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By Bridget B. Hughes, CFA and Michael Rawson, CFA | 12-23-2014 11:00 AM

Why Vanguard Was Hard to Beat in 2014

It was tough for active managers to outpace Vanguard's low-cost index funds in 2014, and many of its active funds also outperformed.

Jason Stipp: I'm Jason Stipp for Morningstar.

Vanguard had a record year of inflows in 2014, but how about their fund performance? I am here with Bridget Hughes and Mike Rawson from Morningstar's Manager Research team covering Vanguard to get their take on how Vanguard did in 2014.

Bridget, Mike, thanks for joining me.

Bridget Hughes: Thanks, Jason.

Mike Rawson: Thanks.

Stipp: Bridget I'd like to start out by talking about some of the fundamental news from Vanguard before we talk about performance and fund flows. Let's talk about any big manager changes that happened at Vanguard.

Hughes: There are always a few here and there, whether it's changes at the subadvisor level or changes to the subadvisors that Vanguard is using. Vanguard Explorer, which is the U.S. small-cap fund that Vanguard uses subadvisors, is an actively managed fund, and it added its eighth subadvisor in June this year--Arrowpoint Partners. I think they wanted to get exposure to a couple of managers that had left Janus who had had some strong performance there. But remember, it's the eighth subadvisor, and we've been critical of Vanguard in the number of subadvisors that it uses on this fund, because it is such a sprawling, 700-stock portfolio. On the other hand, it's typical of Vanguard to offer a lot of diversification, and the small expense ratio helps. So while it doesn't always shoot the lights out in any one year, over the long term it has produced pretty solid results.

Stipp: Mike what about new funds? Were there any new flashy new offerings from Vanguard?

Rawson: Fortunately, no. Vanguard is not one to launch on a hot trend or launch a fund in a hot category just because it tends to be popular. They tend to very meticulous before they come out with new funds. In fact, I think the most recent fund they launched was the Global Minimum Volatility Fund, which was launched last year.

Hughes: Last December.

Stipp: Were there any notable closings of Vanguard funds, Bridget?

Hughes: Not really this year. The PRIMECAP funds have been closed for a while, and last year they reopened Capital Opportunity, which was the all-cap, smaller-cap one. But they only opened it to a small level of investment, and they recently reclosed that one. Those three funds have had pretty good results.

Stipp: And when we look at the firm as a whole and the customers that it's serving, its customer base has gotten a lot bigger and maybe different than it had been in the years past.

Rawson: It has. Traditionally Vanguard has been a direct-to-consumer type of asset manager. They didn't really pay for distribution--no loads or 12b-1 fees. So financial advisors didn't really have an incentive to use Vanguard for the most part.

Now that's starting to change as more of the wirehouse financial advisors, those who would use a load-based fund, are now becoming independent RIAs and are becoming fee-based financial advisors, where their incentive is aligned with their clients' to keep their costs as low as possible. So they are more likely to use a Vanguard fund, particularly on the ETF side where Vanguard ETFs are traded on an exchange, making it much easier for financial advisors to go out and use Vanguard products, where in the past financial advisors were less likely to do so.

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