Manager Exit Triggers Downgrade at Giant Vanguard Fund

The following is our latest Fund Analyst Report for Vanguard Short-Term Investment-Grade VFSUX.

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Vanguard Short-Term Investment Grade provides consistent exposure to short-term corporate and securitized bonds at an attractive price. Yet, with the departure of lead manager and co-head of Vanguard's U.S. corporate bond desk, Greg Nassour, the fund's People Pillar has been downgraded to Neutral from Positive. The fund's Morningstar Analyst Rating has also been lowered to Bronze from Silver.

On April 13, 2018, Vanguard announced that longtime corporate bond skipper Nassour had left the firm. He had managed more than $110 billion in active fixed-income assets and oversaw U.S. corporate bond trading and portfolio management at Vanguard for nearly a decade. Until Vanguard finds a replacement to fill Nassour's seat, Samuel Martinez and Daniel Shaykevich will comanage this fund. Martinez and Shaykevich ascended Vanguard's ranks as assistant portfolio managers but are relatively new as lead managers themselves. Shaykevich has run Vanguard Emerging Markets Bond VEMBX since early 2016, while Martinez had comanaged Vanguard Ultra-Short-Term Bond VUBFX with Nassour since the beginning of 2017. Vanguard still has ample fixed-income resources supporting this fund, including a deep corporate research team, but the vacancy left by Nassour's departure highlights the need for improved succession planning.

Otherwise, the fund continues to be managed in a regimented fashion and is unlikely to see big changes under its new leadership. Top-down themes will continue to come down as directives from senior fixed-income leaders, while specialist portfolio managers oversee their assigned sectors. As the lead manager of corporate credit, Nassour curated the fund's corporate bond stake (60%-70% of the portfolio at times) and oversaw its allocation across corporate sectors.

While any changes made by the fund's new managers bear watching, Vanguard's team-oriented approach and the advantage of a cheap price tag should keep this fund on a steady course.

Process Pillar: Neutral | Alaina Bompiedi 04/25/2018 Vanguard's "hub-and-satellite" structure has guided this fund's approach since its implementation in 2007. The hub, composed of Vanguard's senior fixed-income leaders, sets broad investment guidelines and risk parameters for the fund, while satellite teams of sector-specific analysts, traders, and portfolio managers develop and execute themes within their sectors.

Like many Vanguard bond funds, this portfolio is managed to an internal benchmark which informs, but does not dictate, the fund's yield curve, duration, sector, and quality positioning. Portfolio managers have some discretion to tailor the fund's stance, but its well-defined internal benchmark grants limited wiggle room. While Vanguard hasn't shared the exact specifications of that benchmark, the fund has limitations on the size of its BBB stake (maximum 30%), high yield (maximum 5%), and duration (within half a year of its index's).

The fund maintains a consistent overweighting in investment-grade corporates (60%-70%), with a slant toward financials and industrials. The remainder is typically held in asset-backed (10%-20%) and commercial mortgage-backed (2%-20%) securities, with a sprinkling of foreign bonds and U.S. Treasuries. A simple, if not cutting-edge, process supports a Neutral Process rating.

The short-term bond Morningstar Category is heterogeneous in its credit quality and sector makeup. This fund's bias to corporate bonds saddles it with more credit risk than average, but its investment-grade tilt makes the fund a higher-quality option in the category.

In addition to its large holdings of corporates, the fund maintains a ballast of ABS and CMBS, usually in the range of 10%-20% combined. In March 2018, the fund held 60% in corporate bonds and 20% in securitized debt. In recent years, the team has preferred shorter-term auto loans within its ABS exposure, and high-quality CMBS tranches.

A persistent 5%-15% ballast of Treasuries (6.5% as of March 2018) provides a source of liquidity and will fluctuate as the managers find buying opportunities or decide to increase or decrease risk. Over the past two years, the fund has also held less BBB exposure than the category. That allocation stood at 21% versus it's typical peer's 23% in March 2018.

The fund's duration tends to be longer than the category average but doesn't stray far from its Bloomberg-Barclays U.S. Credit 1-5 Year iIndex. As of March 2018, the fund's 2.7-year duration fell just short of its benchmark (roughly 2.8 years) but was amply longer than the peer group median (1.8 years). That range has been typical for the fund over the trailing five years, which tends to run at the long end of the category.

Performance Pillar: Neutral | Alaina Bompiedi 04/25/2018 Funds in the short-term bond category can vary widely in their sector and quality makeup. This fund, with its focus on corporate bonds, lies on the more aggressive end of the category with respect to its credit risk and interest-rate sensitivity. The fund has accrued a strong long-term record, but its recent manager departure leads us to reset the fund's Performance rating to Neutral.

Over Nassour's decade-long tenure, from 2008 through March 2018, the fund returned 2.9% annualized, landing in the top quartile of its category. Its volatility, as measured by standard deviation, also sat at the high end of the peer group. Much of the fund's strong relative returns and heightened volatility can be attributed to its persistent overweighting in corporate credit and, more recently, its longer duration relative to peers. These characteristics have helped the fund in the wake of the credit crisis, which has mostly been supportive for credit and interest-rate risk.

Still, the fund hasn't held positions as large in mid- to lower-grade bonds as others in its category have. This characteristic helped it turn in a top-decile return in 2015, a difficult year for corporate bond funds, which were affected by a sell-off in energy company debt. However, during the first two months of 2018, the fund's longer duration became a liability as yields jumped, causing the fund to underperform 80% of its peers.

People Pillar: Neutral | Alaina Bompiedi 04/25/2018 Longtime manager Greg Nassour unexpectedly left Vanguard on April 13, 2018. The firm responded by handing the reins to Daniel Shaykevich and Samuel Martinez--who have managed Vanguard Emerging Markets Bond since 2016 and Vanguard Ultra-Short-Term Bond since 2017, respectively--while it searched for a new lead corporate bond manager to assume Nassour's vacated seat. The fund continues to have the support of 22 corporate analysts and traders, but this impromptu transition raises concerns about the firm's succession planning, resulting in a downgrade of the fund's People rating to Neutral from Positive.

Shaykevich and Martinez have ascended through the ranks as assistant portfolio managers since joining Vanguard in 2013 and 2007, respectively, though neither had more than two years of lead portfolio manager experience when they took over here. Shaykevich has overseen emerging-markets debt trading and portfolio management since 2016, and Martinez has performed the same function for the asset-backed and commercial mortgage-backed desk since 2017.

These personnel changes coincide with Vanguard's reshuffling among its fixed-income heads. Effective June 2018, Vanguard's global head of credit, Paul Jakubowski, will take over as global head of fixed-income indexing for a retiring Ken Volpert, and Vanguard municipal head Chris Alwine will move into Jakubowski's seat.

Parent Pillar: Positive | 12/12/2016 Vanguard has one of the mutual fund industry's strongest corporate cultures and earns a Positive Parent rating. Its consistent messages to investors to keep costs low, diversify, and stay the course are reflected in the firm's own behavior. Vanguard's U.S. fundholders own the firm through small investments by each mutual fund, mitigating potential conflicts of interest that can exist at other firms that are serving two masters. Fund performance is strong overall: Over the past three-, five-, and 10-year periods, its Morningstar Success Ratios are greater than 70%--high among large, diversified fund families.

Over the past year, the firm has collected more than USD 200 billion in net inflows, thanks in large part to investors' interest in passive investing. The firm's indexing and ETF prowess, low costs, and success in penetrating the financial-advisor sales channel all have fueled growth. Total assets under management now exceed USD 3.3 trillion, giving Vanguard a significant more-than-20% market share across U.S. mutual funds.

Vanguard has been a global player for years but has only more recently turned its focus to growing internationally. The firm is a large player in Australia, where it has the most history, but doesn't yet have the brand recognition and trust it enjoys in the United States in other parts of the world. While non-U.S. funds don't participate in the ownership of Vanguard, the firm's investorcentric culture extends globally.

Price Pillar: Positive | Alaina Bompiedi 04/25/2018 In typical Vanguard fashion, the fund's fees are low across all share classes, earning a Price rating of Positive. The fund is offered in Vanguard's standard Investor and Admiral share classes, which charge 20 and 10 basis points per year, respectively, as well as an Institutional share class, priced at 7 basis points. Most assets are held in the Admiral class; its fee ranks low relative to other no-load short-term bond funds. The Admiral share class has a $50,000 investment minimum, and the Investor share class carries a $3,000 minimum.