Why Vanguard Was Hard to Beat in 2014

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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Stipp: And Bridget as we think about a firm and its corporate culture, Vanguard has grown tremendously, obviously, with these inflows. What do you look at from a family level to make sure that they are growing in a way that's still going to serve investors?

Hughes: Vanguard has a very long heritage of serving that end investor dating all the way back to its structure, which is that the mutual fund owners actually own the advisor through the mutual funds. As it reaches out to different geographies, different constituents through different channels, it's going to have to listen to those different channels--institutional investors, advisors, maybe different geographies. So what we're looking for is that they stay true to their roots, which is a very strong culture and has given investors a very good experience overall.

Stipp: So far do we think that they've been able to grow and maintain that focus on individual investors?

Hughes: So far so good. We would look at things like the retention of their managers, the types of funds that they launch--and this year just goes to show you, they haven't launched any, and they have grown by leaps and bounds. So you don't have to be everything to everybody if you have a very strong identity and culture, and produce good results.

Stipp: Let's talk about performance of Vanguard funds. A lot of folks were getting into Vanguard funds in 2014, but how did their mutual funds do? Let's take it asset class by asset class. Bridget, on the allocation fund side, how did their funds perform?

Hughes: On the allocation fund side, which would include the target-date series, which is about a dozen funds, all but one of the funds has so far outperformed the median fund in the respective category.

Stipp: Strong performance there. On the U.S. equity side?

Hughes: 89% of the funds have outperformed their medians, so yes very strong. On the international side, it's not quite as strong--it's a little bit of a tougher go--but still two-thirds of the offerings are ahead of their category medians. Then we flip over to the bond side, and it's equally strong there. More than 80% on the taxable side, and 10 out of 12 on the municipal side.

Stipp: Mike, what are some of the reasons why we're seeing such outperformance from the Vanguard funds? Is there anything that ties it together.

Rawson: Vanguard funds are predominantly index funds, and it's been a particularly difficult year for active managers to beat indexes this year. So in 2014, for example, the S&P 500 is beating about 80% of active managers, and you could attribute that to several factors. First of all, a lot of active managers tend to be a bit conservative, especially coming out of 2013 where the market was up so strong. I don't think people really expected the market to be up as much as it is. So far we're up about 15% in the S&P 500 in 2014. When the market rallies strong, a lot of active managers tend to lag, maybe because they're being more conservative, holding more quality stocks, or maybe holding a little bit of a cash--it is common for an active manager to hold some cash. So it's difficult to keep up with the rising market.

In addition, active managers sometimes will use small-cap stocks or international stocks in their portfolios to be more diverse, to offer a more complete portfolio than just the S&P 500. However, that would have worked against them in 2014, as small caps lagged and international stocks lagged.

Finally, Apple is up about 50% last year; that's the largest stock in the index. If you were to underweight Apple, which would be easy to do since it is such a large weight in the index, that is going to create a performance drag.

On the bond side, I think a lot of active bond fund managers [were] thinking that interest rates are going to continue to rise. Well, long-term interest rates fell in 2014, so that would have worked against an active bond fund manager who was betting that interest rates would rise, so they would have shortened duration.

Secondly, one way to beat the most common bond benchmark, which is the Barclays Agg, would be to use some high-yield bonds. High-yield bonds are not included in that index, so that gives you a little bit of a performance edge over the long term, but not so in 2014, as we saw high-yield or low-quality bonds' credit spreads widen out a little bit, particularly among the energy high-yield bonds. So the bond index funds had a better year than they typically would have in 2014.

Stipp: A lot of the places active managers would go for that outperformance just haven't performed as well as we've seen a lot of the cap-weighted indexes perform, giving Vanguard that tailwind.

Then what about fees? Low fees are an ever-present tailwind for Vanguard, right?

Hughes: I think you would almost always expect low fees to work in your favor, and Morningstar's research has time and time again shown that it's one of the best predictors of future outperformance. But as you think about it intuitively, you would really think about how that fee advantage could compound over time, and you would see that advantage in the long-term results. And you do at Vanguard.

But I think that even this year where some of the results are a little bit closer together, some of the indexes aren't that far apart in terms of their returns, the Total Stock Market Index versus the S&P 500, as an example, isn't that far apart this year. So in a year when the returns might be a little bit compressed, a fee advantage would work in your favor even over the shorter term.

Rawson: I think a lot of people have an assumption, too, that ETFs are always going to be cheaper than mutual funds. We did a study this year looking at index mutual funds versus similar ETFs, and it turns out that, on an asset-weighted basis, mutual funds are actually for the most part cheaper than index ETFs, and the reason for that is so much of the assets are in Vanguard funds. Vanguard funds are low cost, and their index mutual funds are separate share classes of their ETFs, so it actually skews the distribution in favor of index mutual funds on an asset-weighted basis, making the index mutual funds look a little bit cheaper.

Stipp: Let's talk about some of the leaders and laggards in the Vanguard lineup. PRIMECAP had a really good year this year.

Hughes: All three of the funds that are sub-advised by PRIMECAP for Vanguard had great years. One of the reasons they all had such strong results was they have a higher concentration in health care--biotech and pharmaceutical stocks--which did really well. The PRIMECAP Funds also owned Southwest, which had a very strong year, up more than 100% this year.

One thing to note about these funds, though, is that they are long-term oriented, contrarian growth funds. The funds had a very strong 2014 and a strong 2013, but in the couple of years prior to 2013, they weren't as strong. So in years like this, they are sort of reaping what they sow, and so investors need to be patient with PRIMECAP funds. It is a long-term offering. Investors should not expect to see these strong results year-in and year-out.

Stipp: Vanguard has a pretty new fund, the Global Minimum Volatility Fund, that launched last year, and it had a pretty good year.

Hughes: It did have a pretty good year. It's in the world stock category, as it is an equity fund, and it also is an active fund from Vanguard, though it is a quantitative fund. One of the main reasons this fund did so well is in its effort to lower volatility, it hedges almost all of its currency exposure, and that really would help it in a category where much of the currency exposure is left unhedged, because of the international drag when those other [funds' results are translated into U.S. dollars].

It's a fairly small fund right now, but has a 20 basis point expense ratio, so it's priced very nicely. It's very diversified and what you would expect, again, from Vanguard. But I wouldn't want investors to expect a fund that did so well in a rally year like 2014 to perform the same way going forward. Its objective is to outperform in the down market, not necessarily to outperform in the upmarket.

Stipp: Then turning to look at the funds that were laggards in the Vanguard lineup: One that we've discussed before and that has had some streaky performance is Vanguard Capital Value. It didn't have a great year in 2014.

Hughes: It's up 5% or 6%, but that makes it a bottom-decile performer for 2014 in its category. It has a good amount of energy, which has helped it in the past, but not so much this year. It also owns Groupon, which was a great stock for the portfolio last year, and the fund bought it in the second half of 2013, and really caught it on its way up. But it hasn't been a good performer this year.

This is a portfolio that's split between two Wellington managers that are contrarian value or deeper value. So some of their stocks can be a little bit more controversial at times than some other value mangers.

Stipp: And may need a little bit longer to play out.

Hughes: Certainly. And higher risk tolerance for those ups and downs.

Stipp: Mike, let's talk about those fund flows at Vanguard. When you said they had a record year, what does that mean? How much did they bring in?

Rawson: Through the first 11 months, they were at about $190 billion, so that puts them on pace to surpass $200 billion in flows in 2014. That will be a record for Vanguard and a record for any fund going back historically. So it's a truly phenomenal year.

Now they've been number one in terms of flows for eight straight years--really phenomenal. Going back over that span, they've attracted about $1 trillion in new investor cash. About $0.44 of every dollar invested in long-term mutual funds and ETF have gone to a Vanguard Fund.

Now in that span they've been able to increase market share--they are up to about 20% of the mutual fund and ETF market, which is phenomenal. They are ahead of Fidelity, which is the next closest rival. On the ETF side, they had strong flows, but not as strong as iShares flows. But because Vanguard is a little bit smaller than iShares on the ETF side, their organic growth has been stronger. So they are gaining market share against iShares and State Street. In fact, they are on the cusp of overtaking State Street to be the number two largest ETF provider.

Stipp: Bridget, when you think about getting all those flows in, if you are running index funds, they can pretty well manage all of those flows.

Hughes: Right. The index offerings are highly scalable, but it isn't just the index offerings where Vanguard is getting flows. Their active funds are also getting flows. Again, with strong long-term performance and recent performance for many of their funds, that's not a surprise. The way Vanguard has addressed that capacity issue in the past historically is add subadvisors on the funds that they use subadvisors, which is virtually all of their active funds. They do also use their quantitative group as a subadvisor, which does have a little bit more capacity than maybe a regular active manager does.

Stipp: One of their big active managers or subadvised funds are the PRIMECAP funds, and those funds are actually closed right now.

Hughes: Those funds are closed right now to investors.

Stipp: Do we have any insight on when investors could get back into those funds?

Hughes: No, we don't. PRIMECAP does offer funds direct-to-investors as well, and those are open, but I would guess on the Vanguard side that they would reopen after worse performance and redemptions.

Stipp: Which probably is a better time for investors to be taking a look at them anyway.

Hughes: Exactly.

Stipp: It was certainly a big year for Vanguard both on the inflow side and on the performance side. Thanks for joining me with that recap.

Hughes: Thank you, Jason.

Rawson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.