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Will Tailwinds Keep Vanguard on Course?

Christine Benz
Bridget B. Hughes, CFA

Christine Benz: Hi, I'm Christine Benz for Vanguard had another solid year in 2013, both in terms of performance and in terms of asset gathering. Joining me to provide a recap as well as a look forward is Bridget Hughes. She is associate director of fund research for Morningstar. Bridget, thank you so much for being here.

Bridget Hughes: Thanks, Christine.

Benz: Vanguard is obviously very much in the news in terms of its big asset-gathering capabilities over the past couple of years. I'd like to start, Bridget, by taking a look backward at 2013, looking at asset class by asset class to see how Vanguard did, when you look at average returns within each of the asset classes. How about domestic equity?

Hughes: Vanguard had, I think, a pretty solid year in domestic equity. None of its funds landed in the worst third in its respective categories. On average they were at about the top third. And what we saw there really, again, just like last year, is that those actively managed funds were sort of pushing that average up. A lot of the index-oriented funds were maybe in the [top] 40th percentile, so they were better than average, but some of the domestic-equity actively managed funds really brought the number even higher.

Benz: Can you name a couple of those funds?

Hughes: Yes, there is the Primecap suite of funds; there are three of them. They really stood out with top-decile performance across the board. Then there is also, again, just like last year, some of the more aggressively managed active funds like Vanguard Capital Value that really performed well in this continued equity rally.

Benz: International-equity [funds were] not quite as impressive in terms of that average performance, but still above-average?

Hughes: Right, still above-average. It's a similar story in a way that some of the index funds were sort of around the middle. But remember there is a much smaller suite of mutual funds on that international side, and some of those categories are very disparate. It's not surprising to see kind of a broader distribution of category rankings.

Benz: Then in terms of asset-allocation funds, or funds that split their assets between stocks and bonds, you found a decent performance there, as well?

Hughes: Right. They also did very well. We were including the Vanguard target-date series in that calculation. And again, on average, they landed around the top third of their respective categories.

Benz: For fixed income, it was a tough year for bond managers or any sort of bond investors last year. The relative rankings weren't quite as good.

Hughes: Right. I split this into two groups: the municipal side and the taxable fixed-income side. On the municipal side, actually Vanguard did quite well with an average category rank around the top quartile, and that includes some of those single-state categories. But even looking at Vanguard's muni-national funds, short duration, intermediate term and long term, they all did pretty well.

On the taxable side, it really was a struggle. There was a lot of bottom-decile performance from some of those funds, but remember Vanguard is an index manager. There is no duration management. They tend to have more Treasuries than some of the other funds in their categories, and that really hurt them in 2013.

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Benz: Bridget, I want to run through some of the news that hit last year in 2013. One of the big news items was that one of the Primecap-managed funds, Vanguard Capital Opportunity, opened and then closed its doors?

Hughes: Right. And this is not surprising. Really, this kind of pattern has happened with Primecap before. The funds performed very strongly and were among the relatively few actively managed funds that brought in assets, so they decided to close the doors. Vanguard Capital Opportunity, unlike Vanguard Primecap and Vanguard Primecap Core, tries to put a little bit more money in the smaller-cap names.

Benz: Vanguard also made some changes in terms the indexes that its passively managed products track. Let's talk about the changes there in which funds they affect?

Hughes: Primarily, it was on the international side. What they did was they moved away from the index heavyweight, MSCI, which really could have been a risk considering how many institutional investors use those benchmarks in evaluating performance. I don't think they've seen any backlash from that. But it was really truly in the name of lowering costs for the end investors, and they thought that they could get a better deal from the new index provider.

Benz: Another change came on the fixed-income side. One of the leaders of the fixed-income management team is retiring. Let's talk about the changes there and what you think the implications will be for that fixed-income management team as well as the funds.

Hughes: Bob Auwaerter is expected to retire in March. They announced this some time ago. This is a fairly long transition as these things go. Greg Davis will be taking the reins from him, and Greg had most recently been in Australia and was named as the chief investment officer for the Asia-Pacific region. He had spent some time as head of bond index management at Vanguard previously, and as Vanguard likes to do, [the firm offers] different leadership roles to get their up-and-coming middle-management people ready for these more senior roles.

Because the fixed-income group is very stable, long-tenured, and seems to be running pretty well, I wouldn't expect many changes under Greg Davis' watch. On the other hand, we haven't seen a really sustained rising interest-rate market and again with that kind of stability that the Vanguard fixed-income group has had, succession risk always comes to mind even in other parts of the group.

Benz: I also want to talk with you, Bridget, about a couple of the bond products that were launched in 2013. Let's talk about the new funds.

Hughes: For the new bond products, one is a total international fixed-income index fund, and the other is in an emerging-markets index bond fund. I think it was about mid-year that they came out. They are still very small, which is a little bit surprising because of the interest that there has been in some of the world-bond funds from other places.

Benz: I know the international-bond fund grew right out of the box because they put it in some of the target-date products.

Hughes: Right.

Benz: Vanguard also launched another new product. This one is a little bit surprising to me, Bridget. This is a low-volatility product, and to me that feels a little bit trendy, which I don't associate with Vanguard.

Hughes: You are right. It does seem a little bit out of their wheelhouse. It's the Vanguard Global Minimum Volatility fund. It's an actively managed, global-equity fund. The idea is that the Vanguard quant group will run it, and it's going to be diversified. It will have 200-some stocks, and they are going to attempt to use quantitative models to predict return patterns and look at correlations so that the portfolio itself balances out. That part of it seems very Vanguard-like, focusing on diversification and low volatility, and of course it's cheap. The investor shares are 30 basis points; the Admiral shares will be 20 basis points.

Benz: I also want to touch on the asset growth, Bridget, because anytime you see the extent to which a firm like Vanguard has gathered assets, you sometimes are a little bit concerned. Is that a concern for you? What are the pros and cons of that asset growth?

Hughes: They really have run away with the assets in 2013. Most of the money is going into passively managed strategies. So, Vanguard is benefiting from that shift in mentality, or in dollars, to more of a passively managed portfolio construction. In that sense, there isn't in a whole of concern because these are passively managed index funds that should be able to handle a lot more money and have the capacity to take that on. Vanguard's actively managed funds, just like with American funds and PIMCO funds, are really seeing redemptions of their own.

Benz: To the extent that anyone is concerned about it, they might be concerned about it for indexes at large and the fact that we've been seeing a lot of asset growth there?

Hughes: Right.

Benz: The last thing, Bridget, I'd like you to talk about is as you look forward into 2014, what are the things you will be watching as our lead Vanguard analyst?

Hughes: One of the things we will be watching certainly is just the new management in place. Tim Buckley has been the CIO through most of 2013 but is still fairly new. Greg Davis now taking over the fixed-income operations is another area we will be watching.

The other thing I would say that we will be keeping an eye on, and this maybe speaks a little bit to your comment about the new Global Minimum Volatility fund being a little bit unusual for Vanguard, is Vanguard's move even further into the financial advisor world. They've been very aggressive about increasing their staff to go out and talk to advisors. And so, one of the things we'll be looking for, one of the red flags might be, with that advisor demand, what happens to the product lineup. Vanguard has always wanted to keep thing simple, straightforward, and, of course, low-cost. Will that continue, and will we see that in their fund lineup?

Benz: Bridget, thank you so much for being here to provide a recap.

Hughes: You're welcome.

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