIODS ENDED OCTOBER 31, 1999 -------------------------------------------------------- 1 YEAR 5 YEARS 10 YEARS ------------------ ----------------- ----------------- PRETAX AFTER-TAX PRETAX AFTER-TAX PRETAX AFTER-TAX - -------------------------------------------------------------------------------- Windsor Fund 13.7% 11.4% 15.8% 11.9% 12.5% 9.0% Average Mid-Cap Value Fund* 8.7 6.6 14.6 11.4 12.1 9.6 - -------------------------------------------------------------------------------- *Based on data from Morningstar, Inc. Over the past decade, Windsor Fund's pretax returns exceeded those of the average fund in Morningstar's mid-cap value category before taxes, but not after taxes. For the ten years ended October 31, 1999, Windsor slightly outpaced its average peer, but lost more to taxes (3.5 percentage points) than its peer-group average (2.5 points). We stress that because many interrelated factors affect how tax-friendly a fund may be, it's very difficult to predict tax efficiency. A fund's tax efficiency can be influenced by its turnover rate, the types of securities it holds, the accounting practices it uses when selling shares, and the net cash flow it receives. Finally, it's important to understand that our calculation does not reflect the tax effect of your own investment activities. Specifically, you may incur additional capital gains taxes--thereby lowering your after-tax return--if you decide to sell all or some of your shares. A NOTE ABOUT OUR CALCULATIONS: Pretax total returns assume that all distributions received (income dividends, short-term capital gains, and long-term capital gains) are reinvested in new shares, while our after-tax returns assume that distributions are reduced by any taxes owed on them before reinvestment. When calculating the taxes due, we used the highest individual federal income tax rates at the time of the distributions. Those rates are currently 39.6% for dividends and short-term capital gains and 20% for long-term capital gains. State and local income taxes were not considered. The competitive group returns provided by Morningstar are calculated in a manner consistent with that used for Vanguard funds. 5 THE MARKETS IN PERSPECTIVE YEAR ENDED OCTOBER 31, 1999 Caution followed exuberance in the U.S. stock market during the fiscal year ended October 31, 1999. Improving economic conditions during the first half of the year set off a raucous rally from the lows of summer 1998, when fears of a global economic slump swept world markets. However, during the second half of the fiscal year, interest rates kept rising, pulling down bond prices and tempering the stock market's optimism. The notion of a global slump was replaced by worries that economic growth might be so strong as to threaten a surge in inflation. U.S. STOCK MARKETS A booming U.S. economy and solid increases in corporate earnings lifted the U.S. stock market, especially during the first half of the fiscal year. The nation's economic output increased by about 4% during the year. Consumer spending, which accounts for roughly two-thirds of economic activity, powered the expansion. Americans spent virtually every dollar they earned, encouraged by rising wealth from a long bull market, plentiful employment, and rising incomes. (After-tax personal income rose about 5% during the year; unemployment fell to a 30-year low of 4.1% of the workforce in October.) - -------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS PERIODS ENDED OCTOBER 31, 1999 ---------------------------------- 1 YEAR 3 YEARS 5 YEARS - -------------------------------------------------------------------------------- STOCKS S&P 500 Index 25.7% 26.5% 26.0% Russell 2000 Index 14.9 9.4 12.6 Wilshire 5000 Index 25.7 23.8 23.8 MSCI EAFE Index 23.4 12.5 9.5 - -------------------------------------------------------------------------------- BONDS Lehman Aggregate Bond Index 0.5% 6.2% 7.9% Lehman 10 Year Municipal Bond Index -1.2 5.2 7.0 Salomon Smith Barney 3-Month U.S. Treasury Bill Index 4.6 5.0 5.2 - -------------------------------------------------------------------------------- OTHER Consumer Price Index 2.6% 2.0% 2.4% - -------------------------------------------------------------------------------- From October 31, 1998, through April 30, 1999, the stock market rose 22.8%, as measured by the Wilshire 5000 Total Market Index. Investor confidence, already high due to the booming economy, was bolstered by easier monetary policy--the Federal Reserve cut short-term interest rates in November 1998 for the third time in less than two months. But by summer, the Fed reversed course, twice boosting its target for short-term interest rates to slow the economy and reduce inflationary pressures. Higher interest rates helped take the steam out of the stock market's rally during the second half of the fiscal year, even though estimates of corporate earnings kept rising. Higher rates tend to hurt stocks because many investors use current interest rates to discount the value of a stock's projected earnings and dividends. The higher the rate, the more future earnings are discounted, and the less investors will pay for the stock now. After a second-half gain of 2.3%, the Wilshire 5000 Index recorded a 25.7% return for the full fiscal year. Big stocks outperformed small stocks in fiscal 1999, and growth stocks outpaced value stocks. The S&P 500 Index, which is dominated by large-capitalization stocks, gained 25.7%, 6 while the small-cap Russell 2000 Index was up 14.9%. Growth stocks--whose high prices in relation to earnings, book value, and dividends indicate high expectations for future growth--lost none of their appeal, despite soaring valuations for many. Both large- and small-cap growth issues gained roughly 30%, while value stocks within the S&P 500 Index were up 19.0%, and the Russell 2000's value stocks had a scant 0.7% return. The growth/value gap was due partly to the incredible performance of technology stocks, most of which are classified as growth issues. Within the S&P 500 Index, tech stocks gained 67% during the fiscal year. Advances of about 30% were recorded by retailers and other consumer-discretionary stocks and by the utilities sector, where gains were concentrated in telecommunications stocks. The only sector with a loss was consumer staples (-8%), where food and beverage company stocks suffered from falling profits. Other laggards were the auto & transportation sector (+6%) and health-care stocks (+9%). U.S. BOND MARKETS Rapid economic growth was a help to the stock market but a hindrance to bonds. Investors worried that, with unemployment so low, growth above the 2.5% to 3% range would cause wages and prices to accelerate. Indeed, inflation did rise a bit, although the Consumer Price Index was up a relatively modest 2.6% during the 12-month period. As mentioned, the Fed sought to combat inflationary pressures by increasing short-term interest rates by a quarter-point on June 30 and again on August 24. The bond market was already pushing up rates well before the Fed acted. Yields of long-term U.S. Treasury bonds began rising significantly in February. By fiscal year-end, the 30-year Treasury bond's yield was 6.16%, up precisely 1 percentage point for the year. The 10-year Treasury's yield rose 1.41 percentage points, from 4.61% to 6.02%. Short-term interest rates didn't rise as far, and 3-month Treasury bill yields were up 0.77 point to 5.09% at fiscal year-end. Rising interest rates mean lower prices for existing bonds, of course. Price declines were higher for longer-term bonds, which are most sensitive to changing rates. For the taxable bond market as a whole, as measured by the Lehman Aggregate Bond Index, prices fell -5.7%, resulting in a total return of just 0.5% for the fiscal year. High-yield (junk) bonds and mortgage-backed securities posted higher returns than Treasuries. INTERNATIONAL STOCK MARKETS International markets soared in local currencies during the 12 months ended October 31, with European stocks gaining 22.7% and Pacific-region stocks advancing 37.8%. The U.S. dollar rose in value against most European currencies but fell against the Japanese yen. For U.S. investors, the upshot of these currency fluctuations was to trim returns from Europe to 12.7% in dollar terms and to boost returns from the Pacific to 50.5%. In the major developed international markets, U.S. investors earned 23.4%, as measured by the Morgan Stanley Capital International Europe, Australasia, Far East (EAFE) Index. The bull markets in most nations stemmed from a renewed appetite for risk on the part of investors encouraged by clear signs of expanding business activity and generally easier monetary policy. Japan and the rest of Asia, which were hit hardest by currency and economic crises in 1997 and 1998, saw the biggest gains. In Japan, massive government spending programs appeared to be working--at least in the short run--to lift that nation out of a recession. Emerging markets, as measured by the Select Emerging Markets Free Index, gained 34.1% for U.S. investors, as local returns of better than 70% were cut nearly in half by weaker currencies in Latin America and eastern Europe. 7 REPORT FROM WELLINGTON MANAGEMENT COMPANY, LLP Vanguard Windsor Fund's 13.7% return during the fiscal year ended October 31, 1999, was ahead of the 11.7% return of the average multi-cap value fund but behind returns of both the S&P 500 Index (25.7%) and its value component, the S&P 500/BARRA Value Index (19.0%). We continue to invest as we have in the past. Our approach is to look for good companies that the market has misappraised for some reason, that have price/earnings (P/E) ratios below the market's, and that have an upside appreciation potential of at least 30%. We make commitments only after thorough research and careful deliberation, and we then follow closely everything we own. The P/E ratio of our portfolio (and of the fund as a whole) is distinctly below the market's, usually by about one-third. Yet our prospective total return--which we define as 5-year earnings growth and dividend yield--is within 10%-15% of the market's. That is our value proposition. We buy stocks when we think they are undervalued, sell them when they get to fair value, and replace them with new undervalued names. We are not afraid to concentrate when it makes sense and when, having done our homework, our conviction is strong. Our goal is to provide returns on your investment that are out of the ordinary, without taking undue risks. "Closet indexing"--aligning the portfolio with a market index--is not consistent with this objective. All this makes for a portfolio that is very different from the S&P 500 Index. The current portfolio is overweight in selected commodity and materials producers--energy,aluminum, paper, and specialty chemicals--with holdings equal to about 25% of the portfolio versus about 9% of the S&P 500. These stocks hurt us in fiscal 1998, but helped in 1999. Alcoa, which gained about 55%, is our largest holding in this phalanx and the third-largest holding in our portion of the fund, at 51/2% of the portfolio. These stocks shot up in April and May, and the market has been digesting those gains since. But we see another upward leg or two ahead, if our forecast for global economic growth of 3.5% for next year is right. Our energy fortunes are, importantly, also tied to the domestic natural gas market, where we see strong fundamentals--demand growing 2% a year, a supply base that has peaked out, and a market that will need higher prices to bring supply into balance with demand. We also have an outsize position in financial services--banks, savings & loans, specialty finance, and some insurance--where our portfolio's weighting is 24% versus 16% for the S&P 500 Index. Again, these stocks lagged in 1998, which we used as an opportunity to buy more. This paid off in 1999; Citigroup, the fund's biggest holding at 6.5% of assets, was up about 75%. We still see a lot of value in selected financials, such as Associates First, a new 2.2% stake for the fund in a well-managed, 15%-a-year grower selling at only 15 times next year's earnings. - -------------------------------------------------------------------------------- INVESTMENT PHILOSOPHY The fund reflects a belief 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 fund may concentrate a large portion of assets in those securities or industries the advisers believe offer the best return potential. - -------------------------------------------------------------------------------- We own no consumer nondurables--food, household products, beverages, and tobacco--which make up 8 nearly 10% of the S&P 500. This void served us well in fiscal 1999, as these stocks lagged the market by about 30 percentage points. Such companies as Coca-Cola, Procter & Gamble, and Gillette are still trading at 25 to 40 times earnings while offering long-term growth prospects on the order of 10% to 12%. This seems pricey to us, and so we still have nothing in this sector. The other big sector difference between us and the market is technology--which makes up 6% of our portfolio versus 21% of the market. This disparity was a significant negative in 1999, because the tech piece of the S&P 500 Index was up 67%, accounting for more than half of the index's 25.7% gain. Our tech weighting is low for good valuation reasons. Our view is that the P/E multiples--from 40 to 70 times earnings--sported by a number of large tech stocks are built on investor expectations that will be difficult to live up to. An old rule of thumb is that growth stocks' P/E ratios should be roughly twice the stocks' growth rates. This suggests that these large tech stocks need to grow at 20% to 35% on a long-term basis to justify their multiples. Given that U.S. information technology spending is growing at 11% a year, we expect to see a lot of potholes in the technology landscape in the next 12 months as some companies "fall short" of expectations and their stocks correct. When tech stocks correct, they tend to come down hard, and we may get some buying opportunities. If we're going to close our large gap versus the S&P 500's tech weighting, we want to do so on our terms. A recent instance was IBM, where we grabbed a new position of nearly 2% of assets when the company suggested that Y2K distortions would hurt earnings for the next two quarters. We paid about 211/2 times earnings for this 15% grower, which also pays a 0.5% dividend yield; its P/E-to-total-return ratio of 1.4 is well below the market's 1.9 ratio. Our portion of the fund continues to be highly concentrated, with the ten largest holdings totaling 41% of assets. Our overall portfolio P/E of 15.1, based on estimated year 2000 earnings, is 63% of the market's 23.9 P/E multiple. By way of comparison, our projected total return is 12.4%, about 90% of the market's projected return. We have been looking for, and finding, solid double-digit growers, with P/E-to-total-return ratios well below average for the market. Besides Associates First and IBM, these are TJX Companies, Ross Stores, Air Products, MCI WorldCom, and Pharmacia & Upjohn--names that account for about 12% of the portfolio. The dedicated Windsor team that I am proud to lead will continue to forage, in our usual entrepreneurial style, for undervalued situations that can add to the portfolio's already considerable appreciation potential. Charles T. Freeman, Portfolio Manager November 16, 1999 9 REPORT FROM SANFORD C. BERNSTEIN & CO., INC. When Sanford C. Bernstein & Co. began managing a portion of Vanguard Windsor Fund on June 1, we saw enormous opportunities in an unusually bifurcated market. Prices for traditional cyclical companies, particularly commodity producers, had fallen sharply over the previous two years because investors feared that earnings shortfalls due to the spread of the Asian crisis would last indefinitely. At the same time, euphoria surrounding the Internet was lifting technology and telecommunications stock prices to extraordinarily high levels, and a handful of very large, very expensive stocks were driving most of the market's rally. We positioned the portfolio to capture the deep values we saw in cyclicals, particularly the commodity producers and railroads. We also saw opportunity in health maintenance organizations (HMOs) and in retail, food, and tobacco companies. Although growth stocks have continued to outperform, the outlook for value stocks has become very strong--indeed, even better than we anticipated when we initiated these positions. Economic growth has been surprisingly strong around the globe, and inventories have shrunk for many commodities. As a result, commodity prices are rising, as are consensus earnings expectations for many of our holdings. In several cases, third-quarter earnings reports significantly beat expectations. At the same time, an extraordinary burst of restructuring activity and mergers has increased the long-term earnings power of many commodity producers we hold. For example, Dow Chemical's acquisition of Union Carbide this summer is creating a global behemoth with enormous opportunities to cut costs and to increase revenues through cross-selling a more complete product line to both companies' customers. We also see large opportunities in railroad companies that are smoothing out operational difficulties that arose from strategically sound mergers. Railroads should benefit as freight volumes recover from declining sales to Asia. Other opportunities are more insulated from global considerations. HMO stocks recently fell because of concern about adverse political developments and possible class-action lawsuits. In our view, it is highly unlikely that such suits will withstand court scrutiny, and the industry appears able to pass through to consumers the costs of regulatory changes; indeed, pricing power is finally returning to the industry. These stocks offer exceptional value. Our portion of Windsor Fund has no holdings in the high-priced semiconductor and Internet industries, and few in computer software or services. One very attractive company in the hardware and peripherals segment is Seagate Technology, a maker of disk drives that has recovered its market leadership and gained a compelling cost advantage; as a result, it is the only disk-drive manufacturer with current profits. Overall, the value opportunities we see today are the largest in our experience. We expect improvement in both forecast and reported earnings to be the catalyst for stock price gains. Such improvement is now appearing for some of our holdings, increasing our confidence in our current strategy. Marilyn G. Fedak, Portfolio Manager Steven Pisarkiewicz, Portfolio Manager November 10, 1999 10 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. An investor's shares, when redeemed, could be worth more or less than their original cost. - -------------------------------------------------------------------------------- TOTAL INVESTMENT RETURNS: OCTOBER 31, 1979-OCTOBER 31, 1999 WINDSOR FUND S&P 500 - -------------------------------------------------------------------------------- FISCAL CAPITAL INCOME TOTAL TOTAL YEAR RETURN RETURN RETURN RETURN - -------------------------------------------------------------------------------- 1980 17.2% 7.0% 24.2% 32.1% 1981 11.1 6.9 18.0 0.6 1982 14.2 7.0 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 - -------------------------------------------------------------------------------- WINDSOR FUND S&P 500 - -------------------------------------------------------------------------------- FISCAL CAPITAL INCOME TOTAL TOTAL YEAR RETURN RETURN RETURN RETURN - -------------------------------------------------------------------------------- 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 1999 12.1 1.6 13.7 25.7 - -------------------------------------------------------------------------------- See Financial Highlights table on page 20 for dividend and capital gains information for the past five years. CUMULATIVE PERFORMANCE: OCTOBER 31, 1989-OCTOBER 31, 1999 [MOUNTAIN CHART] - -------------------------------------------------------------------------------- AVERAGE WINDSOR MULTI-CAP S&P 500 FUND VALUE FUND* INDEX - -------------------------------------------------------------------------------- 1989/10 10000 10000 10000 1990/01 9038 9630 9747 1990/04 9002 9662 9882 1990/07 9261 10204 10738 1990/10 7207 8702 9252 1991/01 8813 10013 10566 1991/04 9776 10947 11623 1991/07 10045 11342 12108 1991/10 10428 11764 12351 1992/01 10784 12363 12963 1992/04 11416 12586 13253 1992/07 11813 12825 13656 1992/10 11398 12921 13581 1993/01 12974 13873 14334 1993/04 13311 14101 14478 1993/07 13977 14527 14849 1993/10 14622 15444 15610 1994/01 15554 16034 16180 1994/04 14511 15235 15248 1994/07 15347 15445 15615 1994/10 15550 16009 16214 1995/01 14927 15694 16266 1995/04 16473 17072 17911 1995/07 18365 18668 19692 1995/10 18318 19288 20501 1996/01 19599 20874 22555 1996/04 20845 21764 23323 1996/07 20304 20995 22954 1996/10 22561 23267 25441 1997/01 25564 25522 28497 1997/04 25622 25359 29184 1997/07 29980 30056 34922 1997/10 28661 29968 33610 1998/01 29342 30787 36165 1998/04 33717 34171 41169 1998/07 30716 32346 41657 1998/10 28436 31407 41001 1999/01 29522 33792 47915 1999/04 34692 35760 50154 1999/07 33760 35898 50073 1999/10 32344 35087 51526 - -------------------------------------------------------------------------------- AVERAGE ANNUAL TOTAL RETURNS PERIODS ENDED OCTOBER 31, 1999 ------------------------------- FINAL VALUE OF A 1 YEAR 5 YEARS 10 YEARS $10,000 INVESTMENT - -------------------------------------------------------------------------------- Windsor Fund 13.74% 15.77% 12.46% $32,344 Average Multi-Cap Value Fund* 11.72 16.99 13.37 35,087 S&P 500 Index 25.67 26.02 17.82 51,526 - -------------------------------------------------------------------------------- *Derived from data provided by Lipper Inc. - -------------------------------------------------------------------------------- AVERAGE ANNUAL TOTAL RETURNS: PERIODS ENDED SEPTEMBER 30, 1999* - -------------------------------------------------------------------------------- 10 YEARS INCEPTION --------------------------- DATE 1 YEAR 5 YEARS CAPITAL INCOME TOTAL - -------------------------------------------------------------------------------- Windsor Fund 10/23/1958 19.36% 15.57% 7.88% 3.64% 11.52% - -------------------------------------------------------------------------------- *SEC rules require that we provide this average annual total return information through the latest calendar quarter. 11 FUND PROFILE WINDSOR FUND This Profile provides a snapshot of the fund's characteristics as of October 31, 1999, compared where appropriate to an unmanaged index. Key elements of this Profile are defined on page 13. PORTFOLIO CHARACTERISTICS - --------------------------------------------------------- WINDSOR S&P 500 - --------------------------------------------------------- Number of Stocks 195 500 Median Market Cap $13.1B $72.6B Price/Earnings Ratio 17.4x 27.7x Price/Book Ratio 2.2x 5.1x Yield 1.6% 1.2% Return on Equity 15.0% 23.0% Earnings Growth Rate 9.6% 15.0% Foreign Holdings 11.4% 1.5% Turnover Rate 56% -- Expense Ratio 0.28% -- Cash Reserves 1.3% -- INVESTMENT FOCUS - --------------------------------------------------------- [GRID] Style............Value Market Cap.......Medium VOLATILITY MEASURES - --------------------------------------------------------- WINDSOR S&P 500 - --------------------------------------------------------- R-Squared 0.78 1.00 Beta 1.05 1.00 TEN LARGEST HOLDINGS (% OF TOTAL NET ASSETS) - --------------------------------------------------------- Citigroup, Inc. 6.5% AT&T Corp. 4.6 Rhone-Poulenc SA 4.6 Alcoa Inc. 4.3 Bank of America Corp. 3.1 Columbia/HCA Healthcare Corp. 2.3 Washington Mutual, Inc. 2.2 Associates First Capital Corp. 2.2 Golden West Financial Corp. 2.1 MCI WorldCom, Inc. 2.0 - --------------------------------------------------------- Top Ten 33.9% SECTOR DIVERSIFICATION (% OF COMMON STOCKS) - --------------------------------------------------------- OCTOBER 31, 1998 OCTOBER 31, 1999 ------------------------------------ WINDSOR WINDSOR S&P 500 ------------------------------------ Auto & Transportation ... 6.4% 7.4% 2.2% Consumer Discretionary .. 0.8 4.7 12.5 Consumer Staples ........ 0.0 1.1 7.2 Financial Services ...... 29.0 29.4 16.1 Health Care ............. 7.8 6.9 11.0 Integrated Oils ......... 3.5 2.8 5.2 Other Energy ............ 10.3 6.2 1.4 Materials & Processing .. 21.0 21.2 3.2 Producer Durables ....... 5.8 3.3 3.3 Technology .............. 5.4 4.8 20.5 Utilities ............... 7.3 9.7 11.2 Other ................... 2.7 2.5 6.2 - --------------------------------------------------------- 12 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 35%.) 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. 13 FINANCIAL STATEMENTS OCTOBER 31, 1999 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, but may differ because certain investments or transactions may be treated differently for financial statement and tax purposes. 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 (96.7%)+ - -------------------------------------------------------------------------------- AUTO & TRANSPORTATION (7.2%) Compagnie Generale des Etablissements Michelin Class B 6,000,586 261,106 Canadian National Railway Co. 5,042,100 153,784 Eaton Corp. 2,015,900 151,696 Delta Air Lines, Inc. 2,301,522 125,289 o(1) America West Holdings Corp. Class B 3,484,500 72,086 Burlington Northern Santa Fe Corp. 1,869,000 59,574 Union Pacific Corp. 1,059,300 59,056 General Motors Corp. 722,100 50,728 Delphi Automotive Systems Corp. 2,937,059 48,278 Norfolk Southern Corp. 1,923,600 47,008 CSX Corp. 1,124,000 46,084 TRW, Inc. 909,000 38,973 Genuine Parts Co. 1,486,500 38,742 Ford Motor Co. 578,800 31,762 Dana Corp. 886,200 26,198 ---------- 1,210,364 ---------- CONSUMER DISCRETIONARY (4.6%) May Department Stores Co. 4,737,800 164,342 (1) Ross Stores, Inc. 6,509,600 134,261 o Republic Services, Inc. Class A 8,091,500 99,121 o BJ's Wholesale Club, Inc. 2,224,800 68,552 TJX Cos., Inc. 1,928,200 52,302 - -------------------------------------------------------------------------------- MARKET VALUE SHARES (000) - -------------------------------------------------------------------------------- o Federated Department Stores, Inc. 1,100,300 46,969 Whirlpool Corp. 619,800 43,192 o Jones Apparel Group, Inc. 1,182,900 37,409 VF Corp. 994,300 29,891 Mattel, Inc. 2,231,300 29,844 Sears, Roebuck & Co. 841,800 23,728 o Saks Inc. 1,239,100 21,297 Dillard's Inc. 616,900 11,644 o(1) HomeBase, Inc. 2,307,100 8,796 ---------- 771,348 ---------- CONSUMER STAPLES (1.1%) Philip Morris Cos., Inc. 2,502,900 63,042 ConAgra, Inc. 2,175,800 56,707 Tyson Foods, Inc. 1,812,600 27,642 SuperValu Inc. 942,100 19,784 IBP, Inc. 736,500 17,630 ---------- 184,805 ---------- FINANCIAL SERVICES (28.4%) BANKS--NEW YORK CITY (0.2%) The Chase Manhattan Corp. 197,800 17,283 J.P. Morgan & Co., Inc. 99,900 13,074 BANKS--OUTSIDE NEW YORK CITY (7.2%) Bank of America Corp. 8,017,971 516,157 National City Corp. 5,172,800 152,598 UnionBanCal Corp. 3,213,000 139,565 U.S. Bancorp 3,643,900 135,052 Fleet Boston Corp. 2,009,530 87,666 Bank One Corp. 2,220,900 83,423 First Union Corp. 1,944,300 82,997 Regions Financial Corp. 583,200 17,532 14 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- DIVERSIFIED FINANCIAL SERVICES (6.8%) Citigroup, Inc. 20,353,400 1,101,628 American General Corp. 637,000 47,257 FINANCIAL MISCELLANEOUS (2.8%) Associates First Capital Corp. 10,034,900 366,274 MBIA, Inc. 803,800 45,867 AMBAC Financial Group Inc. 579,900 34,649 Fannie Mae 344,600 24,380 INSURANCE--MULTI-LINE (3.5%) CIGNA Corp. 3,945,800 294,949 Allstate Corp. 7,075,400 203,418 American International Group, Inc. 472,100 48,597 Torchmark Corp. 1,061,800 33,115 Horace Mann Educators Corp. 257,300 7,253 Old Republic International Corp. 383,800 5,253 INSURANCE--PROPERTY-CASUALTY (0.8%) PartnerRe Ltd. 1,860,500 58,024 The Chubb Corp. 907,500 49,799 IPC Holdings Ltd. 1,649,800 28,047 REAL ESTATE INVESTMENT TRUST (2.8%) Archstone Communities Trust REIT 5,541,600 110,832 (1) Liberty Property Trust REIT 4,440,500 103,797 Equity Residential Properties Trust REIT 2,370,900 99,133 Spieker Properties, Inc. REIT 1,292,300 45,150 CarrAmerica Realty Corp. REIT 1,372,400 30,536 Duke Realty Investments, Inc. REIT 1,357,100 26,633 Avalonbay Communities, Inc. REIT 796,336 25,732 Camden Property Trust REIT 870,000 23,544 SAVINGS & LOAN (4.3%) Washington Mutual, Inc. 10,216,664 367,161 (1) Golden West Financial Corp. 3,145,100 351,465 ---------- 4,777,840 ---------- HEALTH CARE (6.7%) Columbia/HCA Healthcare Corp. 16,020,800 386,502 Aetna Inc. 3,560,000 178,890 Pharmacia & Upjohn, Inc. 3,201,600 172,686 o Tenet Healthcare Corp. 6,792,800 132,035 o(1) PacifiCare Health Systems, Inc. 2,619,300 103,299 American Home Products Corp. 976,400 51,017 o(1) Foundation Health Systems Class A 6,028,660 39,940 o(1) LifePoint Hospitals, Inc. 2,032,189 24,005 o(1) Triad Hospitals, Inc. 2,170,789 21,165 Bergen Brunswig Corp. Class A 1,017,100 7,247 Rhone-Poulenc SA Class A 99,671 5,573 ------------ 1,122,359 ------------ - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- INTEGRATED OILS (2.7%) USX-Marathon Group 4,897,700 142,646 Exxon Corp. 1,529,200 113,256 Occidental Petroleum Corp. 2,623,200 59,842 Shell Transport & Trading Co. ADR 1,302,300 59,743 Phillips Petroleum Co. 1,105,400 51,401 Mobil Corp. 253,200 24,434 451,322 OTHER ENERGY (6.0%) Burlington Resources, Inc. 6,729,800 234,702 Anderson Exploration Ltd. 11,672,400 150,379 Ultramar Diamond Shamrock Corp. 4,547,400 111,411 Union Pacific Resources Group, Inc. 7,333,900 106,342 Transocean Offshore, Inc. 3,434,200 93,367 Anadarko Petroleum Corp. 2,636,300 81,231 (1) Valero Energy Corp. 3,635,300 66,799 Alberta Energy Co. Ltd. 1,411,100 43,039 (1) Cabot Oil & Gas Corp. Class A 2,409,500 38,853 Tosco Corp. 1,279,300 32,382 Devon Energy Corp. 556,475 21,633 Ashland, Inc. 607,000 20,031 o(1) EEX Corp. 4,148,499 15,298 ---------- 1,015,467 ---------- MATERIALS & PROCESSING (20.4%) Rhone-Poulenc SA ADR 13,748,650 763,050 Alcoa Inc. 11,993,834 728,625 Air Products & Chemicals, Inc. 5,226,500 143,729 (1) Hercules, Inc. 5,500,600 132,358 o Smurfit-Stone Container Corp. 5,825,850 125,984 Sigma-Aldrich Corp. 4,326,800 123,314 Engelhard Corp. 6,276,900 110,630 Jefferson Smurfit Group PLC ADR 3,997,541 102,937 Abitibi-Consolidated, Inc. 8,081,100 97,478 Pechiney SA ADR A 2,721,128 79,083 International Paper Co. 1,248,300 65,692 Dow Chemical Co. 543,300 64,245 (1) Phosphate Resources Partners LP 6,302,400 63,418 Lafarge Corp. 1,918,300 56,950 AK Steel Corp. 3,167,852 54,843 Lyondell Chemical Co. 4,385,903 53,179 Praxair, Inc. 1,108,200 51,808 Donohue, Inc. Class A 3,097,600 49,279 Archer-Daniels-Midland Co. 3,798,715 46,772 Bowater Inc. 756,680 39,726 Nucor Corp. 732,600 38,004 Willamette Industries, Inc. 909,600 37,805 o(1) Kaiser Aluminum & Chemical Corp. 5,789,334 37,269 Reynolds Metals Co. 541,600 32,733 o Owens-Illinois, Inc. 1,303,800 31,210 Champion International Corp. 493,400 28,525 Temple-Inland Inc. 467,800 27,191 o(1) Albany International Corp. 1,695,741 25,754 15 - -------------------------------------------------------------------------------- MARKET VALUE* WINDSOR FUND SHARES (000) - -------------------------------------------------------------------------------- Crown Cork & Seal Co., Inc. 986,900 23,624 o American Standard Cos., Inc. 591,400 22,584 Fluor Corp. 526,800 21,006 Sonoco Products Co. 823,000 19,752 (1) Century Aluminum Co. 2,000,000 18,000 Great Lakes Chemical Corp. 485,000 17,218 Boise Cascade Corp. 473,900 16,883 Ryerson Tull, Inc. 625,846 12,830 CK Witco Corp. 1,334,129 12,507 Deltic Timber Corp. 549,471 12,329 Cabot Corp. 553,300 10,305 Sherwin-Williams Co. 460,000 10,293 (1) Mississippi Chemical Corp. 1,685,300 9,374 o Burlington Industries, Inc. 2,383,700 8,790 Owens Corning 425,900 8,731 Georgia Pacific Group 100,000 3,969 Armstrong World Industries Inc. 54,300 2,029 ---------- 3,441,815 ---------- PRODUCER DURABLES (3.2%) Alcatel SA ADR 3,567,600 109,481 Case Corp. 1,611,500 85,410 o(1) Toll Brothers, Inc. 3,529,166 61,760 New Holland NV 3,865,100 58,701 Lockheed Martin Corp. 1,820,900 36,418 Kaufman & Broad Home Corp. 1,698,600 34,078 o(1) U.S. Home Corp. 1,168,495 32,718 Northrop Grumman Corp. 552,300 30,307 Thomas & Betts Corp. 475,800 21,352 (1) MDC Holdings, Inc. 1,156,300 18,067 o(1) Beazer Homes USA, Inc. 860,464 16,456 The BFGoodrich Co. 625,800 14,824 Centex Corp. 464,900 12,465 ---------- 532,037 ---------- Technology (4.7%) International Business Machines Corp. 2,994,200 294,554 o(1) Arrow Electronics, Inc. 6,393,100 139,449 o Quantum Corp.- DLT & Storage Systems 6,525,500 100,737 Avnet, Inc. 1,593,500 86,547 o Seagate Technology Inc. 1,473,800 43,385 o Adaptec, Inc. 873,700 39,317 o(1) General Semiconductor, Inc. 3,468,600 36,420 o Quantum Corp.- Hard Disk Drive 2,424,000 14,847 Harris Corp. 627,900 14,089 o Litton Industries, Inc. 279,900 13,138 Scientific-Atlanta, Inc. 49,300 2,822 ---------- 785,305 ---------- UTILITIES (9.4%) AT&T Corp. 16,680,316 779,805 o MCI WorldCom, Inc. 3,947,093 338,710 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- FirstEnergy Corp. 1,704,100 44,413 PG&E Corp. 1,919,100 44,019 Ameren Corp. 1,152,100 43,564 SBC Communications Inc. 837,720 42,671 Central & South West Corp. 1,778,500 39,460 Bell Atlantic Corp. 585,800 38,040 Cinergy Corp. 1,334,900 37,711 New Century Energies, Inc. 1,065,300 34,689 GPU, Inc. 993,600 33,720 Allegheny Energy, Inc. 978,900 31,141 BellSouth Corp. 667,400 30,033 o MediaOne Group, Inc. 415,000 29,491 Alliant Energy Corp. 607,500 16,516 ---------- 1,583,983 ---------- OTHER (2.3%) Minnesota Mining & Manufacturing Co. 857,200 81,488 Cooper Industries, Inc. 743,900 32,034 Allegheny Teledyne Inc. 1,586,200 24,090 Kemira Oyj ADR 628,200 7,758 Miscellaneous (1.5%) 250,391 395,761 - -------------------------------------------------------------------------------- TOTAL COMMON STOCKS (COST $14,280,126) 16,272,406 - -------------------------------------------------------------------------------- PREFERRED STOCK (1.0%) News Corp. Ltd. ADR (COST $92,778) 5,957,875 164,214 CONVERTIBLE PREFERRED STOCK (0.1%) Kaufman & Broad Home Corp. 8.25% Cvt. Pfd. (COST $23,120) 3,163,700 22,541 - -------------------------------------------------------------------------------- FACE AMOUNT (000) - -------------------------------------------------------------------------------- TEMPORARY CASH INVESTMENTS (2.1%)+ - -------------------------------------------------------------------------------- FEDERAL HOME LOAN MORTGAGE CORP. (2) 5.64%, 2/2/2000 5,000 4,922 FEDERAL NATIONAL MORTGAGE ASSN. (2 5.64%, 1/18/2000 10,000 9,868 REPURCHASE AGREEMENTS Collateralized by U.S. Government Obligations in a Pooled Cash Account 5.24%, 11/1/1999 308,125 308,125 5.26%, 11/1/1999--Note F 30,270 30,270 - -------------------------------------------------------------------------------- TOTAL TEMPORARY CASH INVESTMENTS (COST $353,203) 353,185 - -------------------------------------------------------------------------------- TOTAL INVESTMENTS (99.9%) (COST $14,749,227) 16,812,346 - -------------------------------------------------------------------------------- 16 - -------------------------------------------------------------------------------- MARKET VALUE* (000) - -------------------------------------------------------------------------------- OTHER ASSETS AND LIABILITIES (0.1%) - -------------------------------------------------------------------------------- Other Assets--Note C 218,263 Liabilities--Note F (206,887) 11,376 - -------------------------------------------------------------------------------- NET ASSETS (100%) - -------------------------------------------------------------------------------- Applicable to 994,989,422 outstanding $.001 par value shares of beneficial interest (unlimited authorization) $16,823,722 ================================================================================ NET ASSET VALUE PER SHARE $16.91 ================================================================================ * See Note A in Notes to Financial Statements. o Non-Income-Producing Security. + The fund invests a portion of its cash reserves in equity markets through the use of index futures contracts. After giving effect to futures investments, the fund's effective common stock and temporary cash investment positions represent 97.6% and 1.2%, respectively, 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 companies. The total market value of investments in affiliated companies was $1,570,807,000. (2) Security segregated as initial margin for open futures contracts. ADR--American Depositary Receipt. REIT--Real Estate Investment Trust. - -------------------------------------------------------------------------------- AMOUNT PER (000) SHARE - -------------------------------------------------------------------------------- AT OCTOBER 31, 1999, NET ASSETS CONSISTED OF: - -------------------------------------------------------------------------------- Paid in Capital $12,801,594 $12.87 Undistributed Net Investment Income 93,521 .09 Accumulated Net Realized Gains 1,859,220 1.87 Unrealized Appreciation-- Note E Investment Securities 2,063,119 2.07 Futures Contracts 6,268 .01 - -------------------------------------------------------------------------------- NET ASSETS $16,823,722 $16.91 ================================================================================ 17 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 FUND YEAR ENDED OCTOBER 31, 1999 (000) - -------------------------------------------------------------------------------- INVESTMENT INCOME INCOME Dividends* $ 309,153 Interest 15,017 Security Lending 1,232 Total Income 325,402 EXPENSES Investment Advisory Fees--Note B Basic Fee 22,023 Performance Adjustment (14,040) The Vanguard Group--Note C Management and Administrative 38,797 Marketing and Distribution 2,519 Custodian Fees 498 Auditing Fees 23 Shareholders' Reports 408 Trustees' Fees and Expenses 27 Total Expenses 50,255 Expenses Paid Indirectly--Note C (2,460) Net Expenses 47,795 - -------------------------------------------------------------------------------- NET INVESTMENT INCOME 277,607 - -------------------------------------------------------------------------------- REALIZED NET GAIN (LOSS) Investment Securities Sold* 1,952,962 Futures Contracts (12,431) - -------------------------------------------------------------------------------- REALIZED NET GAIN 1,940,531 - -------------------------------------------------------------------------------- CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) Investment Securities 36,551 Futures Contracts 6,268 - -------------------------------------------------------------------------------- CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) 42,819 - -------------------------------------------------------------------------------- NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $2,260,957 ================================================================================ *Dividend income and realized net gain from affiliated companies were $86,331,000 and $567,678,000, respectively. 18 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, -------------------------- 1999 1998 (000) (000) - -------------------------------------------------------------------------------- INCREASE (DECREASE) IN NET ASSETS OPERATIONS Net Investment Income 277,607 270,099 Realized Net Gain 1,940,531 1,346,037 Change in Unrealized Appreciation (Depreciation) 42,819 (1,700,942) Net Increase (Decrease) in Net Assets Resulting from Operations 2,260,957 (84,806) DISTRIBUTIONS Net Investment Income (255,285) (268,858) Realized Capital Gain (1,341,486) (3,045,000) Total Distributions (1,596,771) (3,313,858) CAPITAL SHARE TRANSACTIONS1 Issued 1,402,297 1,632,455 Issued in Lieu of Cash Distributions 1,504,748 3,148,447 Redeemed (5,102,907) (3,704,909) Net Increase (Decrease) from Capital Share Transactions (2,195,862) 1,075,993 - -------------------------------------------------------------------------------- Total Decrease (1,531,676) (2,322,671) - -------------------------------------------------------------------------------- NET ASSETS Beginning of Year 18,355,398 20,678,069 End of Year $16,823,722 $18,355,398 ================================================================================ 1Shares Issued (Redeemed) Issued 82,191 92,583 Issued in Lieu of Cash Distributions 100,940 187,538 Redeemed (311,166) (214,952) NetIncrease (Decrease)in Shares Outstanding (128,035) 65,169 ================================================================================ 19 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 1999 1998 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------- NET ASSET VALUE, BEGINNING OF YEAR $16.34 $19.55 $16.99 $15.55 $14.55 - ----------------------------------------------------------------------------------------------------------- INVESTMENT OPERATIONS Net Investment Income .27 .23 .36 .43 .44 Net Realized and Unrealized Gain (Loss) on Investments 1.77 (.32) 3.94 2.85 1.86 --------------------------------------------- Total from Investment Operations 2.04 (.09) 4.30 3.28 2.30 --------------------------------------------- DISTRIBUTIONS Dividends from Net Investment Income (.24) (.24) (.41) (.46) (.44) Distributions from Realized Capital Gains (1.23) (2.88) (1.33) (1.38) (.86) --------------------------------------------- Total Distributions (1.47) (3.12) (1.74) (1.84) (1.30) - ----------------------------------------------------------------------------------------------------------- NET ASSET VALUE, END OF YEAR $16.91 $16.34 $19.55 $16.99 $15.55 =========================================================================================================== TOTAL RETURN 13.74% -0.78% 27.04% 23.16% 17.80% =========================================================================================================== RATIOS/SUPPLEMENTAL DATA Net Assets, End of Year (Millions) $16,824 $18,355 $20,678 $15,841 $13,008 Ratio of Total Expenses to Average Net Assets 0.28% 0.27% 0.27% 0.31% 0.45% Ratio of Net Investment Income to Average Net Assets 1.56% 1.31% 1.89% 2.75% 3.01% Portfolio Turnover Rate 56% 48% 61% 34% 32% ===========================================================================================================
20 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. FUTURES CONTRACTS: The fund uses S&P 500 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 share 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. Wellington Management Company, LLP, and as of June 1, 1999, Sanford C. Bernstein & Co., Inc., provide investment advisory services to the fund for fees calculated at an annual percentage rate of average net assets. The basic fee of Wellington Management Company, LLP, is subject to quarterly adjustments based on performance relative to the S&P 500 Index for the preceding three years. For the year ended October 31, 1999, the aggregate investment advisory fee represented an effective annual basic rate of 0.12% of the fund's average net assets before a decrease of $14,040,000 (0.08%) based on performance. The Vanguard Group manages the cash reserves of the fund on an at-cost basis. 21 NOTES TO FINANCIAL STATEMENTS (CONTINUED) 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, 1999, the fund had contributed capital of $3,551,000 to Vanguard (included in Other Assets), representing 0.02% of net assets and 3.5% 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 security 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 management and administrative expenses. For the year ended October 31, 1999, these arrangements reduced the fund's expenses by $2,460,000 (an annual rate of 0.01% of average net assets). D. During the year ended October 31, 1999, the fund purchased $9,799,245,000 of investment securities and sold $13,843,338,000 of investment securities, other than temporary cash investments. During the year ended October 31, 1999, the fund realized $81,929,000 of net capital gains resulting from in-kind redemptions--in which shareholders exchanged fund shares for securities held by the fund rather than for cash. Because such gains are not taxable to the fund, and are not distributed to shareholders, they have been reclassified from accumulated net realized gains to paid in capital. E. At October 31, 1999, net unrealized appreciation of investment securities for financial reporting and federal income tax purposes was $2,063,119,000, consisting of unrealized gains of $3,767,787,000 on securities that had risen in value since their purchase and $1,704,668,000 in unrealized losses on securities that had fallen in value since their purchase. At October 31, 1999, the aggregate settlement value of open futures contracts expiring in December 1999 and the related unrealized appreciation were: - -------------------------------------------------------------------------------- (000) ------------------------------------ AGGREGATE NUMBER OF SETTLEMENT UNREALIZED FUTURES CONTRACTS LONG CONTRACTS VALUE APPRECIATION - -------------------------------------------------------------------------------- S&P 500 Index 359 $123,514 $6,015 S&P MidCap 400 Index 130 26,081 253 - -------------------------------------------------------------------------------- Unrealized appreciation of $6,268,000 on open future 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, 1999, was $29,871,000, for which the fund held cash collateral of $30,270,000. Cash collateral received is invested in repurchase agreements. 22 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and 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, 1999, 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, 1999 by correspondence with the custodian and brokers, provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 November 30, 1999 23 - -------------------------------------------------------------------------------- SPECIAL 1999 TAX INFORMATION (UNAUDITED) FOR VANGUARD WINDSOR FUND This information for the fiscal year ended October 31, 1999, is included pursuant to provisions of the Internal Revenue Code. The fund distributed $1,341,486,000 as capital gain dividends (from net long-term capital gains) to shareholders in December 1998, all of which is designated as a 20% rate gain distribution. For corporate shareholders, 32.4% of investment income (dividend income plus short-term gains, if any) qualifies for the dividends-received deduction. - -------------------------------------------------------------------------------- 24 - -------------------------------------------------------------------------------- THE PEOPLE WHO GOVERN YOUR FUND The Trustees of your mutual fund are there to see that the fund is operated and managed in your best interests since, as a shareholder, you are part owner of the fund. Your fund Trustees also serve on the Board of Directors of The Vanguard Group, which is owned by the funds and exists solely to provide services to them on an at-cost basis. Seven of Vanguard's nine board members are independent, meaning that they have no affiliation with Vanguard or the funds they oversee, apart from the sizable personal investments they have made as private individuals. They bring distinguished backgrounds in business, academia, and public service to their task of working with Vanguard officers to establish the policies and oversee the activities of the funds. Among board members' responsibilities are selecting investment advisers for the funds; monitoring fund operations, performance, and costs; reviewing contracts; nominating and selecting new Trustees/Directors; and electing Vanguard officers. The list below provides a brief description of each Trustee's professional affiliations. Noted in parentheses is the year in which the Trustee joined the Vanguard Board. TRUSTEES JOHN C. BOGLE o (1967) 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 o (1987) 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. JOANN HEFFERNAN HEISEN o (1998) Vice President, Chief Information Officer, and a member of the Executive Committee of Johnson & Johnson; Director of Johnson & JohnsonoMerck Consumer Pharmaceuticals Co., The Medical Center at Princeton, and Women's Research and Education Institute. BRUCE K. MACLAURY o (1990) President Emeritus of The Brookings Institution; Director of American Express Bank Ltd., The St. Paul Companies, Inc., and National Steel Corp. BURTON G. MALKIEL o (1977) 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 Select Sector SPDR Trust. ALFRED M. RANKIN, JR. o (1993) 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 o (1991) 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. o (1971) 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 o (1985) Retired Chairman of Rohm & Haas Co.; Director of Cummins Engine Co. and The Mead Corp.; Trustee of Vanderbilt University. - -------------------------------------------------------------------------------- OTHER FUND OFFICERS RAYMOND J. KLAPINSKY o Secretary; Managing Director and Secretary of The Vanguard Group, Inc.; Secretary of each of the investment companies in The Vanguard Group. THOMAS J. HIGGINS o Treasurer; Principal of The Vanguard Group, Inc.; Treasurer of each of the investment companies in The Vanguard Group. VANGUARD MANAGING DIRECTORS R. GREGORY BARTON o Legal Department. ROBERT A. DISTEFANO o Information Technology. JAMES H. GATELY o Individual Investor Group. KATHLEEN C. GUBANICH o Human Resources. IAN A. MACKINNON o Fixed Income Group. F. WILLIAM MCNABB, III o Institutional Investor Group. MICHAEL S. MILLER o Planning and Development. RALPH K. PACKARD o Chief Financial Officer. GEORGE U. SAUTER o Core Management Group. ABOUT OUR COVER Our cover art, depicting HMS Vanguard at sea, is a reproduction of Leading the Way, a 1984 work created and copyrighted by noted naval artist Tom Freeman, of Forest Hill, Maryland. All comparative mutual fund data are from Lipper Inc. or Morningstar, Inc., unless otherwise noted. "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. [SHIP LOGO] [THE VANGUARD GROUP(R) LOGO] Post Office Box 2600 Valley Forge, Pennsylvania 19482-2600 WORLD WIDE WEB www.vanguard.com FUND INFORMATION 1-800-662-7447 INDIVIDUAL ACCOUNT SERVICES 1-800-662-2739 INSTITUTIONAL INVESTOR SERVICES 1-800-523-1036 This report is intended for the fund's shareholders. It may not be distributed to prospective investors unless it is preceded or accompanied by the current fund prospectus. Q220-12/09/1999 (C) 1999 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. VANGUARD(R) WINDSOR II FUND Annual Report October 31, 1999 [SHIP GRAPHIC] [A MEMBER OF THE VANGUARD GROUP LOGO] [PHOTO OF JOHN C. BOGLE] JOHN C. BOGLE FELLOW SHAREHOLDERS: TWO ROADS DIVERGED IN A WOOD, AND I--I TOOK THE ONE LESS TRAVELED BY, AND THAT HAS MADE ALL THE DIFFERENCE. I can think of no better words than those of Robert Frost to begin this special letter to our shareholders, who have placed such extraordinary trust in me and in Vanguard over the past quarter century. When the firm was founded 25 years ago, we deliberately took a new road to managing a mutual fund enterprise. Instead of having the funds controlled by an outside management company with its own financial interests, the Vanguard funds--there were only 11 of them then--would be controlled by their own shareholders and operate solely in their financial interests. The outcome of our unprecedented decision was by no means certain. We described it then as "The Vanguard Experiment." Well, I guess it's fair to say it's an experiment no more. During the past 25 years, the assets we hold in stewardship for investors have grown from $1 billion to more than $500 billion, and I believe that our reputation for integrity, fair-dealing, and sound investment principles is second to none in this industry. Our staggering growth--which I never sought--has come in important part as a result of the simple investment ideas and basic human values that are the foundation of my personal philosophy. I have every confidence that they will long endure at Vanguard, for they are the right ideas and right values, unshakable and eternal. While Emerson believed that "an institution is the lengthened shadow of one man," Vanguard today is far greater than any individual. The Vanguard crew has splendidly implemented and enthusiastically supported our founding ideas and values, and deserves the credit for a vital role in forging our success over the years. It is a dedicated crew of fine human beings, working together in an organization that is well prepared to press on regardless long after I am gone. Creating and leading this enterprise has been an exhilarating run. Through it all, I've taken the kudos and the blows alike, enjoying every moment to the fullest, and even getting a second chance at life with a heart transplant three years ago. What more could a man ask? While I shall no longer be serving on the Vanguard Board, I want to assure you that I will remain vigorous and active in a newly created Vanguard unit, researching the financial markets, writing, and speaking. I'll continue to focus whatever intellectual power and ethical strength I possess on my mission to assure that mutual fund investors everywhere receive a fair shake. In the spirit of Robert Frost: BUT I HAVE PROMISES TO KEEP, AND MILES TO GO BEFORE I SLEEP, AND MILES TO GO BEFORE I SLEEP. You have given me your loyalty and friendship over these long years, and I deeply appreciate your thousands of letters of support. For my part, I will continue to keep an eagle eye on your interests, for you deserve no less. May God bless you all, always. - -------------------------------------------------------------------------------- CONTENTS REPORT FROM THE CHAIRMAN ........... 1 FUND PROFILE .......................10 AFTER-TAX RETURNS REPORT ........... 5 PERFORMANCE SUMMARY ................12 THE MARKETS IN PERSPECTIVE ......... 6 FINANCIAL STATEMENTS ...............13 ADVISER'S REPORT ................... 8 REPORT OF INDEPENDENT ACCOUNTANTS ..22 - -------------------------------------------------------------------------------- [PHOTO OF JOHN J. BRENNAN] JOHN J. BRENNAN REPORT FROM THE CHAIRMAN Vanguard Windsor II Fund made a poor showing during its 1999 fiscal year, returning 4.6% during the 12 months ended October 31, when broad stock market measures advanced nearly 26%. The table at right presents the fiscal-year total returns (capital change plus reinvested dividends) for the Windsor II Fund, the average large-capitalization value mutual fund, the unmanaged S&P 500 Index, and the value stock component of the S&P 500. As you can see, your fund's return was a full 13 percentage points behind that of its average peer, and more than 21 percentage points behind that of the S&P 500 Index, which was propelled by a roaring market for large technology stocks. Windsor II's return was 14.4 percentage points behind the return of the S&P 500/BARRA Value Index, which is a good measure of the types of stocks that Windsor II emphasizes. It was, by far, the fund's worst performance ever relative to the S&P 500 Index and to the S&P 500/BARRA Value Index. - -------------------------------------------- TOTAL RETURNS FISCAL YEAR ENDED OCTOBER 31, 1999 - -------------------------------------------- Vanguard Windsor II Fund 4.6% - -------------------------------------------- Average Large-Cap Value Fund* 17.6% - -------------------------------------------- S&P 500 Index 25.7% - -------------------------------------------- S&P 500/BARRA Value Index 19.0% - -------------------------------------------- *Derived from data provided by Lipper Inc. The fund's total return is based on net asset values of $31.07 per share on October 31, 1998, and $29.03 per share on October 31, 1999, and is adjusted for dividends totaling $0.74 per share paid from net investment income and a distribution of $2.67 per share paid from net realized capital gains. We estimate that the fund will make a distribution of approximately $2.40 from net realized capital gains in December 1999. FINANCIAL MARKETS IN REVIEW The fiscal year ended October 31 comprised two distinctly different halves. For most of the first half, stock prices worldwide were rebounding strongly from a slump in the summer of 1998 that had been prompted by economic crises in Asia, Russia, and parts of Latin America. The stock market's comeback was aided by a pickup in global economic activity and by interest rate reductions by the Federal Reserve Board that autumn. These developments--and the continued ebullience of the U.S. economy--erased investors' fears that the troubles abroad would depress business activity and profits at home. Even though interest rates rose during the six months from October 31 through April 30, the stock market, as measured by the Wilshire 5000 Total Market Index, gained 22.8% and the S&P 500 Index was up 22.3%. The returns of value stocks and growth stocks were nearly identical during the six months, with the S&P 500's growth component returning 22.6% and its value component earning 21.7%. However, during the second half of our fiscal year, most stock prices stagnated or fell (with the notable exception of technology stocks). The Wilshire 5000 advanced 2.3%, bringing its full-year return to 25.7%. The S&P 500's second-half return of 2.7% brought it to an identical 25.7% return for our fiscal year. The second half was particularly tough on large value stocks, which returned -2.2% from May through October, compared with a 7.3% return for the S&P 500's growth stocks. Large-cap growth stocks were the strongest 1 market sector during the fiscal year, led by simply stupendous gains for a number of technology stocks, such as QUALCOMM (700%), Sun Microsystems (263%), Cisco Systems (135%), Microsoft (75%), and Intel (74%). The growth stocks within the S&P 500 Index gained 31.6%, while the index's value stocks returned 19.0%. One factor restraining the stock market in general was a strong uptrend in interest rates starting in February. The Federal Reserve encouraged this move, acting in late June and again in August to boost short-term interest rates by a total of 0.5 percentage point. Fears of a global economic slump were supplanted by worries that economic growth--especially in the United States--was so strong that it would cause wages and commodity prices to surge, pushing up inflation. For the full year, yields on long-term U.S. Treasury bonds rose significantly. The yield of the 30-year Treasury increased exactly 1 percentage point (100 basis points) to 6.16% on October 31, 1999. Bond prices, which move in the opposite direction from interest rates, fell during the year. The Lehman Brothers Aggregate Bond Index, a benchmark for taxable bonds, eked out a return of 0.5% for the year, as its interest income of 6.2% only barely offset price declines of -5.7%. FISCAL 1999 PERFORMANCE OVERVIEW Vanguard Windsor II Fund's 4.6% total return during the 1999 fiscal year was mediocre on an absolute basis and even worse relative to competing mutual funds and market indexes. The fund got off to a relatively strong start, returning 6.5% during the first two months of the period and 17.3% for the first half of the fiscal year. But the second half was a different, and very disappointing, story. The fund posted a negative total return of -10.8% from May through October, well below the 2.7% return of the S&P 500 Index, and the -2.2% return of the S&P 500/BARRA Value Index, which is a better measure of the types of stocks that Windsor II emphasizes. Though the market's tilt toward growth stocks over value stocks was a detriment to your fund during the period, our difficulties went far beyond investment style. Even when compared specifically to the Value Index, our performance was disappointing. Our return was 14.4 percentage points lower than the 19.0% return of the index. As a value fund, Windsor II focuses on stocks that are relatively cheap in terms of measures such as price/earnings ratios and book value and that pay dividend yields considerably above the market average. This mandate naturally steered the fund toward certain market segments (financial services and utilities) and away from others, particularly technology stocks, which at present carry sky-high valuations and pay little or no dividends. On a relative basis, our small commitment to the top-performing technology sector (about 4% of our average assets, versus 18% for the S&P 500 Index) meant big trouble for the fund, given the sector's return of 67%. Our big stake in the financial-services group (26% of average assets for Windsor II; 16% for the index) was also troublesome because of the relatively low returns earned by many bank stocks during the period. The bulk of our shortfall, however, stemmed from the inferior performance of stocks selected by our investment advisers, particularly among issues in the consumer-discretionary group and the utilities sector. As always, the performances of the stocks selected by each of our four advisers varied from the others during fiscal 1999. The prices of many of the stocks we own--including some of our biggest holdings--declined sharply during the fiscal year because the market had expected better earnings. Waste Management Inc., one of our ten largest holdings six months ago, was hit especially hard. The 2 company's share price plummeted about 70% during the period--much of that during a brief span this fall--in response to the revelation of accounting problems, losses, and the departure of its chairman. Other big names that suffered sharp drops included Xerox, Service Corporation International, and J.C. Penney. The Adviser's Report beginning on page 8 provides further details. While none of us on the Windsor II team is happy with our results for the fiscal year, our belief in the fund's value-oriented investment strategy is not shaken. Since its inception in June 1985, Windsor II has enjoyed periods of outperformance (it topped the S&P 500 Index from fiscal 1991 through fiscal 1993) as well as underperformance (it trailed large-cap stocks in 1997 and 1998). These variations from the broad market are the nature of active portfolio management and the fund's emphasis on out-of-favor stocks. The challenge of active management, naturally, is to make those variations positive. We are closely monitoring the portfolio, and we remain confident in the abilities of the four investment advisers who select stocks for Windsor II. We fully expect the fund to provide competitive returns over the long run. - -------------------------------------------------------------------------------- TOTAL ASSETS MANAGED AS OF OCTOBER 31, 1999 ------------------------ $ MILLION PERCENTAGE - -------------------------------------------------------------------------------- Barrow, Hanley, Mewhinney & Strauss, Inc. $19,733 64% Equinox Capital Management, Inc. 4,135 14 Tukman Capital Management, Inc. 3,716 12 Vanguard Core Management Group 1,781 6 Cash Reserve* 1,176 4 - -------------------------------------------------------------------------------- Total $30,541 100% - -------------------------------------------------------------------------------- * This cash reserve is invested in equity index futures to simulate investment in stocks; each adviser may also maintain a modest cash reserve. The table above shows the share of assets supervised by each adviser at the end of the fiscal year. LONG-TERM PERFORMANCE OVERVIEW Any annual review of a mutual fund's performance should also include a look at the fund's longer-term record. The table below presents the average annual returns of the Windsor II Fund and its comparative benchmarks for the past ten years. It also presents the results of hypothetical $10,000 investments made a decade ago in the fund, its average competitor, the S&P 500 Index, and the S&P 500/BARRA Value Index. - -------------------------------------------------------------------------------- TOTAL RETURNS 10 YEARS ENDED OCTOBER 31, 1999 ----------------------------------- AVERAGE FINAL VALUE OF ANNUAL A $10,000 RATE INITIAL INVESTMENT - -------------------------------------------------------------------------------- Vanguard Windsor II Fund 14.5% $38,787 - -------------------------------------------------------------------------------- Average Large-Cap Value Fund 15.2% $41,026 - -------------------------------------------------------------------------------- S&P 500 Index 17.8% $51,526 - -------------------------------------------------------------------------------- S&P 500/BARRA Value Index 15.4% $41,790 - -------------------------------------------------------------------------------- As you might expect, your fund's poor performance over the past 12 months had a considerable negative impact on its longer-term results. One year ago--at the end of the 1998 fiscal year--Windsor II's average annual return over the previous decade was 1.8 percentage points better than that of its average peer. Now, just 12 months later, our annualized return over the past ten years comes up short by 0.7 percentage point. A $10,000 investment in the Windsor II Fund would have grown to $38,787, compared with the $41,026 that would have accumulated in the average large-cap value fund over the same period. 3 A similar investment in the large-cap-dominated S&P 500 Index would have amounted to $51,526, a terrific--and I'd say unsustainable--average annual return of 17.8%. Our ultimate goal, of course, is to provide performance that is superior to that of comparable mutual funds over long periods. We are aided in this objective by our low expenses, which provide us with an advantage over higher-cost funds. Our expense ratio (expenses as a percentage of average net assets) is 0.37%, nearly a full percentage point lower than the 1.26% charged by the average peer mutual fund. Our low costs may provide little comfort during a period when our performance lags, but rest assured that this cost advantage remains a powerful ally in our quest to provide superior long-term returns. The returns earned by stocks--particularly large growth stocks--over the past decade were high by historical standards and will probably be lower in the future. This is not a prediction, but rather a prudent assumption that should be a part of every investor's long-range investment planning. The long-term average return for stocks is about 11%, but that average includes lean years as well as the fabulous decade of the 1990s. IN SUMMARY Though the U.S. stock market was rewarding as a whole during the past 12 months, the narrow nature of the market's gains highlighted the fact that investing in stocks is a risky endeavor. Individual stocks, and even entire industry groups, move in different directions at different times and in varying degrees, just as the returns of stocks, bonds, and short-term investments diverge and fluctuate. That is why building and maintaining an investment program that has exposure to the different asset classes, as well as to a variety of issues within each class, is the surest road to long-term investing success. Creating such a program tailored to your objectives, time horizon for investing, and tolerance for risk--and sticking with it through good times and bad--is a sound approach to participating in the rewards of the financial markets while limiting the risk. /S/ John J. Brennan Chairman and Chief Executive Officer November 12, 1999 ================================================================================ A NOTE OF THANKS TO OUR FOUNDER ================================================================================ As you may have read on the inside cover of our report, our founder, John C. Bogle, is retiring December 31, 1999, as Senior Chairman of our Board after nearly 25 years of devoted service to Vanguard and our shareholders. Vanguard investors have Jack to thank for creating a truly mutual mutual fund company that operates solely in the interest of its fund shareholders. And mutual fund investors everywhere have benefited from his energetic efforts to improve this industry. Finally, on a personal note, I am forever grateful to Jack for giving me the opportunity to join this great company in 1982. 4 A REPORT ON YOUR FUND'S AFTER-TAX RETURNS Beginning with this annual report, Vanguard is pleased to provide a review of the Windsor II Fund's after-tax performance. The figures on this page demonstrate the considerable impact that federal income taxes can have on a fund's return--an important consideration for investors who own mutual funds in taxable accounts. While the pretax return is most often used to tally a fund's performance, the fund's after-tax return, which accounts for taxes on distributions of capital gains and income dividends, is a better representation of the return that many investors actually received. IF YOU OWN THE WINDSOR II FUND IN A TAX-DEFERRED ACCOUNT SUCH AS AN INDIVIDUAL RETIREMENT ACCOUNT OR A 401(K), THIS INFORMATION DOES NOT APPLY TO YOU. SUCH ACCOUNTS ARE NOT SUBJECT TO CURRENT TAXES. The table below presents the pretax and after-tax returns for your fund and an appropriate peer group of mutual funds. Two things to keep in mind: o The after-tax return calculations use the top federal income tax rates in effect at the time of each distribution. The tax burden, therefore, would be somewhat less, and the after-tax return somewhat more, for those in lower tax brackets. o The peer funds' returns are provided by Morningstar, Inc. (Elsewhere in this report, returns for comparable mutual funds are derived from data provided by Lipper Inc., which differs somewhat.) - -------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS: PRETAX AND AFTER-TAX PERIODS ENDED OCTOBER 31, 1999 ----------------------------------------------------- 1 YEAR 5 YEARS 10 YEARS ---------------- ---------------- ----------------- PRETAX AFTER-TAX PRETAX AFTER-TAX PRETAX AFTER-TAX - -------------------------------------------------------------------------------- Vanguard Windsor II Fund 4.6% 1.6% 20.1% 17.3% 14.5% 11.9% Average Large Value Fund* 12.2 10.3 18.2 15.3 14.0 11.4 - -------------------------------------------------------------------------------- *Based on data from Morningstar, Inc. As you can see, the Windsor II Fund's pretax total return of 4.6% for the 12 months ended October 31, 1999, was reduced by taxes to 1.6%. In other words, for investors in the highest tax bracket, the fund's pretax return was cut by 3 percentage points. In comparison, the average comparable fund earned a pretax return of 12.2% and an after-tax return of 10.3%, a difference of 1.9 percentage points. Over longer periods, the fund has fared better. Over the five- and ten-year periods ended October 31, 1999, our fund generated slightly higher returns than the peer-group average, both before and after taxes. We stress that because many interrelated factors affect how tax-friendly a fund may be, it's very difficult to predict tax efficiency. A fund's tax efficiency can be influenced by its turnover rate, the types of securities it holds, the accounting practices it uses when selling shares, and the net cash flow it receives. Finally, it's important to understand that our calculation does not reflect the tax effect of your own investment activities. Specifically, you may incur additional capital gains taxes--thereby lowering your after-tax return--if you decide to sell all or some of your shares. A NOTE ABOUT OUR CALCULATIONS: Pretax total returns assume that all distributions received (income dividends, short-term capital gains, and long-term capital gains) are reinvested in new shares, while our after-tax returns assume that distributions are reduced by any taxes owed on them before reinvestment. When calculating the taxes due, we used the highest individual federal income tax rates at the time of the distributions. Those rates are currently 39.6% for dividends and short-term capital gains and 20% for long-term capital gains. State and local income taxes were not considered. The competitive group returns provided by Morningstar are calculated in a manner consistent with that used for Vanguard funds. 5 THE MARKETS IN PERSPECTIVE YEAR ENDED OCTOBER 31, 1999 Caution followed exuberance in the U.S. stock market during the fiscal year ended October 31, 1999. Improving economic conditions during the first half of the year set off a raucous rally from the lows of summer 1998, when fears of a global economic slump swept world markets. However, during the second half of the fiscal year, interest rates kept rising, pulling down bond prices and tempering the stock market's optimism. The notion of a global slump was replaced by worries that economic growth might be so strong as to threaten a surge in inflation. U.S. STOCK MARKETS A booming U.S. economy and solid increases in corporate earnings lifted the U.S. stock market, especially during the first half of the fiscal year. The nation's economic output increased by about 4% during the year. Consumer spending, which accounts for roughly two-thirds of economic activity, powered the expansion. Americans spent virtually every dollar they earned, encouraged by rising wealth from a long bull market, plentiful employment, and rising incomes. (After-tax personal income rose about 5% during the year; unemployment fell to a 30-year low of 4.1% of the workforce in October.) - -------------------------------------------------------------------------------- AVERAGE ANNUAL RETURNS PERIODS ENDED OCTOBER 31, 1999 ------------------------------ 1 YEAR 3 YEARS 5 YEARS - -------------------------------------------------------------------------------- STOCKS S&P 500 Index 25.7% 26.5% 26.0% Russell 2000 Index 14.9 9.4 12.6 Wilshire 5000 Index 25.7 23.8 23.8 MSCI EAFE Index 23.4 12.5 9.5 - -------------------------------------------------------------------------------- BONDS Lehman Aggregate Bond Index 0.5% 6.2% 7.9% Lehman 10 Year Municipal Bond Index -1.2 5.2 7.0 Salomon Smith Barney 3-Month U.S. Treasury Bill Index 4.6 5.0 5.2 - -------------------------------------------------------------------------------- OTHER Consumer Price Index 2.6% 2.0% 2.4% - -------------------------------------------------------------------------------- From October 31, 1998, through April 30, 1999, the stock market rose 22.8%, as measured by the Wilshire 5000 Total Market Index. Investor confidence, already high due to the booming economy, was bolstered by easier monetary policy--the Federal Reserve cut short-term interest rates in November 1998 for the third time in less than two months. But by summer, the Fed reversed course, twice boosting its target for short-term interest rates to slow the economy and reduce inflationary pressures. Higher interest rates helped take the steam out of the stock market's rally during the second half of the fiscal year, even though estimates of corporate earnings kept rising. Higher rates tend to hurt stocks because many investors use current interest rates to discount the value of a stock's projected earnings and dividends. The higher the rate, the more future earnings are discounted, and the less investors will pay for the stock now. After a second-half gain of 2.3%, the Wilshire 5000 Index recorded a 25.7% return for the full fiscal year. Big stocks outperformed small stocks in fiscal 1999, and growth stocks outpaced value stocks. The S&P 500 Index, which is dominated by large-capitalization stocks, gained 6 25.7%, while the small-cap Russell 2000 Index was up 14.9%. Growth stocks--whose high prices in relation to earnings, book value, and dividends indicate high expectations for future growth--lost none of their appeal, despite soaring valuations for many. Both large- and small-cap growth issues gained roughly 30%, while value stocks within the S&P 500 Index were up 19.0%, and the Russell 2000's value stocks had a scant 0.7% return. The growth/value gap was due partly to the incredible performance of technology stocks, most of which are classified as growth issues. Within the S&P 500 Index, tech stocks gained 67% during the fiscal year. Advances of about 30% were recorded by retailers and other consumer-discretionary stocks and by the utilities sector, where gains were concentrated in telecommunications stocks. The only sector with a loss was consumer staples (-8%), where food and beverage company stocks suffered from falling profits.Other laggards were the auto & transportation sector (+6%) and health-care stocks (+9%). U.S. BOND MARKETS Rapid economic growth was a help to the stock market but a hindrance to bonds. Investors worried that, with unemployment so low, growth above the 2.5% to 3% range would cause wages and prices to accelerate. Indeed, inflation did rise a bit, although the Consumer Price Index was up a relatively modest 2.6% during the 12-month period. As mentioned, the Fed sought to combat inflationary pressures by increasing short-term interest rates by a quarter-point on June 30 and again on August 24. The bond market was already pushing up rates well before the Fed acted. Yields of long-term U.S. Treasury bonds began rising significantly in February. By fiscal year-end, the 30-year Treasury bond's yield was 6.16%, up precisely 1 percentage point for the year. The 10-year Treasury's yield rose 1.41 percentage points, from 4.61% to 6.02%. Short-term interest rates didn't rise as far, and 3-month Treasury bill yields were up 0.77 point to 5.09% at fiscal year-end. Rising interest rates mean lower prices for existing bonds, of course. Price declines were higher for longer-term bonds, which are most sensitive to changing rates. For the taxable bond market as a whole, as measured by the Lehman Aggregate Bond Index, prices fell -5.7%, resulting in a total return of just 0.5% for the fiscal year. High-yield (junk) bonds and mortgage-backed securities posted higher returns than Treasuries. INTERNATIONAL STOCK MARKETS International markets soared in local currencies during the 12 months ended October 31, with European stocks gaining 22.7% and Pacific-region stocks advancing 37.8%. The U.S. dollar rose in value against most European currencies but fell against the Japanese yen. For U.S. investors, the upshot of these currency fluctuations was to trim returns from Europe to 12.7% in dollar terms and to boost returns from the Pacific to 50.5%. In the major developed international markets, U.S. investors earned 23.4%, as measured by the Morgan Stanley Capital International Europe, Australasia, Far East (EAFE) Index. The bull markets in most nations stemmed from a renewed appetite for risk on the part of investors encouraged by clear signs of expanding business activity and generally easier monetary policy. Japan and the rest of Asia, which were hit hardest by currency and economic crises in 1997 and 1998, saw the biggest gains. In Japan, massive government spending programs appeared to be working--at least in the short run--to lift that nation out of a recession. Emerging markets, as measured by the Select Emerging Markets Free Index, gained 34.1% for U.S. investors, as local returns of better than 70% were cut nearly in half by weaker currencies in Latin America and eastern Europe. 7 ADVISER'S REPORT We have been writing shareholder letters for a long time, but this is by far the most difficult. Vanguard Windsor II Fund declined -10.8% during the second half of the fiscal year ended October 31, while the S&P 500 Index gained 2.7% and the S&P 500/BARRA Value Index declined -2.2%. Results for the full fiscal year were equally disappointing, with a 4.6% return for the fund versus gains of 25.7% for the S&P 500 and 19.0% for the Value Index. We are not doing things differently, and our holdings have not radically changed, but the stock market surely has. The economy continues to be vigorous, with employment high and inflation reputed to be very low. Despite a benign Consumer Price Index, prices have been rising for certain items, such as airline tickets, hotel rooms, energy, chemicals, housing, building materials, and health care. Plainly, for the average consumer, increases in such products more than offset the decline in computer prices. In a very real way, the stock market has been responsible for much of the good economic news--including the federal budget surplus and strong consumer spending. Therefore, the Federal Reserve follows equities with more intense interest than ever before. The top 10% of stocks in the Value Index, in terms of their contribution to its fiscal-year return, account for 41% of the index's market weight. Those companies, on average, sell at 43.5 times next year's estimated earnings and 5.0 times current book value. On average, they have a 1.1% dividend yield. Because we emphasize stocks with low price/earnings ratios (the fund's average P/E is 65% of the market's), low price/book ratios (53% of the market's), and high current yields (twice the market's), we did not participate much in that top tenth of the Value Index. If we had known how "cheap" they were in the eyes of the market, this letter would have been easier to write. For the past year, investors have been drawn to growth as never before. They seemed to feel required to sell, at any price, any stock that fell short of expectations in revenues or earnings. Even small disappointments were punished by instantaneous declines of 25% or more. Our problem issues of Waste Management, Raytheon, Xerox, Allstate, Service Corporation International, and J.C. Penney lost 40% within a day or two of announcing earnings disappointments. Waste Management continues to struggle through consolidation problems, the loss of its CEO, who stepped down due to illness, and problems with legacy accounting systems. Management twice lowered earnings expectations, causing Wall Street to lose confidence. The directors have stepped in and are selling underperforming assets, hiring consultants to solve the information technology problems, and bringing on a new CEO with an outstanding reputation. Raytheon recently acquired E-Systems, Hughes, and a division of Texas Instruments, and has been one of the fastest-growing and highest-margin defense companies. In September, its new chairman announced that Raytheon would take additional restructuring charges and that its revenue was slipping because of procurement delays by the U.S. Defense Department and foreign governments. Raytheon's market-leading - ------------------------------------------- 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. - ------------------------------------------- 8 products, combined with projected increases in defense spending, will drive this stock going forward. Xerox suffered from falling prices in the digital copier market and higher expenses associated with its new "Solutions Approach" sales program. The management had been unwilling or unable to inform the investment community about problems, and investors dumped the stock. We feel this situation can improve fairly soon. We purchased Allstate because of its industry-leading position, improving business mix, low-cost operations, energized management, and powerful generation of cash (which it is using to make acquisitions and buy back stock). The stock was selling at a huge discount to the market based on its price/earnings and price/book ratios. Still, Allstate operates in a competitive and challenging industry. In 1999, price competition remained high, claims costs rose (partly due to Hurricane Floyd), and management decided to substantially boost marketing expenditures to sell auto insurance on the Internet and via 800-type offerings. The net effect was that earnings estimates fell by about 15%--but the stock fell twice as much! Allstate now sells for less than 9 times current earnings, at a mere 12% premium to book value. It has a 2.5% dividend yield. Service Corporation International, the world's largest funeral company, is undergoing a transformation from an acquisition story to an operational one. Its investments in personnel, training, and infrastructure have raised current costs, but will have substantial future benefits. Several other factors are hurting revenue growth: Death rates have declined; price competition is tougher; and there is a trend toward cremations. However, we believe the stock will perform much better as the company's transformation is completed and the environment improves. J.C. Penney stock fell due to disappointing sales growth and expectations that higher interest rates will slow consumer spending. The company is going to spin off the Eckerd drug stores, and we expect results to improve. These six companies are industry leaders providing real services. However, they have lost earnings and price momentum, which leads believers in Wall Street's "new paradigm" to sell them. A number of stocks that have underperformed are now significantly undervalued and have become takeover targets for companies that will seek to turn them around and/or sell off pieces. The question arises: "What is the value in value investing?" We continue to believe that price is a very important component of any buying decision, whether a stock or a meal. In relation to the broad market, our holdings are cheaper than at almost any time in the past. On an industry basis, we have concentrations in banks, energy, utilities, and insurance. Our underweighting in technology reflects the fact that few of those issues have value characteristics. We have been through periods like this before, though those memories are not nearly so painful as 1999. For the most part, we are sticking with our holdings. Indeed, we're adding to the cheaper ones. Barrow, Hanley, Mewhinney & Strauss, Inc. November 12, 1999 9 FUND PROFILE WINDSOR II FUND This Profile provides a snapshot of the fund's characteristics as of October 31, 1999, compared where appropriate to an unmanaged index. Key elements of this Profile are defined on page 11. - --------------------------------------------- PORTFOLIO CHARACTERISTICS - --------------------------------------------- WINDSOR II S&P 500 - --------------------------------------------- Number of Stocks 282 500 Median Market Cap $28.3B $72.6B Price/Earnings Ratio 18.0x 27.7x Price/Book Ratio 2.7x 5.1x Yield 2.4% 1.2% Return on Equity 18.8% 23.0% Earnings Growth Rate 8.6% 15.0% Foreign Holdings 1.4% 1.5% Turnover Rate 26% -- Expense Ratio 0.37% -- Cash Reserves 3.2% -- INVESTMENT FOCUS - --------------------------------------------- [GRID] STYLE.........VALUE MARKET CAP....LARGE VOLATILITY MEASURES - --------------------------------------------- WINDSOR II S&P 500 - --------------------------------------------- R-Squared 0.87 1.00 Beta 0.90 1.00 TEN LARGEST HOLDINGS (% OF TOTAL NET ASSETS) - --------------------------------------------- The Chase Manhattan Corp. 3.2% Bank of America Corp. 2.9 SBC Communications Inc. 2.7 GTE Corp. 2.7 Honeywell, Inc. 2.5 Atlantic Richfield Co. 2.4 Citigroup, Inc. 2.1 Washington Mutual, Inc. 2.1 Anheuser-Busch Cos., Inc. 2.1 Baker Hughes, Inc. 2.0 Top Ten 24.7% SECTOR DIVERSIFICATION (% OF COMMON STOCKS) - -------------------------------------------------------------------------------- OCTOBER 31, 1998 OCTOBER 31, 1999 - -------------------------------------------------------------------------------- WINDSOR II WINDSOR II S&P 500 - -------------------------------------------------------------------------------- Auto & Transportation ............ 4.8% 3.4% 2.2% Consumer Discretionary ........... 11.0 10.7 12.5 Consumer Staples ................. 8.4 6.9 7.2 Financial Services ............... 24.0 27.9 16.1 Health Care ...................... 1.8 2.6 11.0 Integrated Oils .................. 3.6 7.4 5.2 Other Energy ..................... 7.9 8.5 1.4 Materials & Processing ........... 3.7 4.2 3.2 Producer Durables ................ 4.8 4.5 3.3 Technology ....................... 3.6 4.4 20.5 Utilities ........................ 18.5 15.1 11.2 Other ............................ 7.9 4.4 6.2 - -------------------------------------------------------------------------------- 10 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 35%.) 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 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. An investor's shares, when redeemed, could be worth more or less than their original cost. TOTAL INVESTMENT RETURNS: JUNE 24, 1985-OCTOBER 31, 1999 - ---------------------------------------|---------------------------------------- WINDSOR II FUND S&P 500 | WINDSOR II FUND S&P 500 FISCAL CAPITAL INCOME TOTAL TOTAL |FISCAL CAPITAL INCOME TOTAL TOTAL YEAR RETURN RETURN RETURN RETURN |YEAR RETURN RETURN RETURN RETURN - ---------------------------------------|---------------------------------------- 1985 -0.9% 1.1% 0.2% 1.8% |1993 15.8% 3.7% 19.5% 14.9% 1986 31.2 4.4 35.6 33.2 |1994 -0.8 3.0 2.2 3.9 1987 -0.6 1.5 0.9 6.4 |1995 19.2 3.9 23.1 26.4 1988 14.5 6.0 20.5 14.8 |1996 23.8 3.4 27.2 24.1 1989 19.5 5.2 24.7 26.4 |1997 28.1 3.2 31.3 32.1 1990 -21.5 4.0 -17.5 -7.5 |1998 14.1 2.4 16.5 22.0 1991 29.4 7.2 36.6 33.5 |1999 2.2 2.4 4.6 25.7 1992 7.9 4.6 12.5 10.0 | - ---------------------------------------|---------------------------------------- See FINANCIAL HIGHLIGHTS table on page 19 for dividend and capital gains information for the past five years. CUMULATIVE PERFORMANCE: OCTOBER 31, 1989 -- OCTOBER 31, 1999 [MOUNTAIN CHART] - -------------------------------------------------------------------------------- WINDSOR II AVERAGE LARGE-CAP S&P 500 FUND VALUE FUND INDEX - -------------------------------------------------------------------------------- 1989/10 10000 10000 10000 1990/01 9614 9681 9747 1990/04 9382 9770 9882 1990/07 9763 10463 10738 1990/10 8252 8965 9252 1991/01 9733 10401 10566 1991/04 10779 11322 11623 1991/07 11168 11729 12108 1991/10 11273 12106 12351 1992/01 11785 12704 12963 1992/04 12216 12931 13253 1992/07 12747 13142 13656 1992/10 12683 13128 13581 1993/01 13527 13964 14334 1993/04 13860 14238 14478 1993/07 14449 14578 14849 1993/10 15157 15483 15610 1994/01 15567 16037 16180 1994/04 14763 15189 15248 1994/07 15100 15404 15615 1994/10 15493 15917 16214 1995/01 15396 15812 16266 1995/04 16911 17275 17911 1995/07 18204 18724 19692 1995/10 19069 19423 20501 1996/01 21407 21230 22555 1996/04 22317 22008 23323 1996/07 21920 21448 22954 1996/10 24250 23741 25441 1997/01 26848 26244 28497 1997/04 27138 26559 29184 1997/07 31954 31345 34922 1997/10 31835 30500 33610 1998/01 33519 32162 36165 1998/04 38787 35948 41169 1998/07 37820 35210 41657 1998/10 37092 34883 41001 1999/01 39817 39029 47915 1999/04 43497 41258 50154 1999/07 41820 40773 50073 1999/10 38787 41026 51526 - -------------------------------------------------------------------------------- AVERAGE ANNUAL TOTAL RETURNS PERIODS ENDED OCTOBER 31, 1999 ------------------------------------ FINAL VALUE OF A 1 YEAR 5 YEARS 10 YEARS $10,000 INVESTMENT - -------------------------------------------------------------------------------- Windsor II Fund 4.57% 20.15% 14.52% $38,787 Average Large-Cap Value Fund* 17.61 20.85 15.16 41,026 S&P 500 Index 25.67 26.02 17.82 51,526 - -------------------------------------------------------------------------------- *Derived from data provided by Lipper Inc. AVERAGE ANNUAL TOTAL RETURNS: PERIODS ENDED SEPTEMBER 30, 1999* - -------------------------------------------------------------------------------- 10 YEARS INCEPTION ---------------------------- DATE 1 YEAR 5 YEARS CAPITAL INCOME TOTAL - -------------------------------------------------------------------------------- Windsor II Fund 6/24/1985 10.33% 20.10% 10.19% 3.75% 13.94% - -------------------------------------------------------------------------------- *SEC rules require that we provide this average annual total return information through the last calendar quarter. 12 FINANCIAL STATEMENTS OCTOBER 31, 1999 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, but may differ because certain investments or transactions may be treated differently for financial statement and tax purposes. 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* SHARES (000) - -------------------------------------------------------------------------------- WINDSOR II FUND - -------------------------------------------------------------------------------- COMMON STOCKS (92.9%)+ - -------------------------------------------------------------------------------- AUTO & TRANSPORTATION (3.1%) Ford Motor Co. 8,675,800 476,085 General Motors Corp. 5,972,300 419,554 Burlington Northern Santa Fe Corp. 333,300 10,624 Delta Air Lines, Inc. 151,600 8,253 Tidewater Inc. 224,600 6,738 o UAL Corp. 88,900 6,051 TRW, Inc. 141,100 6,050 PACCAR, Inc. 122,300 5,763 o Continental Airlines, Inc. Class B 128,000 5,184 o SPX Corp. 59,400 5,034 o Navistar International Corp. 117,300 4,890 Autoliv, Inc. 146,470 4,678 Cooper Tire & Rubber Co. 98,600 1,658 ----------- 960,562 ----------- CONSUMER DISCRETIONARY (9.9%) o(1) Kmart Corp. 41,622,500 418,826 Waste Management, Inc. 22,355,297 410,779 Sears, Roebuck & Co. 14,335,200 404,073 Gannett Co., Inc. 4,105,200 316,614 Wal-Mart Stores, Inc. 5,282,300 299,440 (1) Service Corp. International 23,045,900 220,376 Time Warner, Inc. 2,491,000 173,592 o The Walt Disney Co. 6,074,932 160,226 J.C. Penney Co., Inc. 5,878,200 149,159 Eastman Kodak Co. 1,942,700 133,925 Kimberly-Clark Corp. 1,728,200 109,093 Newell Rubbermaid, Inc. 2,990,600 103,550 Dayton Hudson Corp. 680,300 43,964 o Viacom Inc. Class B 200,800 8,986 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- Hasbro, Inc. 321,200 6,625 o AT&T Corp.-Liberty Media Group Class A 152,000 6,033 The Limited, Inc. 141,200 5,807 o Tricon Global Restaurants, Inc. 143,300 5,759 Darden Restaurants Inc. 295,100 5,625 o Mandalay Resort Group 274,500 5,113 Galileo International, Inc. 166,400 5,002 McDonald's Corp. 120,600 4,975 R.R. Donnelley & Sons Co. 203,600 4,937 Premark International, Inc. 85,700 4,692 o Toys R Us, Inc. 294,800 4,164 Maytag Corp. 100,300 4,018 o Cendant Corp. 213,600 3,524 The Warnaco Group, Inc. Class A 226,600 3,229 May Department Stores Co. 74,037 2,568 American Greetings Corp. Class A 98,600 2,551 o Outback Steakhouse Inc. 85,300 1,962 o The Neiman Marcus Group, Inc. Class A 55,600 1,331 Dillard's Inc. 68,800 1,299 VF Corp. 24,300 731 o ACNielson Corp. 28,600 629 IKON Office Solutions, Inc. 58,500 402 Hertz Corp. Class A 5,200 226 ----------- 3,033,805 ----------- CONSUMER STAPLES (6.4%) Anheuser-Busch Cos., Inc. 8,956,000 643,153 Philip Morris Cos., Inc. 22,592,000 569,036 Imperial Tobacco Group ADR 12,448,100 259,854 13 - -------------------------------------------------------------------------------- MARKET VALUE* WINDSOR II FUND SHARES (000) - -------------------------------------------------------------------------------- PepsiCo, Inc. 6,186,600 214,598 H.J. Heinz Co. 2,802,200 133,805 Sara Lee Corp. 2,896,300 78,381 Nabisco Group Holdings Corp. 3,220,600 41,264 IBP, Inc. 249,700 5,977 Tyson Foods, Inc. 294,400 4,490 SuperValu Inc. 157,000 3,297 ConAgra, Inc. 50,000 1,303 Brown-Forman Corp. Class B 15,100 1,019 Dean Foods Corp. 9,900 458 ----------- 1,956,635 ----------- FINANCIAL SERVICES (26.0%) BANKS--NEW YORK CITY (3.4%) The Chase Manhattan Corp. 11,352,956 991,965 The Bank of New York Co., Inc. 366,400 15,343 J.P. Morgan & Co., Inc. 104,400 13,663 Republic New York Corp. 90,700 5,731 BANKS--OUTSIDE NEW YORK CITY (10.1%) Bank of America Corp. 13,714,212 882,852 First Union Corp. 13,769,602 587,790 PNC Bank Corp. 9,687,900 577,641 Bank One Corp. 11,199,283 420,673 Wells Fargo Co. 8,329,100 398,756 SunTrust Banks, Inc. 1,687,000 123,467 Fleet Boston Corp. 443,084 19,330 Wachovia Corp. 130,200 11,230 KeyCorp 327,200 9,141 AmSouth Bancorp 278,100 7,161 UnionBanCal Corp. 146,678 6,371 Old Kent Financial Corp. 145,500 5,929 Pacific Century Financial Corp. 203,000 4,631 City National Corp. 105,400 4,084 Peoples Heritage Financial Group Inc. 170,300 3,236 U.S. Bancorp 86,300 3,198 Huntington Bancshares Inc. 99,400 2,945 SouthTrust Corp. 61,300 2,452 Commerce Bancshares, Inc. 34,860 1,351 Provident Financial Group, Inc. 29,600 1,271 National City Corp. 27,900 823 DIVERSIFIED FINANCIAL SERVICES (3.4%) Citigroup, Inc. 12,070,880 653,336 Morgan Stanley Dean Witter & Co. 1,773,800 195,672 American General Corp. 1,965,400 145,808 Merrill Lynch & Co., Inc. 200,300 15,724 PaineWebber Group, Inc. 155,100 6,320 The CIT Group, Inc. 216,900 5,178 American Express Co. 23,700 3,650 Marsh & McLennan Cos., Inc. 13,900 1,099 Household International, Inc. 17,400 776 FINANCE COMPANIES Mellon Financial Corp. 325,400 12,019 o FIRSTPLUS Financial Group, Inc. 319,300 42 FINANCIAL DATA PROCESS SERVICES First Data Corp. 126,900 5,798 Deluxe Corp. 176,000 4,972 o DST Systems, Inc. 53,000 3,375 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- FINANCIAL INFORMATION SERVICES Dow Jones & Co., Inc. 98,000 6,027 Dun & Bradstreet Corp. 107,400 3,155 FINANCIAL MISCELLANEOUS (1.7%) Fannie Mae 7,173,500 507,525 Nationwide Financial Services, Inc. 134,400 5,090 AMBAC Financial Group Inc. 73,900 4,416 Associates First Capital Corp. 24,900 909 INSURANCE--LIFE Jefferson-Pilot Corp. 118,300 8,880 INSURANCE--MULTILINE (4.9%) Allstate Corp. 19,282,044 554,359 (1) Aon Corp. 13,202,862 468,702 American International Group, Inc. 4,186,361 430,934 The Hartford Financial Services Group Inc. 185,600 9,616 CIGNA Corp. 118,000 8,821 Hartford Life, Inc. 122,000 6,375 Old Republic International Corp. 267,100 3,656 American National Insurance Co. 4,700 322 INSURANCE--PROPERTY-CASUALTY (0.1%) Travelers Property Casualty Corp. 188,200 6,775 The PMI Group Inc. 109,350 5,673 Everest Reinsurance Holdings, Inc. 152,900 3,937 REAL ESTATE INVESTMENT TRUST (0.1%) Equity Office Properties Trust REIT 309,400 6,845 Equity Residential Properties Trust REIT 158,100 6,611 Simon Property Group, Inc. REIT 197,000 4,543 Host Marriott Corp. REIT 434,300 3,909 Spieker Properties, Inc. REIT 43,500 1,520 RENT & LEASE SERVICES--COMMERCIAL Ryder System, Inc. 227,200 4,856 SAVINGS & LOAN (2.2%) Washington Mutual, Inc. 17,993,194 646,630 Golden West Financial Corp. 65,600 7,331 o Golden State Bancorp Inc. 298,400 6,229 Dime Bancorp, Inc. 309,000 5,523 Sovereign Bancorp, Inc. 506,600 4,464 Charter One Financial, Inc. 59,745 1,467 Peoples Bank Bridgeport 47,000 1,190 SECURITIES BROKERS & SERVICES (0.1%) Bear Stearns Co., Inc. 171,000 7,289 A.G. Edwards & Sons, Inc. 229,850 6,910 Legg Mason Inc. 145,600 5,296 Countrywide Credit Industries, Inc. 148,800 5,050 ----------- 7,915,638 ----------- 14 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- HEALTH CARE (2.4%) American Home Products Corp. 4,861,900 254,034 Bristol-Myers Squibb Co. 2,254,000 173,135 Columbia/HCA Healthcare Corp. 6,676,500 161,071 Aetna Inc. 1,831,500 92,033 Abbott Laboratories 296,000 11,951 United Healthcare Corp. 119,300 6,166 Johnson & Johnson 54,600 5,719 o Chiron Corp. 188,900 5,395 o IVAX Corp. 298,600 5,244 C.R. Bard, Inc. 96,100 5,183 o Tenet Healthcare Corp. 251,900 4,896 Mylan Laboratories, Inc. 241,600 4,334 Pharmacia & Upjohn, Inc. 69,700 3,759 o Genzyme Corp. 13,200 505 ----------- 733,425 ----------- INTEGRATED OILS (6.9%) Atlantic Richfield Co. 8,029,000 748,202 (1) Occidental Petroleum Corp. 20,894,900 476,665 Phillips Petroleum Co. 9,517,500 442,564 Mobil Corp. 1,980,100 191,080 Exxon Corp. 2,466,100 182,646 Conoco Inc. Class B 1,341,500 36,388 Chevron Corp. 177,200 16,181 Texaco Inc. 111,200 6,825 Amerada Hess Corp. 109,100 6,260 ----------- 2,106,811 ----------- OTHER ENERGY (7.9%) (1) Baker Hughes, Inc. 21,645,400 604,718 Schlumberger Ltd. 8,854,500 536,251 Halliburton Co. 14,083,900 530,787 Williams Cos., Inc. 13,044,046 489,152 Enron Corp. 5,502,600 219,760 Tosco Corp. 261,100 6,609 Apache Corp. 117,200 4,571 Ashland, Inc. 122,700 4,049 Sunoco, Inc. 159,000 3,836 Ultramar Diamond Shamrock Corp. 145,700 3,570 Union Pacific Resources Group, Inc. 198,900 2,884 EOG Resources, Inc. 81,700 1,700 Dynegy, Inc. 30,500 698 ----------- 2,408,585 ----------- MATERIALS & PROCESSING (3.9%) (1) Fort James Corp. 18,728,600 492,796 (1) Millennium Chemicals, Inc. 7,719,942 142,819 Phelps Dodge Corp. 2,523,400 142,257 Dow Chemical Co. 1,187,100 140,375 Hanson PLC ADR 3,426,750 132,572 CK Witco Corp. 5,020,069 47,063 E.I. du Pont de Nemours & Co. 212,787 13,711 The Mead Corp. 179,500 6,462 The Timber Co. 258,000 6,160 Praxair, Inc. 130,800 6,115 USG Corp. 119,000 5,898 USX-U.S. Steel Group 228,800 5,849 Lafarge Corp. 171,000 5,077 - -------------------------------------------------------------------------------- MARKET VALUE* SHARES (000) - -------------------------------------------------------------------------------- Solutia, Inc. 286,600 4,926 Avery Dennison Corp. 63,500 3,969 Louisiana-Pacific Corp. 284,300 3,607 Armstrong World Industries Inc. 96,500 3,607 Engelhard Corp. 190,100 3,351 Boise Cascade Corp. 92,400 3,292 IMC Global Inc. 224,000 2,856 Alcoa Inc. 41,800 2,539 Johns Manville Corp. 220,000 2,406 International Paper Co. 29,200 1,537 Owens Corning 30,800 631 Westvaco Corp. 18,500 549 ----------- 1,180,424 ----------- PRODUCER DURABLES (4.1%) (1) Honeywell, Inc. 7,242,700 763,652 Xerox Corp. 13,739,742 384,713 Lockheed Martin Corp. 3,502,800 70,056 Emerson Electric Co. 135,900 8,162 The Boeing Co. 170,300 7,844 United Technologies Corp. 123,696 7,484 o Teradyne, Inc. 143,100 5,509 Northrop Grumman Corp. 73,300 4,022 Pitney Bowes, Inc. 86,600 3,946 Molex, Inc. 67,500 2,464 Pentair, Inc. 58,000 2,182 Caterpillar, Inc. 23,600 1,304 o Howmet International Inc. 77,100 1,137 Centex Corp. 40,800 1,094 Diebold, Inc. 32,300 848 Tecumseh Products Co. Class A 9,160 439 The BFGoodrich Co. 15,100 358 ----------- 1,265,214 ----------- TECHNOLOGY (4.1%) Electronic Data Systems Corp. 7,873,500 460,600 Raytheon Co. Class B 10,916,600 317,946 Intel Corp. 2,730,000 211,404 International Business Machines Corp. 2,053,500 202,013 o Apple Computer, Inc. 129,100 10,344 Motorola, Inc. 86,800 8,458 o Safeguard Scientifics, Inc. 85,300 7,176 o National Semiconductor Corp. 217,100 6,499 o General Instrument Corp. 106,600 5,736 o NCR Corp. 143,500 4,753 Hewlett-Packard Co. 55,000 4,073 o SCI Systems, Inc. 78,300 3,866 o Seagate Technology Inc. 109,200 3,215 o SDL, Inc. 15,900 1,961 Compaq Computer Corp. 20,300 386 ----------- 1,248,430 ----------- UTILITIES (14.0%) SBC Communications Inc. 16,023,947 816,220 GTE Corp. 10,872,600 815,445 (1) Entergy Corp. 19,851,400 594,301 (1) American Electric Power Co., Inc. 10,090,300 348,115 Reliant Energy, Inc. 10,869,900 296,205 FirstEnergy Corp. 10,629,177 277,023 (1) Central & South West Corp. 12,443,000 276,079 AT&T Corp. 4,613,317 215,673 15 - -------------------------------------------------------------------------------- MARKET VALUE* WINDSOR II FUND SHARES (000) - -------------------------------------------------------------------------------- o MCI WorldCom, Inc. 2,435,648 209,009 Public Service Enterprise Group, Inc. 5,263,300 208,229 BellSouth Corp. 764,800 34,416 Bell Atlantic Corp. 467,136 30,335 Sprint Corp. 315,880 23,474 Southern Co. 415,600 11,039 Telephone & Data Systems, Inc. 72,900 8,402 Edison International 283,200 8,390 o MediaOne Group, Inc. 110,200 7,831 PG&E Corp. 327,600 7,514 CenturyTel, Inc. 171,650 6,941 o U.S. Cellular Corp. 73,500 6,505 GPU, Inc. 188,300 6,390 Ameren Corp. 168,200 6,360 o Cox Communications, Inc. Class A 138,800 6,307 Energy East Corp. 248,000 6,231 MidAmerican Energy Holdings Co. 184,900 6,217 DTE Energy Co. 187,100 6,209 PP&L Resources Inc. 222,288 6,016 Constellation Energy Group 195,600 6,002 Unicom Corp. 140,700 5,391 ALLTEL Corp. 64,600 5,378 Pinnacle West Capital Corp. 109,000 4,019 Consolidated Edison Inc. 99,200 3,788 FPL Group, Inc. 59,500 2,994 Duke Energy Corp. 46,700 2,639 o Citizens Utilities Co. Class B 185,000 2,139 Allegheny Energy, Inc. 52,600 1,673 Cinergy Corp. 50,000 1,413 U S WEST, Inc. 10,300 629 PECO Energy Corp. 15,000 573 ----------- 4,281,514 ----------- OTHER (4.2%) General Electric Co. 2,784,200 377,433 AlliedSignal Inc. 5,603,200 319,032 (1) ITT Industries, Inc. 9,282,100 317,332 (1) Tenneco, Inc. 13,588,800 217,421 Minnesota Mining & Manufacturing Co. 230,500 21,912 Textron, Inc. 97,300 7,510 Loews Corp. 63,000 4,465 Johnson Controls, Inc. 57,500 3,493 Fortune Brands, Inc. 70,800 2,509 Brunswick Corp. 98,600 2,231 Crane Co. 91,950 1,879 o FMC Corp. 38,800 1,579 Lancaster Colony Corp. 39,500 1,380 ----------- 1,278,176 ----------- - -------------------------------------------------------------------------------- TOTAL COMMON STOCKS (COST $22,960,628) 28,369,219 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- FACE MARKET AMOUNT VALUE* (000) (000) - -------------------------------------------------------------------------------- TEMPORARY CASH INVESTMENTS (7.4%)+ - -------------------------------------------------------------------------------- FEDERAL HOME LOAN MORTGAGE CORP. (2) 5.57%, 2/3/2000 10,000 9,843 FEDERAL NATIONAL MORTGAGE ASSN. (2) 5.53%, 1/28/2000 17,200 16,944 (2) 5.64%, 1/21/2000 55,000 54,246 REPURCHASE AGREEMENTS Collateralized by U.S. Government Obligations in a Pooled Cash Account 5.24%, 11/1/1999 2,170,817 2,170,817 5.26%, 11/1/1999--Note G 2,215 2,215 - -------------------------------------------------------------------------------- TOTAL TEMPORARY CASH INVESTMENTS (COST $2,254,166) 2,254,065 - -------------------------------------------------------------------------------- TOTAL INVESTMENTS (100.3%) (COST $25,214,794) 30,623,284 - -------------------------------------------------------------------------------- OTHER ASSETS AND LIABILITIES (-0.3%) - -------------------------------------------------------------------------------- Other Assets--Note C 125,688 Liabilities--Note G (208,143) ----------- (82,455) - -------------------------------------------------------------------------------- NET ASSETS (100%) - -------------------------------------------------------------------------------- Applicable to 1,051,864,256 outstanding $.001 par value shares of beneficial interest (unlimited authorization) $30,540,829 ================================================================================ NET ASSET VALUE PER SHARE $29.03 ================================================================================ * See Note A in Notes to Financial Statements. o Non-Income-Producing Security. + The fund invests a portion of its cash reserves in equity markets through the use of index futures contracts. After giving effect to futures investments, the fund's effective common stock and temporary cash investment positions represent 96.8% and 3.5%, respectively, of net assets. See Note F 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 $5,341,802,000. (2) Security segregated as initial margin for open futures contracts. ADR--American Depositary Receipt. REIT--Real Estate Investment Trust. - -------------------------------------------------------------------------------- AT OCTOBER 31, 1999, NET ASSETS CONSISTED OF: - -------------------------------------------------------------------------------- AMOUNT PER (000) SHARE - -------------------------------------------------------------------------------- Paid in Capital $22,391,512 $21.28 Undistributed Net Investment Income 223,131 .21 Accumulated Net Realized Gains 2,498,602 2.38 Unrealized Appreciation-- Note F Investment Securities 5,408,490 5.14 Futures Contracts 19,094 .02 - -------------------------------------------------------------------------------- NET ASSETS $30,540,829 $29.03 ================================================================================ 16 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, 1999 (000) - -------------------------------------------------------------------------------- INVESTMENT INCOME INCOME Dividends* 676,050 Interest 111,896 Security Lending 161 ----------- Total Income 788,107 ----------- EXPENSES Investment Advisory Fees--Note B Basic Fee 39,214 Performance Adjustment (1,642) The Vanguard Group--Note C Management and Administrative 76,419 Marketing and Distribution 5,283 Custodian Fees 74 Auditing Fees 27 Shareholders' Reports 732 Trustees' Fees and Expenses 49 ----------- Total Expenses 120,156 Expenses Paid Indirectly--Note D (2,051) ----------- Net Expenses 118,105 - -------------------------------------------------------------------------------- NET INVESTMENT INCOME 670,002 - -------------------------------------------------------------------------------- REALIZED NET GAIN Investment Securities Sold* 2,259,982 Futures Contracts 340,033 - -------------------------------------------------------------------------------- REALIZED NET GAIN 2,600,015 - -------------------------------------------------------------------------------- CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) Investment Securities (1,852,721) Futures Contracts (78,391) - -------------------------------------------------------------------------------- CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION) (1,931,112) - -------------------------------------------------------------------------------- NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $1,338,905 ================================================================================ *Dividend income and realized net gain from affiliated companies were $165,984,000 and $34,822,000, respectively. 17 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, ---------------------- 1999 1998 (000) (000) - -------------------------------------------------------------------------------- INCREASE (DECREASE) IN NET ASSETS OPERATIONS Net Investment Income 670,002 589,221 Realized Net Gain 2,600,015 2,457,628 Change in Unrealized Appreciation (Depreciation) (1,931,112) 694,834 ---------------------- Net Increase in Net Assets Resulting from Operations 1,338,905 3,741,683 ---------------------- DISTRIBUTIONS Net Investment Income (741,695) (541,835) Realized Capital Gain (2,559,664) (1,694,611) ---------------------- Total Distributions (3,301,359) (2,236,446) ---------------------- CAPITAL SHARE TRANSACTIONS1 Issued 6,123,676 7,469,255 Issued in Lieu of Cash Distributions 3,148,067 2,144,820 Redeemed (6,407,121) (4,048,511) ---------------------- Net Increase from Capital Share Transactions 2,864,622 5,565,564 Total Increase 902,168 7,070,801 - -------------------------------------------------------------------------------- NET ASSETS Beginning of Year 29,638,661 22,567,860 ---------------------- End of Year $30,540,829 $29,638,661 ================================================================================ 1Shares Issued (Redeemed) Issued 198,010 243,421 Issued in Lieu of Cash Distributions 109,009 75,460 Redeemed (209,049) (133,672) Net Increase in Shares Outstanding 97,970 185,209 ================================================================================ 18 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 1999 1998 1997 1996 1995 - ----------------------------------------------------------------------------------------------------------- NET ASSET VALUE, BEGINNING OF YEAR $31.07 $29.36 $24.04 $20.06 $17.33 - ----------------------------------------------------------------------------------------------------------- INVESTMENT OPERATIONS Net Investment Income .64 .65 .64 .62 .58 Net Realized and Unrealized Gain (Loss) on Investments .73 3.91 6.47 4.63 3.17 ---------------------------------------------- Total from Investment Operations 1.37 4.56 7.11 5.25 3.75 ---------------------------------------------- DISTRIBUTIONS Dividends from Net Investment Income (.74) (.66) (.63) (.58) (.55) Distributions from Realized Capital Gains (2.67) (2.19) (1.16) (.69) (.47) Total Distributions (3.41) (2.85) (1.79) (1.27) (1.02) - ----------------------------------------------------------------------------------------------------------- NET ASSET VALUE, END OF YEAR $29.03 $31.07 $29.36 $24.04 $20.06 =========================================================================================================== TOTAL RETURN 4.57% 16.51% 31.27% 27.17% 23.08% =========================================================================================================== RATIOS/SUPPLEMENTAL DATA Net Assets, End of Year (Millions) $30,541 $29,639 $22,568 $14,758 $10,272 Ratio of Total Expenses to Average Net Assets 0.37% 0.41% 0.37% 0.39% 0.40% Ratio of Net Investment Income to Average Net Assets 2.08% 2.16% 2.49% 2.92% 3.27% Portfolio Turnover Rate 26% 31% 30% 32% 30% ===========================================================================================================
19 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 CONTRACTS: 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 share 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. 20 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 $511,000 for the year ended October 31, 1999. For the year ended October 31, 1999, the aggregate investment advisory fee represented an effective annual basic rate of 0.12% of average net assets before a decrease of $1,642,000 (0.01%) 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, 1999, the fund had contributed capital of $6,582,000 to Vanguard (included in Other Assets), representing 0.02% of the fund's net assets and 6.6% of Vanguard's capitalization. The fund's Trustees and officers are also Directors and officers of Vanguard. D. 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 management and administrative expenses. The fund's custodian has also agreed to reduce its fees when the fund maintains cash on deposit in the non-interest-bearing custody account. For the year ended October 31, 1999, these arrangements reduced expenses by $2,045,000 and $6,000 respectively. The total expense reduction represented an effective annual rate of 0.01% of the fund's average net assets. E. During the year ended October 31, 1999, the fund purchased $8,073,231,000 of investment securities and sold $7,658,527,000 of investment securities, other than temporary cash investments. F. At October 31, 1999, net unrealized appreciation of investment securities for financial reporting and federal income tax purposes was $5,408,490,000, consisting of unrealized gains of $8,450,647,000 on securities that had risen in value since their purchase and $3,042,157,000 in unrealized losses on securities that had fallen in value since their purchase. At October 31, 1999, the aggregate settlement value of open futures contracts expiring in December 1999 and the related unrealized appreciation (depreciation) were: - -------------------------------------------------------------------------------- (000) ----------------------------------- AGGREGATE UNREALIZED NUMBER OF SETTLEMENT APPRECIATION FUTURES CONTRACTS LONG CONTRACTS VALUE (DEPRECIATION) - -------------------------------------------------------------------------------- S&P 500 Index 3,028 $1,041,783 $22,378 S&P MidCap 400 Index 710 142,444 (3,284) - -------------------------------------------------------------------------------- Net unrealized appreciation on open futures contracts is required to be treated as realized gain for tax purposes. G. The market value of securities on loan to broker/dealers at October 31, 1999, was $40,000, for which the fund held cash collateral of $2,215,000. Cash collateral received is invested in repurchase agreements. 21 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and 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, 1999, 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, 1999 by correspondence with the custodian and brokers, provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 November 30, 1999 22 - -------------------------------------------------------------------------------- SPECIAL 1999 TAX INFORMATION (UNAUDITED) FOR VANGUARD WINDSOR II FUND This information for the fiscal year ended October 31, 1999, is included pursuant to provisions of the Internal Revenue Code. The fund distributed $2,166,607,000 as capital gain dividends (from net long-term capital gains) to shareholders in December 1998, all of which is designated as a 20% rate gain distribution. For corporate shareholders, 61.2% of investment income (dividend income plus short-term gains, if any) qualifies for the dividends-received deduction. - -------------------------------------------------------------------------------- 23 THE VANGUARD FAMILY OF FUNDS STOCK FUNDS - -------------------------------------------------------------------------------- 500 Index Fund Aggressive Growth Fund Capital Opportunity Fund Convertible Securities Fund Emerging Markets Stock Index Fund Energy Fund Equity Income Fund European Stock Index Fund Explorer Fund Extended Market Index Fund* Global Equity Fund Gold and Precious Metals Fund Growth and Income Fund Growth Index Fund* Health Care Fund Institutional Index Fund* International Growth Fund International Value Fund Mid-Cap Index Fund* Morgan Growth Fund Pacific Stock Index Fund PRIMECAP Fund REIT Index Fund Selected Value Fund Small-Cap Growth Index Fund* Small-Cap Index Fund* Small-Cap Value Index Fund* Tax-Managed Capital Appreciation Fund* Tax-Managed Growth and Income Fund* Tax-Managed International Fund Tax-Managed Small-Cap Fund* Total International Stock Index Fund Total Stock Market Index Fund* U.S. Growth Fund Utilities Income Fund Value Index Fund* Windsor Fund Windsor II Fund BALANCED FUNDS - -------------------------------------------------------------------------------- Asset Allocation Fund Balanced Index Fund Global Asset Allocation Fund LifeStrategy Conservative Growth Fund LifeStrategy Growth Fund LifeStrategy Income Fund LifeStrategy Moderate Growth Fund STAR Fund Tax-Managed Balanced Fund Wellesley Income Fund Wellington Fund BOND FUNDS - -------------------------------------------------------------------------------- Admiral Intermediate-Term Treasury Fund Admiral Long-Term Treasury Fund Admiral Short-Term Treasury Fund GNMA Fund High-Yield Corporate Fund High-Yield Tax-Exempt Fund Insured Long-Term Tax-Exempt Fund Intermediate-Term Bond Index Fund Intermediate-Term Corporate Fund Intermediate-Term Tax-Exempt Fund Intermediate-Term Treasury Fund Limited-Term Tax-Exempt Fund Long-Term Bond Index Fund Long-Term Corporate Fund Long-Term Tax-Exempt Fund Long-Term Treasury Fund Preferred Stock Fund Short-Term Bond Index Fund Short-Term Corporate Fund* Short-Term Federal Fund Short-Term Tax-Exempt Fund Short-Term Treasury Fund State Tax-Exempt Bond Funds (California, Florida, Massachusetts, New Jersey, New York, Ohio, Pennsylvania) Total Bond Market Index Fund* MONEY MARKET FUNDS - -------------------------------------------------------------------------------- Admiral Treasury Money Market Fund Federal Money Market Fund Prime Money Market Fund* State Tax-Exempt Money Market Funds (California, New Jersey, New York, Ohio, Pennsylvania) Tax-Exempt Money Market Fund Treasury Money Market Fund VARIABLE ANNUITY PLAN - -------------------------------------------------------------------------------- Balanced Portfolio Diversified Value Portfolio Equity Income Portfolio Equity Index Portfolio Growth Portfolio High-Grade Bond Portfolio High Yield Bond Portfolio International Portfolio Mid-Cap Index Portfolio Money Market Portfolio REIT Index Portfolio Short-Term Corporate Portfolio Small Company Growth Portfolio *Offers Institutional Shares. For information about Vanguard funds, including charges and expenses, obtain a prospectus from The Vanguard Group, P.O. Box 2600, Valley Forge, PA 19482-2600. Read it carefully before you invest or send money. - -------------------------------------------------------------------------------- THE PEOPLE WHO GOVERN YOUR FUND The Trustees of your mutual fund are there to see that the fund is operated and managed in your best interests since, as a shareholder, you are part owner of the fund. Your fund Trustees also serve on the Board of Directors of The Vanguard Group, which is owned by the funds and exists solely to provide services to them on an at-cost basis. Seven of Vanguard's nine board members are independent, meaning that they have no affiliation with Vanguard or the funds they oversee, apart from the sizable personal investments they have made as private individuals. They bring distinguished backgrounds in business, academia, and public service to their task of working with Vanguard officers to establish the policies and oversee the activities of the funds. Among board members' responsibilities are selecting investment advisers for the funds; monitoring fund operations, performance, and costs; reviewing contracts; nominating and selecting new Trustees/Directors; and electing Vanguard officers. The list below provides a brief description of each Trustee's professional affiliations. Noted in parentheses is the year in which the Trustee joined the Vanguard Board. - -------------------------------------------------------------------------------- TRUSTEES JOHN C. BOGLE (1967) 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 (1987) 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. JOANN HEFFERNAN HEISEN (1998) Vice President, Chief Information Officer, and a member of the Executive Committee of Johnson & Johnson; Director of Johnson & JohnsonoMerck Consumer Pharmaceuticals Co., The Medical Center at Princeton, and Women's Research and Education Institute. BRUCE K. MACLAURY (1990) President Emeritus of The Brookings Institution; Director of American Express Bank Ltd., The St. Paul Companies, Inc., and National Steel Corp. BURTON G. MALKIEL (1977) 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 Select Sector SPDR Trust. ALFRED M. RANKIN, JR. (1993) 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 (1991) 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. (1971) 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 (1985) Retired Chairman 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. VANGUARD MANAGING DIRECTORS R. GREGORY BARTON o Legal Department. ROBERT A. DISTEFANO o Information Technology. JAMES H. GATELY o Individual Investor Group. KATHLEEN C. GUBANICH o Human Resources. IAN A. MACKINNON o Fixed Income Group. F. WILLIAM MCNABB, III o Institutional Investor Group. MICHAEL S. MILLER o Planning and Development. RALPH K. PACKARD o Chief Financial Officer. GEORGE U. SAUTER o Core Management Group. ABOUT OUR COVER Our cover art, depicting HMS Vanguard at sea, is a reproduction of Leading the Way, a 1984 work created and copyrighted by noted naval artist Tom Freeman, of Forest Hill, Maryland. All comparative mutual fund data are from Lipper Inc. or Morningstar, Inc., unless otherwise noted. "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. [SHIP LOGO] [THE VANGUARD GROUP LOGO] Post Office Box 2600 Valley Forge, Pennsylvania 19482-2600 WORLD WIDE WEB www.vanguard.com FUND INFORMATION 1-800-662-7447 INDIVIDUAL ACCOUNT SERVICES 1-800-662-2739 INSTITUTIONAL INVESTOR SERVICES 1-800-523-1036 This report is intended for the fund's shareholders. It may not be distributed to prospective investors unless it is preceded or accompanied by the current fund prospectus. Q730-12/09/1999 (C) 1999 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. -----END PRIVACY-ENHANCED MESSAGE-----