Why Low-Fee Vanguard Market Neutral Lagged in 2017

The following is our latest Fund Analyst Report for Vanguard Market Neutral Fund VMNFX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Market Neutral stumbled in 2017 as its bias toward cheap companies led to subpar returns, but our confidence in this strategy over the long term hasn't wavered. Management's reasonable quantitative strategy and rock-bottom fees continue to support this fund's Morningstar Analyst Rating of Silver.

This fund bets on groups of stocks that score well on five factors--valuation, growth, quality, momentum, and management decisions (such as stock buybacks)--relative to industry peers. The process is designed to discover stocks within an industry that can grow earnings faster than peers but are trading at a discount.

The short positions are the stocks that score poorest on the five factors. The long and short positions are balanced equally across each industry and across company size, which has led to virtually no correlation to the S&P 500 since 2010, when Vanguard took over sole management of the fund.

Since valuation plays a key role in selecting stocks to buy and short, it's not surprising that this fund has generally had a net long bias toward value stocks and net short bias toward growth stocks. Over the past three years, the fund has had an average 17% net long position in value stocks and an average 15% net short position in growth stocks. Given that intended exposure, the fund shouldn't be expected to do well during a year like 2017, when large- and small-cap growth stocks both outperformed value peers by about 15 percentage points, respectively. Indeed, this fund's 4.8% loss for the year trailed 90% of peers.

There's still a lot to like about this fund. For one, its fees, which are 141 basis points below the market neutral Morningstar Category norm of 1.63%, give it a clear advantage. Management has also shown it can tweak the process for the better over time; quantitative strategies that fail to improve can quickly lose any competitive edge. Finally, as a diversifier, the fund has succeeded over the long term. It had virtually zero correlation to major U.S. stock indexes over the trailing three and five years ended Dec. 31, 2017. It remains a strong choice for investors looking for diversification from an alternative strategy.

Process Pillar: Positive | Jason Kephart 01/08/2018 This fund's consistent and transparent approach to equity market-neutral investing earns a Positive rating for Process. Vanguard's quantitative equity research group uses a systematic process to build this market-neutral portfolio out of the largest 2,000 U.S. stocks.

Stocks are first separated into the 24 Global Industry Classification Standard industries. Management then systematically ranks each stock based on five fundamental factors versus its industry peers. The five factors are growth, quality, management, momentum, and valuation. The first three are backward-looking and rely on company balance sheets. They are used to determine if the company can grow earnings faster than peers. Vanguard defines quality as high return on assets and low leverage versus peers. Momentum is included to pick up a real-time signal of how the market views a stock. If the stock is falling in price faster than peers or there is a surge in analyst downgrades, for example, that could suggest there is something going on that wouldn't be found in the balance sheet, like a sudden CEO departure. Finally, valuation is used to make sure the stock is cheaper than the industry norm. Stocks that score highly on those factors versus industry peers make up the long side of the portfolio, and stocks that fare poorly make up the short side. Shorts with high costs of borrowing versus industry peers are disregarded.

The portfolio holds 200-250 stocks long and 200-250 stocks short at any given time. Each stock has a maximum weighting of 0.5% on both the long and short side, so no single stock pick will be driving performance. Instead, management is betting that within each industry, a group of stocks with positive scores on its five-factor model will outperform a group of stocks with poor scores.

Long and short exposures are roughly equal to keep the fund's stock market beta close to zero. Long and short exposures are also kept equal on a market-cap basis, so that there are no unintended bets, such as small companies over large companies, in the portfolio, although at times there may be a small mismatch. As of Sept. 30, 2017, for example, the fund had approximately a 5% net long exposure to large caps and small caps and a 10% net short position in mid-caps.

The portfolio does tend to favor value stocks. In September, it had a 17% net long position in value stocks and a 10% net short position in growth stocks.

Since three of the five factors are based on quarterly earnings reports, this fund doesn't rebalance as often as many peers. In fact, its annual turnover of 64% is one of the lowest turnover rates in the market-neutral category, which gives it another cost advantage since frequent trading can turn into a lot of trading costs. The average market-neutral fund had 250% turnover.

Performance Pillar: Positive | Jason Kephart 01/08/2018 This fund was launched in 1998, but investors should focus on its track record since Vanguard took over sole management of the fund in late 2010. From that point, the fund's 2.8% annualized return and 0.57 Sharpe ratio landed in the top third of the category as of the end of 2017. The category average over the same time was an annualized return of 1.6% and a Sharpe ratio of 0.47. The fund earns a Positive rating for Performance.

The fund did stumble in 2017, losing 4.8% and trailing most peers. The fund struggled as growth stocks outperformed value stocks by the widest margin since 2009. Given the fund's intended exposure to value stocks, it's not surprising that the environment was unfavorable for management’s process. The drawdown has left the fund's trailing three-year performance middling compared with peers, but its longer-term track record is still impressive. Over the trailing five years, for example, the fund still outpaced 85% of peers. It has also done well in the short bursts of volatility over the past few years. In 2011, when the S&P 500 had a maximum drawdown of 17.0%, this fund lost just 1.2%, better than all but two market-neutral category funds. For the full year, it gained 7.80%. In the third quarter of 2015, the S&P 500 lost 6.5%, but this fund gained 6.0%. In both cases, the fund's performance was driven by its short positions falling more than its long positions.

People Pillar: Positive | Jason Kephart 01/08/2018 This fund is managed by Vanguard's experienced quantitative equity team. It earns a Positive rating for People.

The quantitative team at Vanguard totals 24, five of whom are senior investment professionals. All of the team members are involved in monitoring and improving the quantitative screens, and so far, they've shown that they are capable of doing that. The named managers are tasked with overseeing the day-to-day implementation of the strategy. Vanguard does shuffle its lineup of named managers more often than most firms, but the overall team has been stable. In 2016, for example, James Troyer, who had been a comanager since 2007, stepped down from the day-to-day oversight of the fund to focus solely on research. Michael Roach was removed as a named manager on this fund in 2017, but he is also still part of the team.

The group is led by John Ameriks, who has been with Vanguard since 2003. Binbin Guo, who was named as a manager on this fund in 2016, has served as the group's head of equity research and portfolio strategies since 2010. Guo is joined by James Stetler, who has been a named manager since 2012. Stetler has been with the firm since 1982.

The team also manages

Parent Pillar: Positive | 12/12/2016 Vanguard has one of the mutual fund industry's strongest corporate cultures and earns a Positive Parent rating. Its consistent messages to investors to keep costs low, diversify, and stay the course are reflected in the firm's own behavior. Vanguard's U.S. fundholders own the firm through small investments by each mutual fund, mitigating potential conflicts of interest that can exist at other firms that are serving two masters. Fund performance is strong overall: Over the past three-, five-, and 10-year periods, its Morningstar Success Ratios are greater than 70%--high among large, diversified fund families.

Over the past year, the firm has collected more than USD 200 billion in net inflows, thanks in large part to investors’ interest in passive investing. The firm's indexing and ETF prowess, low costs, and success in penetrating the financial-advisor sales channel all have fueled growth. Total assets under management now exceed USD 3.3 trillion, giving Vanguard a significant more-than-20% market share across U.S. mutual funds.

Vanguard has been a global player for years but has only more recently turned its focus to growing internationally. The firm is a large player in Australia, where it has the most history, but doesn't yet have the brand recognition and trust it enjoys in the United States in other parts of the world. While non-U.S. funds don't participate in the ownership of Vanguard, the firm's investorcentric culture extends globally.

Price Pillar: Positive | Jason Kephart 01/08/2018 This fund sports the cheapest price tag of any alternative mutual fund. The fund's institutional shares have an annual report net expense ratio of 0.14%. The median expense ratio of a similarly distributed share class is 1.50%. The retail shares charge 0.22%. The retail share class should be taken with a grain of salt, however, as it has a $250,000 minimum investment. This approach is Vanguard's version of the SEC's accredited investor rule, which restricts access to private placement vehicles, like hedge funds, to high-net-worth investors.

It's worth noting that Vanguard displays the retail share class' net expense ratio as 1.60% on its website. That figure includes the cost of shorting, which Morningstar does not include in its calculation of the annual report expense ratio since it is considered a brokerage cost.