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Vanguard Remains at the Forefront in 2015

Christine Benz
Bridget B. Hughes, CFA

Christine Benz: Hi, I'm Christine Benz for Vanguard continues to garner a high share of the assets flowing into the fund industry. Joining me to provide a recap of 2015 at Vanguard is Bridget Hughes--she is associate director in manager research for Morningstar.

Bridget, thank you so much for being here.

Bridget Hughes: Hi, Christine. Thanks for having me.

Benz: Bridget, one of the things that you and the team keep tabs on is fund flows. This Vanguard juggernaut continues. We have seen Vanguard take in about $140 billion in new assets so far in 2015--just through November. Let's talk about where the flows are going when you look across the firm.

Hughes: Sure, Christine. First, let's start with the sheer dominance of this fund family. So far for year to date through November, they brought in $140 billion. To put that into some kind of context, that's more than the next 10 families combined going into mutual funds. So, it's a significant amount of money, both on an absolute level but also relative to the rest of the industry. It gives Vanguard $2.4 trillion in fund assets out of $3 trillion of its global assets. So, it's a significantly important piece of their business. It also has given them a 20% market share in the industry, which is about double what the next competitor has.

There are a couple of places where this money is going. First of all, the target-date series. Target date is a significant business for Vanguard, bringing in about $30 billion so far this year. In target-date land, there are three major players: Vanguard, Fidelity, and T. Rowe Price. With this year and these new assets, we've seen Vanguard really pull away in terms of market share, coming up to just under 30% market share in that target-date business.

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Benz: So, does that indicate that Vanguard is winning more 401(k) business?

Hughes: Yes, I think it does. And certainly, the record-keeping business helps. But yes, I would say that because we've seen target dates go into so many more defined-contribution plans that that would be a net win for Vanguard.

Benz: And then we've seen this tendency of flows to go into passive products, and surely Vanguard has been a beneficiary there, too?

Hughes: Yes. They are a big beneficiary of the passive push. And, in fact, of the $140 billion in assets so far this year, about $67 billion of that is going into the ETF share classes. Of course, Vanguard also has traditional open-end index funds, so there is a split there. Just as an aside, their target-date series invest in the non-ETF share classes, so some of that money going into traditional open-end passive is coming through the target-date series.

So, they are benefiting significantly from the passive push. But that isn't the only place [in which new assets are flowing]. Even its actively managed funds are seeing some flows. Not all of them. 

There are some large well-known funds that are in redemption--like Wellington and the Primecap series, to name a couple. But there are other actively managed funds that are in inflow. A couple of areas where we've seen that is in Vanguard's actively managed fixed income, which is generally very conservative, very cheap, and it's run in house for the most part. With the other actively managed funds gaining assets, I would say like there is a little bit of an income theme going on. Vanguard Dividend Growth (VDIGX) and Wellesley Income (VWINX) are a couple of the other funds that are in inflow.

Benz: I'd like to take it asset class by asset class and kind of do a review. Let's start with domestic equity and talk about the performance trends there so far in 2015. The index products are certainly dominant, so maybe let's start there.

Hughes: So, if you look at the absolute returns, the Vanguard lineup reflects what the market has been doing. Large growth is doing better; small value is worse. That's where we're seeing the spectrum of returns. But Vanguard has a little bit of a benefit within each category because its index funds are market-cap weighted, so they tend to be a little bit larger cap than their category averages. That's kind of helped them a little bit. Generally, if you look at Vanguard's entire lineup, which would include their actively managed funds as well as their passive funds, they skew higher--

Benz: Toward better relative performance?

Hughes: Exactly. Out of the 35 funds, five of them are in the bottom third. So, that's a pretty good statistic.

Benz: One fund, though, that you flag as being a laggard performer--and it seems like we're either talking about it as worst or first depending on the year--is Vanguard Capital Value (VCVLX). It's having a very tough year so far in 2015.

Hughes: Capital Value is down 11%. It's the worst-performing Vanguard fund in the domestic-equity space. Again, as you mentioned, it's either soaring high or falling low. Part of it had been that it did invest a little bit more in the mid-cap space. So, it was a little bit smaller cap. But Morningstar has recently moved it from the large-blend category into the mid-blend category--and it has historically been on that edge right there. And even in the mid-blend category this year, it looks pretty week. These are two Wellington managers that have come together. They invest similarly. One is more aggressive than the other, but both are contrarian. One of the things that has really hurt them this year is an overweight to energy.

Benz: Another piece of news on the domestic-equity front is that Vanguard Windsor II's (VWNFX) long-tenured manager, Jim Barrow, has announced that he will be retiring.

Hughes: Right. He is retiring at the end of this year. He has been running that fund since its inception in 1985. What he did is he designated two successors a couple of years ago. In early 2013, he added two managers to the portfolio. These two have worked with him, as I mentioned, for about a decade, and they will continue on the fund.

Now, that fund already has four other subadvisors in varying percentage allocations. I think one of the things that's interesting about the Windsor II fund and the retirement is that Vanguard so far hasn't changed the allocations. Over the past 10 years or so, Barrow Hanley has maintained about a 60% portion of that fund, so it's a major driver of returns there, and they are not changing that. I will tell you--nothing bothers Vanguard more than succession issues. So, I think what they are signaling here is that they have confidence in the two new managers; they recognized a long-term transition plan. Also, what's very important to them would be the process that's used. It's a process that can be adopted by the next generation, so to speak. So, I think that they are expressing confidence in that they've maintained the allocation at about 60% for Barrow Hanley.

Benz: Turning over to international equity: Here again, index funds tend to be the most widely owned. So, let's talk about how performance has shaken out with the big foreign index products.

Hughes: Vanguard's international lineup is much smaller--just about a dozen funds. Whereas on the domestic side, they may have multiple funds in different categories that might smooth out some style differences, they don't really have that in the international category. It's generally one fund per category--just one index or one active or something like that.

Overall, these funds have not been as strong this year as the ones we've seen on the domestic-equity side in terms of the relative ranking. As opposed to them skewing better, the international funds are just skewing a little bit worse. As an example, though, in foreign large blend, the two largest international funds at Vanguard are the Total International Stock Fund (VGTSX) and the Developed Markets Index Fund (VTMGX). The Total International Stock Fund is performing relatively poorly--it's in the bottom quartile. The Developed Markets Fund is in the second quartile. The differences are apparent, disclosed, and evergreen.

Benz: Emerging markets.

Hughes: Exactly. And even though Vanguard--as I said earlier--benefits from that cap weighting in a market that prefers larger-cap stocks, in Total International, it's in a large category, but it's going to have a bigger piece in mid- or smaller-cap companies compared with the large-cap categories. But you're right--it has emerging markets. It's about double the category average in emerging markets. The Developed Markets Index has nothing compared with about 6% for the category average. So, on the international side in particular, I think it's pretty easy to understand the differences in the category rankings.

Benz: Fixed income: It's been a tricky year for bond investors--rising rates, high yield hitting a little bit of turbulence here toward the end of the year. What are the overall takeaways in terms performance in the fixed-income lineup?

Hughes: So, in Vanguard's fixed-income lineup, not only do the index funds obviously not adopt any sort of duration strategy or duration management--because they're straight index funds--even the funds that Vanguard actively manages tend to be very conservative. They don't really adopt any kind of wild duration--not even moderate duration management tactics! It's very straightforward, plain-vanilla--

Benz: Certainly, there's less of a tendency to go fishing in the junkier waters.

Hughes: Absolutely. What I noticed in terms of performance is that the funds that have performed at the bottom of their categories have been most of Vanguard's extended duration, long-term Treasury--sort of those longer-term assets. As everybody is aware, interest rates are very, very low and expected to go up at some point. So, that's taken a toll on the relative returns for those longer-term assets.

On the flip side, the conservative nature of Vanguard's fixed-income operation has helped with the scare in high-yield market. Really, they don't have much in terms of high yield. There's the Corporate High-Yield Fund (VWEHX), which is run by Wellington actually--not in-house--and there is the High-Yield Tax-Exempt Fund (VWAHX). Both of them are very conservative in terms of the credit breakdown compared with peers--so much so that we don't even put the High-Yield Tax-Exempt Fund in the muni high-yield category. We've left that in the muni-national intermediate category because its portfolio looks more like that. We think that's a better comparison. So, in terms of credit, they're very conservative, and those funds have performed well compared with their peers.

Just looking at performance overall and over the long term, it's hard to talk about Vanguard's fixed-income performance without bringing up the cost advantage that it has. It certainly allows them to provide better yield, compound more of investor returns over the long term, and then--to that credit question (or any sort of risk)--allows them to take less risk than some of their peers because they don't need to clear a very big hurdle.

Benz: We talked about Vanguard's competitive positioning at the outset. I want to close there, too, because one thing I've noticed--and I know other market watchers have noticed--is that you've got some competitors, at least on the cost front, trying to nip at Vanguard's heels. We're seeing other index providers have ETFs and index funds that are pretty competitive price-wise with Vanguard's funds. So, where does that leave Vanguard if they are in these cost wars with competitors trying to undercut them?

Hughes: Well, I think that leaves them as a bit of a bystander in a way because I don't think that Vanguard is going to engage. I don't think that you will see Vanguard make a big splash announcement that they've cut their fees. You know that they regularly will tell shareholders and investors where expense ratios have changed in any given year; but because of the funds' operative costs, Vanguard's feeling is that they really can't cut costs because the funds are run at cost. It doesn't mean that some of the other firms that are cutting their expense ratios are operating certain funds, from a fund-accounting standpoint, at a loss. It's possible, I guess; but that isn't philosophically the way Vanguard thinks about how they price their funds. In fact, I would say that they don't even really think they price their funds.

Benz: They just let the costs drive.

Hughes: Yes, they let the costs drive it. Now, of course, there are lots of discretionary expenses in any business: "Do we have the Christmas party or do we not?" Whatever the case may be. But generally, I think we've seen, by Vanguard's track record and what they've been able to give shareholders in terms of cost, that they are doing a pretty good job at giving investors an at-cost experience.

Benz: Bridget, a very thorough recap. Thank you so much for being here.

Hughes: Thank you.

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