Behind Vanguard's Surprising China Decision

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Shortly before the Chinese market began its current freefall, Vanguard announced plans to add China A-shares to its Emerging Markets Index Fund (VEMIX). Joining me to discuss this and other news at Vanguard are Bridget Hughes and Michael Rawson.

Bridget and Mike, thank you so much for being here.

Bridget Hughes: Thank you, Christine.

Mike Rawson: Thanks for having us.

Benz: So, the Chinese market has really been making headlines. Mike, let's talk about Vanguard's announcement; but before we get into the specifics of that, let's talk about what China A-shares are for people who haven't been following this too closely.

Rawson: Unlike stocks that trade in the U.S., which are you pretty much free to trade, you are not free to trade stocks that trade in mainland China, which are known as China A-shares.

Benz: So, U.S. investors--

Rawson: U.S. investors, we cannot freely buy and sell those securities. There are capital controls that prevent us from doing that. Now, you can trade more freely shares that trade in Hong Kong, and there have been Hong Kong-based funds for some time. But funds have not been able to access the A-shares in China until just recently. China is attempting to liberalize its market, open up its economy a little bit more, and encourage more stock market investments.

Benz: So, these A-shares are going to be added to the FTSE Index that the Vanguard fund tracks. That's not happening until later this year, though, right?

Rawson: When we say that FTSE is making this decision, they are really making it in concert with Vanguard. Vanguard has a lot of influence over the decisions FTSE is making. It's a little bit unique because MSCI is a little bit more independent than FTSE in this regard. MSCI has decided not to add these shares at this time, so it's quite surprising that Vanguard is going to go ahead and do it because Vanguard is usually very conservative. They plan with FTSE to begin adding China A-shares to their emerging-markets index slowly and in increments to bring it closer to what would be more of a market-cap weight versus where it is now, which is zero.

The reason why I find this surprising is because Vanguard is a very conservative firm, they have a conservative culture, and they don't really like to get into speculative markets. Sometimes, they will close a fund or maybe not launch a fund in a hot area just because they think investors might get burned by the market froth, but here their equity team has decided to go ahead and add these A-shares.

If you look at some of Vanguard's past decisions when they've built funds--if you look at their international-bond fund, for example--they decided to do currency hedging just to tamp down on the volatility. So, I think there is a little bit of a difference in culture between Vanguard's fixed-income team and their equity team. The equity team seems a little bit more adventurous here, and I find it surprising. What's also surprising is that they were going to add it to their emerging-markets fund, but not their total international stock market fund. This is surprising because typically these subcomponent funds add up to equal the total, and that wouldn't be case once they made this change.

Now, fast-forward just one month later and already China seems to be in a panic over the selling that's going on. Stocks are down tremendously--30% in a short period of time. However, if you look over the past year or two, stocks are still doing pretty well. So, you wonder, "Why is China being so heavy-handed with its market intervention?" This is QE on steroids: They are preventing people from trading or selling certain securities; they are trying to boost shares by buying. Vanguard has got to be thinking to themselves, "What are we getting into here?" Now, with an ETF, you really can't have this kind of market closure. We see what's happening right now with the Greece ETF; the market closes and, all of a sudden, you have an ETF trading at a premium or discount. Now, it looks like a closed-end fund. People start to worry. People can get burned. So, it will be interesting to see how Vanguard handles this.

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Benz: Just to back up to your previous comment, Mike, and to play devil's advocate a little bit: Is it possibly that Vanguard is saying, "Well, someone in an emerging-markets equity fund really knows that they are buying a pretty high-risk product?"

Rawson: I think that's what's going on here. Basically, I think they are catering to their ETF clientele. ETF investors typically want to speculate. Vanguard knows that, and Vanguard almost encourages it. [They are basically saying,] "If you want to speculate, please use our ETFs--not our mutual funds." I think that's what's going on here. It's not going to impact their target-date fund. If you're a target-date investor or you have Vanguard in your retirement account, you don't really have to worry about China becoming a big part of your fund; but it will be a part of the emerging-markets ETF, which is a huge ETF that has a lot of volume. So, you can maybe say, "Well, Vanguard is conservative, but they know there's some segment of their customer base that wants to speculate." If you're buying in emerging markets, you're buying risky securities; therefore, [Vanguard] is going to allow you to invest in China if you choose to.

Benz: It's also possible the stocks could be down even more before these additions start to happen.

Rawson: Who knows? Maybe they will end up timing it right.

Benz: A couple of Vanguard funds also had new ratings issued. Let's talk about those two.

Rawson: Speaking of ETFs, there are two popular dividend ETFs from Vanguard that we've covered for quite some time. We just recently rated their mutual fund share class. So, these are aimed at mutual fund investors who maybe haven't seen these funds before. They are funds that have been out there for a while. One of them is Vanguard High Dividend Yield (VHDYX). This is a fund that we've chosen to rate as Silver. It really focuses on getting a higher dividend yield than the other fund we've rating, which is the Gold-rated Vanguard Dividend Appreciation (VDAIX).

Now, Vanguard Dividend Appreciation tilts a little bit more toward growth or quality stocks, so the dividend yield isn't as high as Vanguard High Dividend Yield. Both funds, we think, are suitable investments for long-term investors. Either one could become a core part of your portfolio. One is Gold; one is Silver. They are pretty close. But for investors who are already in Vanguard Dividend Growth (VDIGX), they may be somewhat familiar with the type of strategy and what to expect out of this fund. However, Vanguard Dividend Growth, of course, is actively managed, while the other two funds are a little bit more mechanical in that they follow an index.

Benz: Bridget, we're at midyear. So, you took a look at where Vanguard funds shake out, in aggregate, in the performance statistics. Let's talk about the numbers.

Hughes: Sure. As is typical for Vanguard and any other family that has a large number of funds, the rankings for the year to date sort of run the gamut from the best of the best to the bottom of the barrel. But in Vanguard's case, as has been the pattern over the past couple of years, the funds skew a little bit toward the top half of their categories. About two thirds of the funds are toward the top of their categories. When we look at the subset of index funds, the majority of them are in that middle third--but again, skewed a little bit toward the top end of the middle third of the rankings as opposed to the bottom end.

Benz: When you drill into some of the specific funds, you note that the Primecap funds, which have had such a strong performance run over the past several years, have come back to earth a little bit so far this year.

Hughes: They have. Well, particularly Vanguard Primecap (VPMCX) and Vanguard Primecap Core (VPCCX). They are really large-cap funds. They are kind of flat for the year to date, and part of it is that large mega-cap bias. They've got a lot of large, large companies, which had helped them in 2014 and haven't so much this year, as some of their top holdings like Amgen (AMGN) and Microsoft (MSFT) aren't helping them so much. Another stock that has been a big winner for Primecap in the past but is off about 20% this year is Southwest Airlines (LUV). Now, Primecap is a contrarian fund; they continue to like their airline holdings, and they are continuing to add to them.

Benz: When you look at funds that have had a great year so far--and, of course, it is a very short time period--Windsor (VWNDX) is a fund that hit your screen.

Hughes: Right, exactly. Windsor is a fund that is interesting to watch because it's a little bit of a new mixture now. Wellington's Jim Mordy continues to run about 70% of the fund; Pzena is up at about 30% now. They were added to the fund in 2012. So, it is a little bit of a different mix. Both of them are kind of contrarian, opportunistic managers, but Pzena maybe owns a little bit more of the headline risk--they'll go even deeper value than the Wellington portion. So, that fund has done well with a couple of its tech holdings; it has always had in this current mixture a higher tech weighting than some of the other funds. And so that's helped it this year.

Benz: Mike, you keep an eye on fund flows. It sounds like the Vanguard juggernaut of big inflows into the firm has continued so far in 2015.

Rawson: Absolutely. They're having, actually, one of the most dominant years they've ever had. So far, year to date, they are over $100 billion in flows, while their next-closest competitor, I think, is at $30 billion--that's iShares. So, it's really amazing how they've continued to be dominant in terms of flows.

A couple of fund firms with strong outflows are PIMCO, which is not surprising, and then State Street. State Street has the largest S&P 500 ETF. Well, Vanguard is taking share because Vanguard S&P 500 ETF (VOO) is cheaper and it tracks better. So, I think investors slowly are flocking to that fund.

What really strikes me about Vanguard's flows is how stable they are. A lot of fund firms rely on one hot fund or one hot sector of the market to drive flows. With Vanguard, it's the opposite; they are very stable. Whether the market is up or down, investors continue to save. And I think they really try to cater toward that saver who is looking to put a little bit of money away every single month, and it adds up over time. Vanguard also encourages their investors to be buy-and-hold. [They encourage investors] not to panic and not to pull out of funds. And really, this is the benefit of their fund investors because you wind up having a better tax performance if you don't have people panic-selling.

Benz: And you also note that even though Vanguard is very long-term oriented, they happen to be on the receiving end of a few trends--they have a strong presence in passive and they also are increasingly moving into the advisor market.

Rawson: So, there are different types of financial advisors: Some follow a fiduciary standard; some, like brokers, typically don't follow a fiduciary standard. And a broker typically gets a commission; maybe if they are selling you an A-share, they'll get a load. Well, that commission-based broker would never sell you a Vanguard share because Vanguard doesn't pay for distribution. They don't give commissions; they don't give loads. So, Vanguard traditionally would sell their funds directly. You would call them up or go online and buy your Vanguard fund yourself.

Now, more and more financial advisors are leaving those wire houses and going off on their own. And they are fee based, so they charge you a fee just for their service or for the assets under management. They have an incentive to give you the lowest-cost funds possible. Some of them also like to do a little bit of portfolio management themselves, which can be a risk; but they are increasingly using Vanguard ETFs as core portfolio building blocks because they are so low cost.

Benz: Bridget, you recently authored a report where you looked at Vanguard from a stewardship perspective. Vanguard received an A grade. Let's talk a little bit about the underlying components that go into those stewardship grades.

Hughes: Sure. Our stewardship report is based on five key components that we'll look at. We'll consider a firm's corporate culture--that gets the largest weighting in our methodology--as well as fund-manager incentives, fund-board quality, fees overall, and regulatory history. We have a methodology that assigns points for each of those components, with the exception of regulatory. You get zero points as long as you follow the letter of the law. If you get into trouble, it's deductive--

Benz: So, no points earned for following law.

Hughes: Exactly. Now, in Vanguard's case, it hasn't had any regulatory issues that are material enough or recent enough for us to deduct points, so they earn full credit on regulatory. Perhaps not surprisingly, they are going to earn an A for fees and get full credit there. Then, for board quality and culture, we have assigned an A as well, and that's been the status quo for Vanguard. The culture is so identifiable and mission-driven. They have done a lot of great work for investors in terms of, as Mike mentioned, the kinds of funds that they've launched and the kinds of funds that they don't launch. Their track record is good on fund closures and on trying to keep investors from shooting themselves in the foot, so to speak. They do a really nice job there. The one weak link you could mention about Vanguard would be its manager incentives. We award them a C for manager incentives. Part of the issue is, frankly, that it's a large passive shop, and the managers that run some of the passive funds don't invest in all of the funds that they oversee. A few of the managers cover multiple funds. When we aggregate some of those investments, we do get a better score for Vanguard.

The other thing about index managers is that their goal is not to create alpha but to track the index, and so one of the big hurdles to that would be cost. And Vanguard has a nice program in place where they incentivize not only their managers but others at the firm to think about ways to lower costs and be more efficient in how they do their jobs, which certainly helps those index managers track their indexes better.

The other comment about manager incentive and what has gotten them up to that C level is that in the subadvised actively managed funds, those managers buy the Vanguard funds. Now, there is a long history with Wellington and Primecap managers, and so that may seem like a natural occurrence, because Wellington is a private company that doesn't offer its own mutual funds; but nonetheless--really across the board--many of the Vanguard subadvisors invest in the Vanguard funds.

Benz: There are so many eyes on Vanguard these days. It's so great to hear your insights. Thank you so much for being here.

Hughes: Thank you.

Rawson: Thank you.

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