Vanguard's Leaders and Laggards

Culloton: Well, this is Vanguard's High-Yield Corporate Fund, and normally when you think of high-yield corporate, you think of something that's really out there on the yield curve investing in dicey companies.

Benz: The risk curve anyway, right?

Culloton: Yes. But Vanguard High-Yield Corporate is a little more middle of the road in this category; it invests in higher-quality corporate bonds that have higher yields. So it would be rare to find them owning a company that's either about to default or at high risk of default.

But it's been getting a lot of inflows lately because interest rates are low across the board, and investors are stepping out on the risk curve or yield curve to get more yield, and so it's been one of Vanguard's top 20 sellers, and I think Vanguard decided to close this fund, one, to preserve the flexibility of sub-advisor Wellington Management, who has been running the fund for several years. But also because they are concerned about this investor stretching for yield and stepping out on the yield curve to get ... the income that they desire. They see risk in that because even though this is a middle of the road, high-yield fund, there are still risk inherent to it, it's more risky than an intermediate-term corporate fund. It's more risky than the Total Bond Market Fund. So I think that's part of the reason, to make investors aware of the risk, to cool things off a bit, and also to preserve the flexibility of Wellington Management.

Benz: Another thing I would like to touch on, Dan, is, the best and worst performers within the Vanguard lineup year-to-date. We've just hit this mid-year mark, and you note that actually a couple of other products with decent yields--maybe a little less decent these days--the real estate index funds have had some of the best returns within the firm's line up here to date.

Culloton: Yes, very strong. Vanguard REIT Index and Vanguard Global REIT have been among the best performers in absolute and relative terms. Relative to their category, they rank very high. They give you very pure exposure to that asset class, and that asset class has done very well this year. Real estate has been one of the best-performing sectors of the year, and so it stands to reason that they are up there.

Once again, people are probably turning to REITs because they offer higher yields than government bonds or total bond market funds right now. But they are also riskier, and you have to keep that in mind when you go into them. They are equities, so you can't use them as a bond replacement.

Benz: You also noted that growth has outperformed value year-to-date, and one beneficiary of that trend has been Vanguard U.S. Growth Fund, which has performed quite well. What's been driving that one apart from just its focus on its namesake companies?

Culloton: Well, it has more than third of its assets in technology, about 36% of its assets in technology, and technology has been the second-best sector of the year so far after real estate. That's helped it along.

Also it has a nearly 9% stake in Apple, and we all know how well Apple has done not only year-to-date, but past several years. It's really driven performance of this fund and other funds that have had big stakes in it.

This is still sort of a turnaround story.

Benz: It's been a notable laggard within their lineup for several years.

Culloton: Yes. If you look back at the 10-, 15-year trailing returns, the records are not impressive, but in the last year or so, it's gone over management overhaul. They have three subadvisors there--Wellington, William Blair, and Delaware Investments. So it's a new ballgame, and they are all very experienced investors running this, but we don’t know how this configuration is going to work out over the long term. So far, so good.

Benz: You also note that the big index funds that are linchpins of Vanguard's lineup, the Total Stock Market and the 500 Index products have also performed really well, and I think that this is maybe confounding to some people, because sometimes you think of index funds as having sort of slow and steady outperformance, maybe 45th percentile. They are actually doing much better than that recently.

Culloton: Yes. They are ranked pretty high, and one reason is the index funds are blend funds. So they have a little bit of value, a little bit of growth. But they also have a little bit of a momentum factor in there, too, because they are market-cap weighted, which means the stocks with the highest price get the highest weighting.

Growth has had some momentum in there, and stocks like Apple have really driven performance, and Apple is right now the biggest holding in both of these portfolios, with 3% to 5% of assets, and that's really helped them, along with a significant tech stake and a lot of solid large-cap holdings.

Benz: When you look at some of the firm's funds that have been a little less impressive in terms of year-to-date performance. Let's talk about some of the funds that jump to the top of the list.

Culloton: Well there are three funds in particular that have lost money this year, and one of them, the one that has lost the most money for Vanguard, is Vanguard Precious Metals and Mining. For a while now, precious metals miners, particularly gold miners, have lagged the price of gold, and that's really hurt this particular fund.

Also Vanguard Energy: Energy has been the worst-performing sector of the stock market this year, at least as Morningstar measures it. Vanguard Energy is sub-advised by Wellington Management and is a ... purist play on large-cap energy firms like ExxonMobil, and that fund hasn't done as well year-to-date, either.

Primarily I think these are still good funds long term. They have experienced managers, good long-term strategies. I think this is just a matter of their sectors being out of favor for a period of time.

Benz: You also mentioned that a couple of the firm's growthy-type products have also struggled, even though growth as a whole has done relatively well. That would be some of the PRIMECAP offerings.

Culloton: Yes. Vanguard PRIMECAP Core and Capital Opportunity all are in the bottom quartile of their categories right now. I think primarily this is due to the fact that, while they are growth investors, they are contrarian growth investors. So while a lot of growth funds will own Apple and will own significant stakes in Apple, many of the PRIMECAP funds own insignificant or no Apple.

So they will opt for something like Google, which has been lagging and has been out of favor for a variety of reasons, but notably maybe some of the antitrust issues they have run into recently. And that's in keeping with their strategy. Their strategy is to not buy or not invest heavily into the areas of the growth stocks that everybody is clamoring for, but to look for the growth stocks that are trading at somewhat of a discount to what they think [those stocks] can grow over the long term.

Benz: Dan, thank you for providing a really helpful summary on what's been going on at Vanguard. We appreciate you being here.

Culloton: Thank you very much.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.