<PAGE> 1
VANGUARD
EQUITY INCOME
FUND
Annual Report
September 30, 1996
THE VANGUARD GROUP:
LINKING TRADITION
AND INNOVATION
At Vanguard, we treasure our rich nautical heritage--even as we steer
our course toward the twenty-first century. Our Report cover reflects that
blending of tradition and innovation, of past, present, and future. The montage
includes a bronze medallion with a likeness of our namesake, HMS Vanguard (Lord
Nelson's flagship at The Battle of the Nile); a clock built circa 1816 in
Scotland, featuring a portrait of Nelson (who is also shown, accepting a
surrender, in a detail from a nineteenth-century engraving); and several views
of our recently completed campus, which is steeped in nautical imagery--from
our buildings named after Nelson's warships (Victory, Majestic, and Goliath are
three shown), to our artwork and ornamental compass rose.
[HMS VANGUARD LOGO]
<PAGE> 2
[PHOTO]
VANGUARD HAS ALWAYS STRIVED TO BE THE STANDARD-BEARER for mutual fund
disclosure, going well beyond the "letter of the law" in our shareholder
communications. During the past year, we raised the standard once again by
rewriting and reformatting our Fund prospectuses. They are designed to ensure
that prospective investors fully understand, before they make an investment,
each Fund's investment strategies, risks, and costs. In that spirit, we have
redesigned our Annual Reports to shareholders, which provide a comprehensive
discussion and analysis of the year's results in the context of each Fund's
investment objectives and policies. Since Vanguard has long been recognized for
the quality and content of these Fund Reports, our overriding objective was to
maintain the character of the previous Reports, while adding information to
assist shareholders in understanding the investment characteristics of their
Fund.
THE NEW FUND REPORTS INCLUDE A MESSAGE TO SHAREHOLDERS from Chairman John C.
Bogle and President John J. Brennan. This Message continues to
provide a candid assessment of the Fund's performance relative to an
appropriate unmanaged market benchmark and a peer group of mutual
funds with similar investment policies. It also reviews the principal
factors contributing to--and detracting from--the returns earned by
the Fund. To help you evaluate your Fund's current-year performance,
the Message includes a discussion of the Fund's long-term investment
results, as well as a look ahead to the prospects for the coming year.
A recap of the financial markets, which had been included as part of
the Chairman's letter, now appears in The Markets In Perspective. This
overview covers the world's financial markets, putting the results of
the Fund's strategy in a global perspective.
THE PORTFOLIO PROFILE REPRESENTS AN ADDITION TO OUR FUND REPORTS. In this day
and age, many investors use detailed statistical information to
evaluate their mutual fund holdings, and our new Portfolio Profile
furnishes shareholders with comprehensive data on key
characteristics--sector diversification, volatility, top-ten holdings,
among others--that ultimately define how a Fund is likely to perform
in various market environments. For this information to be used
effectively, we include a brief description of the profiled
characteristics. The Report From The Adviser (for our traditionally
managed Funds) now covers specific topics that we have defined as
being the important ones for the adviser to address--and we do our
best to ensure that this Report is written in the same simple and
candid manner that characterizes all Vanguard communications. Finally,
each Adviser's Report will include an inset reminder of the adviser's
basic investment philosophy.
WE TRUST THAT THIS REDESIGNED FUND REPORT will continue to meet your need for a
fair, candid, and clear presentation of your Fund's investment
results and a thorough portfolio review. We welcome any comments that
you might have at any time regarding these Reports.
CONTENTS
A Message To
Our Shareholders
1
The Markets
In Perspective
3
Report From
The Adviser
5
Performance
Summary
7
Portfolio
Profile
8
Financial
Statements
10
Report Of
Independent
Accountants
18
Directors And
Officers
INSIDE BACK COVER
<PAGE> 3
FELLOW SHAREHOLDER,
[PHOTO]
[PHOTO]
In a vibrant stock market, Vanguard Equity Income Fund provided a total return
(capital change plus reinvested dividends) of +18.2% during its fiscal year
ended September 30, 1996. The Fund outpaced the average equity income mutual
fund but trailed the unmanaged Standard & Poor's 500 Composite Stock Price
Index. We should note that the S&P 500 Index, which contains both growth stocks
and value stocks, is not a perfect measurement standard for the Fund, which
emphasizes income-oriented value stocks, and the year happened to be one in
which growth stocks led the market advance. In any event, the table at right
compares the Fund's return with that of the S&P 500 Index and the average equity
income fund.
The Fund's total return is based on net asset values of $15.65 per share on
September 30, 1995, and $17.69 per share on September 30, 1996, adjusted for the
reinvestment of our quarterly dividends totaling $.60 per share from net
investment income and a distribution of $.17 per share from capital gains
realized during 1995.
<TABLE>
<CAPTION>
- -----------------------------------------------------
TOTAL RETURN
FISCAL YEAR ENDED
SEPTEMBER 30, 1996
- -----------------------------------------------------
<S> <C>
Vanguard Equity Income Fund +18.2%
- -----------------------------------------------------
Average Equity Income Fund +16.8%
- -----------------------------------------------------
S&P 500 Index +20.3%
- -----------------------------------------------------
</TABLE>
FISCAL 1996 PERFORMANCE OVERVIEW
During the past twelve months, the stock market basked in a near-perfect
economic environment: moderate growth accompanied by low inflation. Interest
rates fluctuated broadly during the fiscal year, declining during the first
quarter amid expectations of an economic slowdown, then rising when it became
apparent that the economy was growing quite nicely, with few signs of inflation.
By fiscal year end, interest rates were about where they had been twelve months
earlier. Not surprisingly, given that yield-oriented stocks are especially
sensitive to interest rate movements, the Fund earned a better return during the
first half of the fiscal year (+12.1%), as interest rates declined, than during
the second half of the fiscal year (+5.4%), when interest rates rose.
For the full year, the Fund's return fell short of the S&P 500 Index, due in
part to our outsized holdings in utility stocks, which badly lagged the overall
market. Our participation (25% of our assets on average) in this higher-yielding
market sector, of course, is a critical factor in our ability to achieve our
income objective. We also trailed the Index due to our underweighting in two
particularly strong market sectors: consumer staples and capital goods &
construction. The negative impact of our sector weightings was partially offset
by excellent stock selections, particularly in the utility and health-care
sectors.
As you know, the Fund emphasizes dividend-paying common stocks and seeks an
average stock yield well above that of the S&P 500 Index. Since December 31,
1994, this policy has been implemented through a multi-manager structure using
three advisers--Newell Associates; Spare, Kaplan, Bischel & Associates; and John
A. Levin & Co., Inc. The table on page 2 shows their current allocations.
1
<PAGE> 4
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------
TOTAL ASSETS MANAGED
-------------------------------
$ MILLION PERCENT
- -----------------------------------------------------------------------
<S> <C> <C>
Newell Associates $ 839 64%
Spare, Kaplan, Bischel & Associates 196 15
John A. Levin & Co., Inc. 201 15
Cash Reserves 73 6
- -----------------------------------------------------------------------
Total $1,309 100%
</TABLE>
LONG-TERM PERFORMANCE OVERVIEW
The Fund's fiscal 1996 results added to our long-term advantage over the average
equity income fund. Yet in the nearly ten years since the Fund began operations,
neither we nor our peer group of funds has matched the results of the S&P 500
Index. The Index, of course, is a tough competitor for all equity mutual funds
since it is a theoretical construct, devoid of the operating costs that every
mutual fund incurs. It is an even tougher standard for equity income funds,
which earn a relatively larger proportion of their total return from dividend
income, and a relatively smaller proportion from capital appreciation. Under
this circumstance, equity income funds have tended to provide lower capital
returns than growth-oriented funds, but with lower price volatility as well.
Measured against real-world competitors, the Fund has provided a solid
advantage, as the table below indicates. Based on an investment of $10,000 at
the Fund's inception, our advantage of +1.3% annually over the average equity
income fund amounts to an excess return of $2,610 (final value of $28,510 versus
$25,900)--more than 25% of the amount initially invested. Of course, we should
emphasize that future returns on financial assets may be less generous than
those of the past eight years, which were quite high by historical standards.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------
TOTAL RETURN*
MAR. 21, 1988, TO SEP. 30, 1996
-------------------------------
CUMULATIVE ANNUAL RATE
- ----------------------------------------------------------------
<S> <C> <C>
Vanguard Equity Income Fund +185.1% +13.1%
- ----------------------------------------------------------------
Average Equity Income Fund +159.0% +11.8%
- ----------------------------------------------------------------
S&P 500 Index +232.0% +15.1%
- ----------------------------------------------------------------
</TABLE>
*Assumes reinvestment of all dividends and distributions, and excludes sales
charges, if any, on the other mutual funds.
We should also add that more than half of our advantage was accounted for by
our low operatingcosts: the Fund's annual expense ratio (expenses as a
percentage of average net assets) averaged about 0.45% verses 1.30% for our peer
group, Largely as a result of this difference, our dividend yield at year end
was 3.6%, compared to our average competitor's 2.3% yield. To say that this
advantage is important--if not imperative--for a ture equity income fund seems
almost an understatement.
IN SUMMARY
After two consecutive years of strong returns from the stock market and your
Fund, it must be said that the always-percent risk of investing in stocks may be
higher now than a year or two back. Nonetheless, investors who "stay the course"
with an investment approach consistent with their personal financial goals have
historically had little to fear from rough seas in the financial markets. l In
this context, we belief that Vanguard Equity Income Fund--with its diversified
holdings of stocks chosen primarily for above-average dividen yields and likely
below-average risk--should continue to be suitable for a balanced portfolio that
includes stock funds, bond funds, and money market funds.
/s/ JOHN C. BOGLE /s/ JOHN J. BRENNAN
- ------------------------- --------------------
Chairman of the Board President
October 10, 1996
2
<PAGE> 5
THE MARKETS IN PERSPECTIVE: FISCAL YEAR ENDED SEPTEMBER 30, 1996
[PHOTO]
U.S. EQUITY AND BOND MARKETS
During the past twelve months, expectations about economic growth, inflation,
and Federal Reserve policy shifted markedly, generating some pronounced changes
in the U.S. equity and bond markets. In October 1995, for example, the U.S.
economy was widely considered to be slowing, after exhibiting fairly robust
growth earlier in the year. Reflecting this view, investors were attracted to
long-term U.S. Treasury bonds (the yield on the 30-year maturity fell from 6.5%
to just below 6.0%) and large-capitalization stocks (the Standard & Poor's 500
Composite Stock Price Index advanced 9.6%) from the beginning of October 1995
through the end of January. By contrast, shares of small-capitalization firms
increased only 2.1% in this period.
The view that slow but steady economic growth and minimal inflation would
continue was widely held. Even the Open Market Committee of the Federal Reserve
accepted this outlook, as evidenced by its decision in January to cut both the
discount and Fed funds rates by 0.25% in an effort to stimulate the economy.
By mid-February, however, reports indicated increases in the demand for
technology goods, the number of new jobs, and consumer spending. As a result,
the outlook among investors changed. Common-stock investors began to look for
opportunities offered by a rapidly expanding economy (e.g., rapid earnings
growth among technology, cyclical, and smaller firms), while bond investors saw
the more rapid growth as an indication of future inflation. The result was a
1.2% rise in the 30-year U.S. Treasury yield and sharp jumps in the prices of
economically sensitive stocks during the next three months.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------
AVERAGE ANNUALIZED RETURNS
PERIODS ENDED SEPTEMBER 30, 1996
----------------------------------
1 YEAR 3 YEARS 5 YEARS
- --------------------------------------------------------------------
<S> <C> <C> <C>
Equity
S&P 500 Index 20.3% 17.4% 15.2%
Russell 2000 Index 13.1 12.7 15.8
MSCI-EAFE Index 8.9 8.4 8.5
- --------------------------------------------------------------------
Fixed-Income
Lehman Aggregate Bond Index 4.9% 5.0% 7.5%
Lehman 10-Year Municipal
Bond Index 4.8 4.9 7.6
Lipper Money Market 4.9 4.4 3.9
- --------------------------------------------------------------------
Other
Consumer Price Index 3.0% 2.8% 2.8%
- --------------------------------------------------------------------
</TABLE>
This outlook proved to be short-lived, too, with signs of a slowdown
appearing by late spring. As a result, blue-chip growth stocks became the
preferred segment of the stock market, while smaller-company issues,
particularly technology stocks, declined--often sharply. Bond investors
benefited from the revised outlook, as long-term yields fell -0.5% between early
July and mid-August. By the end of September, however, the long-term Treasury
yield had retraced half of the summer rally.
The markets moved in reaction to wide swings in consensus expectations for
the economy. Bond investors, in aggregate, suffered somewhat as the Lehman
Brothers Aggregate Bond Index posted a total return of 4.9% for the fiscal year,
with income of 6.9% and a -2.0% decline in capital.
3
<PAGE> 6
Equity investors, on the other hand, saw the S&P 500 Index generate a strong
return of 20.3%, largely due to continued earnings growth; yet the S&P 500's
performance trailed by 9.4% the exceptional 29.7% gain generated during the
twelve months ended September 30, 1995. The returns for the S&P 500 Index for
these periods represent approximately two and three times, respectively, the
long-term average returns of the Index.
The best performers among the S&P 500's holdings were often the large
"traditional" growth stocks in the health-care (31.4% over the last twelve
months) and consumer-staples (26.4%) sectors. Such issues have historically
performed especially well during periods of economic uncertainty thanks to the
dependability of their earnings. The utilities (-0.4%), consumer-cyclical
(13.8%), and basic-materials (14.6%) sectors, by contrast, lagged in this year
characterized by uncertain growth and rising interest rates.
A number of the worst--and most volatile--performers among domestic common
stocks could be found among small-capitalization technology issues. While
small-company stocks (as measured by the Russell 2000 Small Stock Index) gained
13.1% in aggregate, stocks of small technology companies gained only 4.2% for
the year, dropping -12.6% in the last four months alone. The most likely cause
was a number of earnings disappointments within the group.
For bond investors, issues of shorter maturity and lower quality generally
performed better than other segments of the bond market. Mortgage-backed
securities also generated attractive relative returns as rising interest rates
reduced prepayment activity. Municipals, however, were strong compared to their
taxable siblings as concern over a "flat-tax" system eased.
INTERNATIONAL EQUITY MARKETS
Returns for international equity investors were solid, as reflected in the 8.9%
return of the Morgan Stanley Capital International-Europe, Australasia, Far East
(EAFE) Index. Performance in the European and Pacific Rim markets differed
widely, however, with returns of 14.6% and 3.2% (measured in U.S. dollars),
respectively. One reason for the disparity was the strength of the U.S. dollar
versus the Japanese yen. The dollar gained 12.9% against the yen, a move that
reduced the Japanese market's 13.5% increase in local terms to a mere 0.5% for
dollar-based investors. The dollar was modestly stronger (3.8%) against the
major European currencies.
The strength of the European markets stemmed, at least in part, from
governments' commitment to the Maastricht Treaty. The Treaty, which seeks to
achieve a common European currency, requires that a nation's budget deficit not
exceed 3% of its GDP. With the Maastricht deadlines approaching, governments are
reaffirming their commitment to the Treaty by reducing spending. These actions
have led to lower interest rates and strong gains, in aggregate, for many
stocks.
In Asian markets, Hong Kong (23.2%) and Malaysia (17.3%) stood out for their
gains. A number of the smaller markets (e.g., Singapore, Thailand) suffered from
slower growth and reduced competitiveness as a result of the weakened Japanese
yen. The Japanese market, depsite the 13.5% gain (measured in yen), proved
disappointing to many investors due to slow sustained growth government efforts
to spur the economy.
4
<PAGE> 7
REPORT FROM THE ADVISER
[PHOTO]
The stock market faltered briefly in July, but powered its way into new
high territory by the end of Vanguard Equity Income Fund's fiscal year on
September 30, 1996. The Fund fell slightly short of the average equity income
mutual fund during the second half of the fiscal year, but outperformed it for
the full twelve months. However, the Fund fell short of the unmanaged Standard &
Poor's 500 Composite Stock Price Index in both halves of the year, as evidenced
in the following table.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------
TOTAL RETURN*
PERIODS ENDED SEPTEMBER 30, 1996
- ----------------------------------------------------------------
SIX MONTHS TWELVE MONTHS
- ----------------------------------------------------------------
<S> <C> <C>
Vanguard Equity Income Fund 5.4% 18.2%
- ----------------------------------------------------------------
Average Equity Income Fund 5.5% 16.8%
- ----------------------------------------------------------------
S&P 500 Index 7.7% 20.3%
- ----------------------------------------------------------------
</TABLE>
*Assuming reinvestment of all dividends and distributions.
NOT THE SAME OLD INDEX
The stock market's impressive performance in the past year is a continuance of
what can fairly be described as the most persistent bull market in U.S. history.
However, one aspect of its strength has received relatively little attention: a
very significant evolution is under way in the relative importance of various
industries to the market. The stock market was once dominated by industrial,
petroleum, and utility companies, but in recent years their influence has waned.
These traditional groups have been supplanted by consumer-product, health-care,
and technology companies, many of which are newer and faster-growing than the
traditional ones.
The greatly increased market capitalization (market price times shares
outstanding) of these faster-growing companies has expanded their influence on
the performance of the overall stock market and the S&P 500 Index. This has
occurred both because the rapidly rising share prices of these stocks have
boosted the relative importance in the Index (which weights its component stocks
according to their market capitalizations) and because the Standard & Poor's
stock committee recently added a large number of faster-growing companies, most
notably in the technology groups, to the Index.
During fiscal 1996, these fast-growing electronics and computer-related
companies supplied a great deal of the impetus behind the bull market. Because
they need cash flow to finance growth, these companies usually pay small
dividends or none at all. Newell Associates uses relative yield as a
portfolio-management discipline to produce a stock portfolio whose dividend
yield is significantly above that of the general market. This approach has many
benefits, including greater reliability of total return and reduced risk in
declining markets. But it is a selection technique that rules out as
inappropriate for the portfolio some popular stocks with low or non-existent
dividend yields. Such has been the case for some time with most electronics and
computer-related stocks. This factor accounts for much of the Fund's shortfall
in performance relative to the S&P 500 Index during the past year.
INVESTMENT PHILOSOPHY
The advisers believe that a portfolio made up of undervalued stocks, most of
which offer high dividend yields compared to their past levels and to the
overall market, can provide a high level of current income, the potential for
capital appreciation, and below-average price volatility for a stock mutual
fund.
5
<PAGE> 8
THE OTHER SIDE OF THE COIN
Forgoing popular stocks has a positive side. Many stocks that seem to promise
rapid growth and high returns ultimately prove to be not just low-yielding but
overvalued as well. Any shortcomings in performance compared with market
expectations can produce breathtaking declines in share price. Many of these
stocks end up providing a high level of risk without a commensurately high
long-term return. Using relative yield to select stocks can help keep such
seriously overvalued stocks out of the portfolio.
However, the relative-yield approach does not preclude participation in
growth opportunities. Recently, one of the Fund's largest industry positions has
been health care--which was also one of the Fund's best-performing groups over
the past twelve months. Most of this position was established during 1993, when
competition and government health-care proposals raised fears that these
companies would not be able to maintain their attractive profit margins in the
future. These fears eventually faded, the companies continued to show good
earnings growth, and the stocks returned to previous valuation levels. The
overblown fears gave us the opportunity to purchase stocks with good potential
for earnings growth at high relative yields and at depressed prices. In short,
this was a case where relative yield steered the Fund into cheap growth stocks.
Telephone stocks--currently out of favor because of the deregulation of the
telecommunications industry that is under way--did not add to the Fund's return
this year. But these stocks, like the drug stocks when they were under siege,
have the potential for significant growth after they work through their
transition to a competitive environment. The dislocations of deregulation have
provided an opportunity to include these stocks at attractive relative yields.
STILL THE SAME CONSERVATIVE PORTFOLIO
This is not to suggest that our Relative Yield Discipline produces a growth
portfolio in disguise. Many of our holdings cannot be said to be in growth
industries, but they are strong companies in core areas of the economy. When
these companies are purchased at favorable prices in relation to the broad
market, they can make a significant contribution to the Fund's results. The
petroleum and bank sectors fit this description and were large contributors to
the Fund's return during fiscal 1996. The Fund is firmly rooted in
well-established companies with conservative valuations, above-market yields,
and below-market volatility, just as it has been since its inception.
Roger D. Newell, Chairman
Newell Associates
October 10, 1996
6
<PAGE> 9
PERFORMANCE SUMMARY: EQUITY INCOME FUND
All of the data on this page represent past performance, which cannot be used to
predict future returns that may be achieved by the Fund. Note, too, that both
share price and return can fluctuate widely so that an investment in the Fund
could lose money.
<TABLE>
<CAPTION>
Total Investment Returns: 3/21/88-9/30/96
- ------------------------------------------------
EQUITY INCOME FUND S&P 500
FISCAL CAPITAL INCOME TOTAL TOTAL
YEAR RETURN RETURN RETURN RETURN
- ------------------------------------------------
<S> <C> <C> <C> <C>
1988 5.8% 2.5% 8.3% 3.2%
1989 23.8 5.0 28.8 33.0
1990 -20.5 4.3 -16.2 -9.2
1991 18.0 8.5 26.5 31.2
1992 6.4 5.9 12.3 11.1
1993 14.1 5.1 19.2 13.0
1994 -6.5 4.3 -2.2 3.7
1995 19.8 5.0 24.8 29.7
1996 14.2 4.0 18.2 20.3
- ------------------------------------------------
</TABLE>
See Financial Highlights table on page 15 for dividend and capital gains
information for the past five years.
[FIGURE]
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------
AVERAGE ANNUAL TOTAL RETURNS
PERIODS ENDED SEPTEMBER 30, 1996
----------------------------------- FINAL VALUE OF A
1 YEAR 5 YEARS SINCE INCEPTION $10,000 INVESTMENT
- -----------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
EQUITY INCOME FUND 18.22% 14.06% 13.07% $28,513
AVERAGE EQUITY INCOME
FUND 16.83 13.06 11.80 25,896
S&P 500 INDEX 20.33 15.23 15.11 33,197
- -----------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
AVERAGE ANNUAL TOTAL RETURNS: PERIODS ENDED 9/30/96
- ----------------------------------------------------------------------------
SINCE INCEPTION
INCEPTION ---------------------------
DATE 1 YEAR 5 YEARS CAPITAL INCOME TOTAL
- ----------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Equity Income Fund 3/21/88 18.22% 14.06% 7.85% 5.22% 13.07%
- ----------------------------------------------------------------------------
</TABLE>
7
<PAGE> 10
PORTFOLIO PROFILE: EQUITY INCOME FUND
SEPTEMBER 30, 1996
This Profile provides a snapshot of the Fund's characteristics, where
appropriate, compared to an unmanaged index. Key elements of this Profile
are defined on page 9.
<TABLE>
<CAPTION>
Portfolio Characteristics
- -------------------------------------------------------
EQUITY INCOME S&P 500
- -------------------------------------------------------
<S> <C> <C>
Number of Stocks 157 500
Median Market Cap $14.3B $21.8B
Price/Earnings Ratio 15.9x 18.4x
Price/Book Ratio 2.5x 3.2x
Dividend Yield 3.6% 2.2%
Return on Equity 17.1% 19.6%
Earnings Growth Rate 3.9% 13.2%
Foreign Holdings 2.2% 3.7%
Turnover Rate 21% --
Expense Ratio 0.42% --
Cash Reserves 6.9% --
</TABLE>
Investment Focus
- -----------------------------------
[FIGURE]
<TABLE>
<CAPTION>
Volatility Measures
- --------------------------------------
EQUITY INCOME S&P 500
- --------------------------------------
<S> <C> <C>
R-Squared 0.83 1.00
Beta 0.86 1.00
</TABLE>
<TABLE>
<CAPTION>
Ten Largest Holdings (% of Total Net Assets)
- --------------------------------------------
<S> <C>
Bristol-Myers Squibb Co. 2.7%
Texaco Inc. 2.5
Philip Morris Cos., Inc. 2.4
Chevron Corp. 2.3
Eli Lilly & Co. 2.2
American Home Products Corp. 2.2
Exxon Corp. 2.1
Atlantic Richfield Co. 2.0
GTE Corp. 1.9
NYNEX Corp. 1.8
- --------------------------------------------
Top Ten 22.1%
</TABLE>
<TABLE>
<CAPTION>
Sector Diversification (% of Common Stock)
- ---------------------------------------------------------------------------------
SEPTEMBER 30, 1995 SEPTEMBER 30, 1996
------------------------------------------------
EQUITY INCOME INCOME EQUITY S&P 500
------------------------------------------------
<S> <C> <C> <C>
Basic Materials .............. 5.6% 5.8% 6.4%
Capital Goods & Construction . 1.4 2.5 8.7
Consumer Cyclical ........... 8.4 7.1 13.0
Consumer Staples ............. 8.8 9.4 12.5
Energy ....................... 14.4 14.9 9.2
Financial .................... 19.1 19.1 14.1
Health Care .................. 13.1 13.4 10.6
Technology ................... 0.5 1.6 11.7
Transport & Services ......... 0.1 0.7 1.5
Utilities .................... 26.6 23.1 10.1
Miscellaneous ................ 2.0 2.4 2.2
- ---------------------------------------------------------------------------------
</TABLE>
8
<PAGE> 11
[PHOTO]
PORTFOLIO CHARACTERISTICS
NUMBER OF STOCKS. An indicator of diversification. The more stocks a portfolio
holds, the more diversified, and the more likely it is to perform in line with
the overall stock market.
MEDIAN MARKET CAP. The midpoint of market capitalization (market price x shares
outstanding) of stocks in the portfolio. Half the stocks in the portfolio have
higher market capitalizations and half lower.
PRICE/EARNINGS RATIO. The ratio of a stock's current price to its per-share
earnings over the past year. For a portfolio, 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.
PRICE/BOOK RATIO. The share price of a stock, divided by its net worth, or book
value, per share. For a portfolio, the weighted average price/book ratio of the
stocks it holds.
DIVIDEND YIELD. The current, annualized rate of dividends paid on a share
of stock, divided by its current share price. For a portfolio, the
weighted average yield for stocks it holds.
RETURN ON EQUITY. The rate of return generated by a company during the past year
for each dollar of shareholder's equity (net income for the year divided by
shareholder's equity). For a portfolio, the weighted average return on equity
for the companies represented in the portfolio.
EARNINGS GROWTH RATE. The annual average rate of growth in earnings over
the past five years for the stocks now in a portfolio.
FOREIGN HOLDINGS. The percentage of a portfolio's equity holdings invested in
non-U.S. companies.
TURNOVER RATE. Indicates trading activity during the past year. Portfolios with
high turnover rates incur higher transaction costs and are more likely to
realize and distribute capital gains (which are taxable to investors). The
average turnover rate for stock mutual funds is about 80%.
EXPENSE RATIO. The percentage of a portfolio's average net assets used to pay
its annual administrative and advisory expenses. These expenses directly reduce
returns to investors. The average expense ratio for a stock mutual fund was
1.34% in 1995.
INVESTMENT FOCUS
This grid indicates a portfolio's characteristics in terms of two
attributes--market capitalization and relative valuation (growth, value, or a
blend). For instance, if the upper right box of the grid is shaded, it indicates
that a portfolio emphasizes large capitalization growth stocks.
VOLATILITY MEASURES
R-SQUARED. A measure of how much of a portfolio's past returns can be explained
by the returns from the overall market (or its benchmark index). If a
portfolio's total return were precisely synchronized with the overall market's
return, its R-squared would be 1.00. If a portfolio's returns bore no
relationship to the market's returns, its R-squared would be 0.
BETA. A measure of the magnitude of a portfolio's past share-price fluctuations
in relation to the fluctuations in the overall market (or appropriate market
index). The market, or index, has a beta of 1.00, so a portfolio 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%.
TEN LARGEST HOLDINGS
Indicates the percentage of a portfolio's total net assets in its ten largest
stocks (25% is the average for stock mutual funds). As this percentage rises, a
portfolio's returns are llikely to be more volatile, since its return is more
dependent on the fortunes of a few companies.
SECTOR DIVERSIFICATION
Indicates the percentage of a portfolio's common stocks invested in each of the
major industry classifications that compose the stock market.
9
<PAGE> 12
[PHOTO]
FINANCIAL STATEMENTS
SEPTEMBER 30, 1996
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, preferred stocks, bonds,
etc.) and by industry sector. Other assets are added to, and liabilities are
subtracted from, the value of Total Investments to calculate the Fund's Net
Assets. Finally, Net Assets are divided by the outstanding shares of the Fund to
arrive at its share price, or Net Asset Value (NAV) Per Share.
At the end of the Statement of Net Assets, you will find a table displaying
the composition of the Fund's net assets on both a dollar and per-share basis.
Because all income and any realized gains must be distributed to shareholders
each year, the bulk of net assets consists of Paid in Capital (money invested by
shareholders). The amounts shown for Undistributed Net Investment Income and
Accumulated Net Realized Gains usually approximate the sums the Fund had
available to distribute to shareholders as income dividends or capital gains as
of the statement date. Any Accumulated Net Realized Losses, and any cumulative
excess of distributions over net income or net realized gains, will appear as
negative balances. Unrealized Appreciation (Depreciation) is the difference
between the market value of the Fund's investments and their cost, and reflects
the gains (losses) that would be realized if the Fund were to sell all of its
investments at their statement-date values.
<TABLE>
<CAPTION>
- -----------------------------------------------------
MARKET
VALUE*
EQUITY INCOME FUND SHARES (000)
- -----------------------------------------------------
COMMON STOCKS (90.7%)
- -----------------------------------------------------
<S> <C> <C>
BASIC MATERIALS (5.2%)
Allegheny Teledyne Inc. 70,700 $ 1,600
ARCO Chemical Co. 123,700 6,185
BetzDearborn Inc. 21,700 1,139
Dow Chemical Co. 247,200 19,838
E.I. du Pont de Nemours & Co. 144,700 12,770
Lubrizol Corp. 54,100 1,555
Monsanto Co. 60,500 2,208
Potlatch Corp. 152,600 5,913
Praxair, Inc. 23,300 1,002
Union Camp Corp. 121,200 5,924
Weyerhaeuser Co. 177,800 8,201
Witco Chemical Corp. 60,900 2,002
--------
68,337
--------
CAPITAL GOODS &
CONSTRUCTION (2.3%)
Cooper Industries, Inc. 35,000 1,514
Emerson Electric Co. 29,500 2,659
General Electric Co. 112,800 10,265
General Motors Corp. Class H 18,400 1,063
Honeywell, Inc. 49,300 3,112
Lockheed Martin Corp. 38,000 3,425
Thomas & Betts Corp. 117,200 4,804
WMX Technologies Inc. 96,100 3,159
--------
30,001
--------
CONSUMER CYCLICAL (6.4%)
Deluxe Corp. 179,900 6,791
The Walt Disney Co. 17,800 1,128
The Dun & Bradstreet Corp. 243,800 14,537
Eastman Kodak Co. 84,050 6,598
Ford Motor Co. 108,500 3,391
Genuine Parts Co. 77,700 3,399
ITT Industries, Inc. 62,000 1,496
Kmart Corp. 509,200 5,219
May Department Stores Co. 106,600 5,183
The McGraw-Hill Cos. 99,200 4,228
J.C. Penney Co., Inc. 266,900 14,446
Reader's Digest Assn., Inc.
Class A 90,000 3,679
Tribune Co. 50,300 3,923
# U S WEST Media Group 169,400 2,859
Wal-Mart Stores, Inc. 121,500 3,205
# Woolworth Corp. 184,100 3,797
--------
83,879
--------
CONSUMER STAPLES (8.5%)
American Brands, Inc. 470,500 19,879
Anheuser-Busch Co., Inc. 108,400 4,079
Avon Products, Inc. 45,400 2,253
The Clorox Co. 62,000 5,944
The Coca-Cola Co. 40,000 2,035
General Mills, Inc. 155,200 9,370
H.J. Heinz Co. 188,100 6,348
International Flavors &
Fragrances, Inc. 39,100 1,706
Nabisco Holdings Corp.
Class A 36,900 1,167
Philip Morris Cos., Inc. 343,250 30,807
The Quaker Oats Co. 125,000 4,578
RJR Nabisco Holdings Corp. 33,500 871
Tambrands, Inc. 209,900 8,842
Tupperware Corp. 95,300 4,670
UST Inc. 289,400 8,573
--------
111,122
--------
</TABLE>
10
<PAGE> 13
<TABLE>
<CAPTION>
- -------------------------------------------------------
MARKET
VALUE*
EQUITY INCOME FUND SHARES (000)
- -------------------------------------------------------
<S> <C> <C>
ENERGY (13.6%)
Amoco Corp. 178,600 $ 12,591
Atlantic Richfield Co. 202,400 25,806
Chevron Corp. 484,000 30,311
Exxon Corp. 328,800 27,373
McDermott International, Inc. 94,300 2,051
Mobil Corp. 182,500 21,124
# Oryx Energy Co. 78,600 1,395
Phillips Petroleum Co. 101,100 4,322
Royal Dutch Petroleum Co. ADR 63,200 9,867
Sun Co., Inc. 87,191 2,005
Texaco Inc. 353,400 32,513
USX-Marathon Group 375,300 8,116
----------
177,474
----------
FINANCIAL (17.3%)
Aetna Inc. 160,600 11,302
H.F. Ahmanson & Co. 390,700 10,940
American Express Co. 37,800 1,748
American General Corp. 333,900 12,605
Banc One Corp. 265,650 10,892
Bankers Trust New York Corp. 143,500 11,283
Barnett Banks, Inc. 148,800 5,022
Boatmen's Bancshares, Inc. 129,700 7,231
CIGNA Corp. 10,300 1,235
Citicorp 50,900 4,613
CoreStates Financial Corp. 214,100 9,260
First Chicago NBD Corp. 135,700 6,140
First Union Corp. 132,400 8,838
Fleet Financial Group, Inc. 127,200 5,660
Great Western Financial Corp. 541,100 14,339
KeyCorp 125,700 5,531
Lincoln National Corp. 352,900 15,483
Marsh & McLennan Cos., Inc. 103,900 10,091
Meditrust 80,000 2,770
Mellon Bank Corp. 222,450 13,180
J.P. Morgan & Co.,Inc. 189,500 16,842
National City Corp. 34,000 1,432
NationsBank Corp. 54,500 4,735
PNC Bank Corp. 452,800 15,112
SAFECO Corp. 148,300 5,153
Sizzlers Property Investors, Inc. 57,500 518
U.S. Bancorp 152,200 5,993
Unitrin Inc. 81,800 3,988
Wachovia Corp. 106,700 5,281
----------
227,217
----------
HEALTH CARE (12.1%)
American Home Products Corp. 457,600 29,172
Baxter International, Inc. 175,300 8,195
Bristol-Myers Squibb Co. 367,000 35,370
# Centocor, Inc. 12,670 448
Glaxo Wellcome PLC ADR 258,100 8,033
Eli Lilly & Co. 455,400 29,373
Merck & Co., Inc. 242,300 17,052
Pharmacia & Upjohn,Inc. 572,025 23,596
Warner-Lambert Co. 113,700 7,505
----------
158,744
----------
TECHNOLOGY (1.5%)
Electronic Data Systems Corp. 63,478 3,896
International Business
Machines Corp. 35,900 4,470
Pitney Bowes, Inc. 76,200 4,020
# Seagate Technology 100,658 5,624
Varian Associates, Inc. 32,600 1,564
----------
19,574
----------
TRANSPORT & SERVICES (0.6%)
Burlington Northern
Santa Fe Corp. 20,759 1,752
Union Pacific Corp. 85,300 6,248
----------
8,000
----------
UTILITIES (21.0%)
Allegheny Power System, Inc. 331,700 9,619
Ameritech Corp. 296,200 15,588
Baltimore Gas & Electric Co. 291,600 7,618
Bell Atlantic Corp. 326,600 19,555
BellSouth Corp. 295,700 10,941
Central & South West Corp. 317,500 8,255
Consolidated Edison Co. of
New York, Inc. 130,700 3,627
Consolidated Natural Gas Co. 260,800 13,985
Dominion Resources, Inc. 124,300 4,692
Duke Power Co. 104,700 4,882
Edison International 397,100 7,098
FPL Group, Inc. 86,200 3,728
GTE Corp. 635,300 24,459
NICOR, Inc. 211,600 7,142
Northeast Utilities 166,700 2,063
Northern States Power Co. 68,700 3,203
NYNEX Corp. 555,850 24,179
Oklahoma Gas & Electric Co. 155,700 6,228
PECO Energy Corp. 43,000 1,021
PP&L Resources Inc. 209,000 4,572
Pacific Enterprises 130,500 3,948
Pacific Telesis Group 322,200 10,834
PacifiCorp 467,000 9,632
Potomac Electric Power Co. 196,400 4,984
Public Service Enterprise
Group Inc. 292,600 7,827
SCANA Corp. 190,600 5,003
Southern New England
Telecommunications Corp. 98,600 3,636
TECO Energy, Inc. 189,300 4,496
Texas Utilities Co. 156,400 6,197
Union Electric Co. 221,000 8,149
U S WEST
Communications Group 584,950 17,402
Western Resources, Inc. 64,000 1,864
Wisconsin Energy Corp. 307,100 8,293
----------
274,720
----------
MISCELLANEOUS (2.2%)
Corning, Inc. 96,800 3,775
Hanson PLC ADR 696,200 8,615
Minnesota Mining &
Manufacturing Co. 133,900 9,356
Ogden Corp. 340,700 6,857
----------
28,603
----------
- -------------------------------------------------------
TOTAL COMMON STOCKS
(COST $867,929) 1,187,671
- -------------------------------------------------------
</TABLE>
11
<PAGE> 14
<TABLE>
<CAPTION>
- --------------------------------------------------------
MARKET
VALUE*
EQUITY INCOME FUND SHARES (000)
- --------------------------------------------------------
PREFERRED STOCKS (2.0%)
- --------------------------------------------------------
<S> <C> <C>
Aetna Inc. 6.25% Series C 27,000 $ 1,968
Airtouch Communications, Inc.
Cvt. 6.00% 80,000 2,280
Atlantic Richfield Co. 9.00% 110,000 2,585
Catellus Development
Cvt. $3.625 60,000 3,270
Crown Cork & Seal Cvt. 4.50% 110,000 5,033
Federal Mogul Cvt. $3.87 515,000 911
Globalstar Telecommunications
6.50% 69,200 3,252
# Golden Books Financial Trust
Cvt. 8.75% 4,000 224
Houghton Mifflin Co. Cvt. 6.00% 23,900 2,318
McDermott International
Cvt. $2.875 17,500 704
# USAir Inc. $4.37519,100 967
Westinghouse Electric
Cvt. $1.30 160,000 2,760
- --------------------------------------------------------
TOTAL PREFERRED STOCKS
(COST $24,445) 26,272
- --------------------------------------------------------
<CAPTION>
FACE
AMOUNT
(000)
- --------------------------------------------------------
CONVERTIBLE BONDS (0.4%)
- --------------------------------------------------------
<S> <C> <C>
Alza Corp.
5.00%, 5/1/06 $ 1,800 1,732
Molten Metal Technology Inc.
5.50%, 5/1/06 1,900 1,929
Roche Holdings, Inc.
0.00%, 4/20/10 800 344
Time Warner Inc.
0.00%, 12/17/12 2,600 943
- --------------------------------------------------------
TOTAL CONVERTIBLE BONDS
(COST $5,098) 4,948
- --------------------------------------------------------
TEMPORARY CASH INVESTMENT (6.7%)
- --------------------------------------------------------
REPURCHASE AGREEMENT
Collateralized by U.S. Government
Obligations in a Pooled Cash
Account
5.74%, 10/1/96
(COST $87,532) 87,532 87,532
- --------------------------------------------------------
TOTAL INVESTMENTS (99.8%)
(COST $985,004) 1,306,423
- --------------------------------------------------------
OTHER ASSETS AND LIABILITIES (0.2%)
- --------------------------------------------------------
Other Assets--Note C 11,418
Liabilities (8,460)
----------
2,958
- --------------------------------------------------------
NET ASSETS (100%)
- --------------------------------------------------------
Applicable to 74,022,181 outstanding
$0.001 par value shares
(authorized 1,000,000,000 shares) $1,309,381
========================================================
NET ASSET VALUE PER SHARE $17.69
========================================================
</TABLE>
*See Note A in Notes to Financial Statements.
#Non-Income Producing Security.
ADR--American Depository Receipt.
<TABLE>
<CAPTION>
- --------------------------------------------------------
AMOUNT PER
(000) SHARE
- --------------------------------------------------------
AT SEPTEMBER 30, 1996, NET ASSETS CONSISTED OF:
- --------------------------------------------------------
<S> <C> <C>
Paid in Capital $ 939,483 $ 12.69
Undistributed Net
Investment Income 12,932 .18
Accumulated Net
Realized Gains 35,547 .48
Unrealized Appreciation--
Note E 321,419 4.34
- --------------------------------------------------------
NET ASSETS $ 1,309,381 $ 17.69
========================================================
</TABLE>
12
<PAGE> 15
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.
<TABLE>
<CAPTION>
- -------------------------------------------------------------
EQUITY INCOME FUND
YEAR ENDED SEPTEMBER 30, 1996
(000)
- -------------------------------------------------------------
<S> <C>
INVESTMENT INCOME
INCOME
Dividends $ 42,929
Interest 4,869
----------
Total Income 47,798
----------
EXPENSES
Investment Advisory Fees--Note B
Basic Fee 2,151
Performance Adjustment (191)
The Vanguard Group--Note C
Management and Administrative 2,472
Marketing and Distribution 215
Taxes (other than income taxes) 76
Custodian Fees 42
Auditing Fees 15
Shareholders' Reports 84
Annual Meeting and Proxy Costs 21
Directors' Fees and Expenses 4
----------
Total Expenses 4,889
Expenses Paid Indirectly--Note C (151)
----------
Net Expenses 4,738
- -------------------------------------------------------------
NET INVESTMENT INCOME 43,060
- -------------------------------------------------------------
REALIZED NET GAIN ON INVESTMENT SECURITIES SOLD 37,039
- -------------------------------------------------------------
CHANGE IN UNREALIZED APPRECIATION (DEPRECIATION)
OF INVESTMENT SECURITIES $107,851
=============================================================
NET INCREASE IN NET ASSETS RESULTING FROM
OPERATIONS $187,950
=============================================================
</TABLE>
13
<PAGE> 16
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 that is
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.
<TABLE>
<CAPTION>
- -----------------------------------------------------------------
EQUITY INCOME FUND
YEAR ENDED SEPTEMBER 30,
---------------------------
1996 1995
(000) (000)
- -----------------------------------------------------------------
<S> <C> <C>
INCREASE IN NET ASSETS
OPERATIONS
Net Investment Income $ 43,060 $ 38,760
Realized Net Gain 37,039 6,800
Change in Unrealized Appreciation
(Depreciation) 107,851 155,649
----------------------
Net Increase in Net Assets Resulting
from Operations 187,950 201,209
----------------------
DISTRIBUTIONS
Net Investment Income (41,545) (37,074)
Realized Capital Gain (10,870) (5,992)
----------------------
Total Distributions (52,415) (43,066)
----------------------
NET EQUALIZATION CREDITS (CHARGES)--NOTE A 2,104 (1,342)
----------------------
CAPITAL SHARE TRANSACTIONS(1)
Issued 390,890 128,018
Issued in Lieu of Cash Distributions 46,196 37,534
Redeemed (232,739) (255,581)
----------------------
Net Increase (Decrease) from Capital
Share Transactions 204,347 (90,029)
- -----------------------------------------------------------------
Total Increase 341,986 66,772
- -----------------------------------------------------------------
NET ASSETS
Beginning of Year 967,395 900,623
----------------------
End of Year $1,309,381 $967,395
=================================================================
(1)Shares Issued and Redeemed
Issued 23,377 9,266
Issued in Lieu of Cash Distributions 2,725 2,741
Redeemed (13,877) (18,631)
----------------------
Net Increase (Decrease) in Shares
Outstanding 12,225 (6,624)
=================================================================
</TABLE>
14
<PAGE> 17
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. Finally, the table lists the Fund's Average Commission Rate
Paid, a disclosure required by the SEC beginning in 1996. This rate is
calculated by dividing total commissions paid on portfolio securities by the
total number of shares purchased and sold on which commissions were charged.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------
EQUITY INCOME FUND
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
FOR A SHARE OUTSTANDING THROUGHOUT EACH YEAR 1996 1995 1994 1993 1992
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
NET ASSET VALUE, BEGINNING OF YEAR $15.65 $13.16 $14.62 $12.81 $12.14
- --------------------------------------------------------------------------------------------------
INVESTMENT OPERATIONS
Net Investment Income .63 .60 .59 .59 .59
Net Realized and Unrealized Gain (Loss)
on Investments 2.18 2.56 (.92) 1.81 .83
----------------------------------------------------
Total from Investment Operations 2.81 3.16 (.33) 2.40 1.42
----------------------------------------------------
DISTRIBUTIONS
Dividends from Net Investment Income (.60) (.58) (.61) (.59) (.65)
----------------------------------------------------
Distributions from Realized Capital Gains (.17) (.09) (.52) -- (.10)
----------------------------------------------------
Total Distributions (.77) (.67) (1.13) (.59) (.75)
- --------------------------------------------------------------------------------------------------
NET ASSET VALUE, END OF YEAR $17.69 $15.65 $13.16 $14.62 $12.81
==================================================================================================
TOTAL RETURN 18.22% 24.77% -2.19% 19.17% 12.26%
==================================================================================================
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Year (Millions) $1,309 $967 $901 $1,106 $778
Ratio of Total Expenses to Average Net
Assets--Note C 0.42% 0.47% 0.43% 0.40% 0.44%
Ratio of Net Investment Income to Average
Net Assets 3.69% 4.27% 4.41% 4.39% 4.74%
Portfolio Turnover Rate 21% 31% 18% 15% 13%
Average Commission Rate Paid $.0598 N/A N/A N/A N/A
- --------------------------------------------------------------------------------------------------
</TABLE>
15
<PAGE> 18
NOTES TO FINANCIAL STATEMENTS
Vanguard Equity Income 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 with generally accepted
accounting principles for mutual funds. The Fund consistently follows such
policies in preparing its financial statements.
1. SECURITY VALUATION: Securities listed on an exchange 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. Securities not listed on an exchange are valued at
the latest quoted bid prices. Temporary cash investments are valued at cost,
which approximates market 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. EQUALIZATION: The Fund follows the accounting practice known as
"equalization," under which a portion of the price of capital shares issued and
redeemed, equivalent to undistributed net investment income per share on the
date of the transaction, is credited or charged to undistributed income. As a
result, undistributed income per share is unaffected by capital share
transactions.
4. 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.
5. DISTRIBUTIONS: Distributions to shareholders are recorded on the
ex-dividend date.
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. Under the terms of advisory contracts, the Fund pays Newell Associates;
Spare, Kaplan, Bischel & Associates; and John A. Levin & Co., Inc. advisory fees
calculated at an annual percentage rate of average net assets. The basic fees
thus computed for Spare, Kaplan, Bischel & Associates are subject to quarterly
adjustments based on performance relative to the Standard & Poor's/BARRA Value
Index; such fees for John A. Levin & Co., Inc. are subject to quarterly
adjustments based on performance relative to the Standard & Poor's 500 Composite
Stock Price Index. For the year ended September 30, 1996, the aggregate advisory
fee represented an effective annual rate of 0.18% of average net assets before a
decrease of $191,000 (0.02%) based on performance.
C. The Vanguard Group furnishes at cost corporate management, administrative,
marketing, and distribution services. The costs of such services are allocated
to the Fund under methods approved by the Board of Directors. At September 30,
1996, the Fund had contributed capital of $124,000 to Vanguard (included in
Other Assets), representing 0.6% of Vanguard's capitalization. The Fund's
directors and officers are also directors and officers of Vanguard.
Vanguard has asked the Fund's investment advisers to direct certain
portfolio trades, subject to obtaining the best price and execution, to brokers
who have agreed to rebate to the Fund part of the commissions generated. Such
rebates are used solely to reduce the Fund's administrative expenses. For the
year ended September 30, 1996, these arrangements reduced the Fund's expenses by
$151,000 (0.01% of average net assets).
16
<PAGE> 19
D. During the year ended September 30, 1996, the Fund purchased $393,434,000 of
investment securities and sold $232,810,000 of investment securities, not
counting U.S. Government securities and temporary cash investments.
E. At September 30, 1996, net unrealized appreciation of investment securities
for financial reporting and Federal income tax purposes was $321,419,000,
consisting of unrealized gains of $332,210,000 on securities that had risen in
value since their purchase and $10,791,000 in unrealized losses on securities
that had fallen in value since their purchase.
17
<PAGE> 20
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholders and
Board of Directors of
Vanguard Equity Income 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 Equity Income Fund (the "Fund") at September 30, 1996, and the results
of its operations, the changes in its net assets and the financial highlights
for each of the periods indicated, 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 September 30, 1996 by correspondence with the
custodian and brokers and the application of alternative auditing procedures
where confirmations from brokers were not received, provide a reasonable basis
for the opinion expressed above.
PRICE WATERHOUSE LLP
Thirty South Seventeenth Street
Philadelphia, Pennsylvania 19103
October 31, 1996
18
<PAGE> 21
SPECIAL 1996 TAX INFORMATION (UNAUDITED)
VANGUARD EQUITY INCOME FUND
This information for the fiscal year ended September 30, 1996, is included
pursuant to provisions of the Internal Revenue Code.
The Fund designates $26,433,000 as capital gain dividends (from net
long-term capital gains), of which $2,335,000 was distributed to shareholders
in December 1995. The balance of $24,098,000, along with any additional gains
realized through October 31, 1996, will be distributed in December 1996.
For corporate shareholders, 77.2% of investment income (dividend income
plus short-term gains, if any) qualifies for the dividends-received deduction.
All comparative mutual fund data are from Lipper Analytical Services, Inc. or
Morningstar unless otherwise noted.
19
<PAGE> 22
DIRECTORS AND OFFICERS
JOHN C. BOGLE, Chairman of the Board and Director of The Vanguard Group, Inc.
and of each of the investment companies in The Vanguard Group.
JOHN J. BRENNAN, President, Chief Executive Officer, and Director of The
Vanguard Group, Inc. and of each of the investment companies in
The Vanguard Group.
ROBERT E. CAWTHORN, Chairman Emeritus of Rhone-Poulenc Rorer Inc.; Director of
Sun Company, Inc. and Westinghouse Electric Corp.
BARBARA BARNES HAUPTFUHRER, Director of The Great Atlantic and Pacific Tea Co.,
Alco Standard Corp., Raytheon Co., Knight-Ridder, Inc., and
Massachusetts Mutual Life Insurance Co.
BRUCE K. MACLAURY, President Emeritus of The Brookings Institution; Director of
American Express Bank Ltd., The St. Paul Companies, Inc., and National
Steel Corp.
ALFRED M. RANKIN, JR., Chairman, President, and Chief Executive Officer of
NACCO Industries, Inc.; Director of NACCO Industries, The BFGoodrich
Co., and The Standard Products Co.
JOHN C. SAWHILL, President and Chief Executive Officer of The Nature
Conservancy; formerly, Director and Senior Partner of McKinsey
& Co. and President of New York University; Director of Pacific Gas
and Electric Co. and NACCO Industries.
JAMES O. WELCH, JR., Retired Chairman of Nabisco Brands, Inc.; retired Vice
Chairman and Director of RJR Nabisco; Director of TECO Energy, Inc.
and Kmart Corp.
J. LAWRENCE WILSON, Chairman and Chief Executive Officer of Rohm & Haas Co.;
Director of Cummins Engine Co.; Trustee of Vanderbilt University.
OTHER FUND OFFICERS
RAYMOND J. KLAPINSKY, Secretary; Senior Vice President and Secretary of The
Vanguard Group, Inc.; Secretary of each of the investment companies
in The Vanguard Group.
RICHARD F. HYLAND, Treasurer; Principal of The Vanguard Group, Inc.; Treasurer
of each of the investment companies in The Vanguard Group.
KAREN E. WEST, Controller; Principal of The Vanguard Group, Inc.; Controller of
each of the investment companies in The Vanguard Group.
OTHER VANGUARD OFFICERS
ROBERT A. DISTEFANO, Senior Vice President,
Information Technology.
JAMES H. GATELY, Senior Vice President,
Individual Investor Group.
IAN A. MACKINNON, Senior Vice President,
Fixed Income Group.
F. WILLIAM MCNABB III, Senior Vice President,
Institutional.
RALPH K. PACKARD, Senior Vice President and
Chief Financial Officer.
[THE VANGUARD GROUP LOGO]
Please send your comments to us at:
Post Office Box 2600, Valley Forge, Pennsylvania 19482
Fund Information: 1-800-662-7447
Individual Account Services: 1-800-662-2739
Institutional Investor Services: 1-800-523-1036
[email protected] http://www.vanguard.com
This Report has been prepared for shareholders and may be distributed to others
only if preceded or accompanied by a current prospectus. All Funds in the
Vanguard Family are offered by prospectus only.
<PAGE> 23
THE VANGUARD FAMILY OF FUNDS
EQUITY AND BALANCED FUNDS
GROWTH AND INCOME FUNDS
Vanguard/Windsor Fund
Vanguard/Windsor II
Vanguard Equity Income Fund
Vanguard Quantitative Portfolios
Vanguard Selected Value Portfolio
Vanguard/Trustees' Equity-U.S. Portfolio
Vanguard Convertible Securities Fund
BALANCED FUNDS
Vanguard/Wellington Fund
Vanguard/Wellesley Income Fund
Vanguard STAR Portfolio
Vanguard Asset Allocation Fund
Vanguard LifeStrategy Portfolios
GROWTH FUNDS
Vanguard/Morgan Growth Fund
Vanguard/PRIMECAP Fund
Vanguard U.S. Growth Portfolio
AGGRESSIVE GROWTH FUNDS
Vanguard Explorer Fund
Vanguard Specialized Portfolios
Vanguard Horizon Fund
INTERNATIONAL FUNDS
Vanguard International Growth Portfolio
Vanguard/Trustees' Equity-International
Portfolio
INDEX FUNDS
Vanguard Index Trust
Vanguard Tax-Managed Fund
Vanguard Balanced Index Fund
Vanguard Bond Index Fund
Vanguard International Equity Index Fund
Vanguard Total International Portfolio
FIXED-INCOME FUNDS
MONEY MARKET FUNDS
Vanguard Money Market Reserves
Vanguard Admiral Funds
INCOME FUNDS
Vanguard Fixed Income Securities Fund
Vanguard Admiral Funds
Vanguard Preferred Stock Fund
TAX-EXEMPT MONEY MARKET FUNDS
Vanguard Municipal Bond Fund
Vanguard State Tax-Free Funds
(CA, NJ, OH, PA)
TAX-EXEMPT INCOME FUNDS
Vanguard Municipal Bond Fund
Vanguard State Tax-Free Funds
(CA, FL, NJ, NY, OH, PA)
Q650-9/96
[PHOTO]
