An Upgrade For This Vanguard Quant Fund

The following is our latest Fund Analyst Report for Vanguard Strategic Equity VSEQX. 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 Strategic Equity’s rock-bottom fees and reasonable process should serve investors well over the long term, although some short-term tumbles are to be expected. Increased conviction in the team and approach leads to an upgrade of its Morningstar Analyst Rating to Silver from Bronze.

This fund is managed by Vanguard’s experienced quantitative team. The team believes that stock prices follow earnings and has a screening method to find stocks it believes will grow earnings faster than peers and are trading at a discount. The screen looks for stocks that score well on five factors--valuation, growth, quality, momentum, and management decisions (such as stock buybacks)--relative to industry peers. The momentum factor plays a defensive role here as it can pick up on real-time changes in how a stock is viewed by the market that wouldn’t be apparent on a balance sheet, such as an abrupt CEO departure. This should help the fund avoid value traps.

Management applies its screen to the MSCI U.S. Small + Mid Cap Index, which excludes the 300 largest U.S. companies. Management will overweight or underweight a stock in the index only by a maximum of 80 basis points, so investors shouldn't expect wild swings versus the benchmark. In the trailing decade through 2017, its tracking error versus its index has been 2.72%; that may scream closet indexer, but the fund has managed to turn its small bets into meaningful outperformance. In the past decade, the fund has beaten its benchmark in 68% of rolling-three year periods and beaten the mid-blend Morningstar Category norm 76% of the time.

Like other quantitative strategies, this fund can struggle with shifts in market sentiment. Its worst performance versus the index, for example, came in 2009 when low-quality stocks surged as it became clear the financial crisis was over.

Despite the potential for short-term hiccups, over the long term this fund should serve investors well. Further cementing its appeal is its price tag. At 0.18% it is the cheapest actively managed mid-cap blend fund; the category’s average price is 1.00%. That’s a significant head start.

Process Pillar: Positive | Jason Kephart 01/24/2018 Vanguard's quantitative equity team has developed a five-factor screen to find companies it believes can grow earnings faster than industry peers and as a result should see their stock price rewarded.

The screen focuses on growth, quality, management decisions, momentum, and valuation. Each stock is ranked on a composite of the five versus their industry peers. The first three are backward-looking and rely on company balance sheets. Momentum is included to pick up a real-time signal of how the market views a stock. Finally, valuation is used to make sure the stock is cheaper than the industry norm.

The model has proved its appeal over time, and management has shown it can improve the model, such as in 2010 when it began to tailor the factors to each individual industry. In biotech, for example, revenue growth carries a higher importance than earnings-per-share growth, because management says it takes longer for revenue to have an impact on earnings in that industry. More recently, management changed the way it weights each of the factors, which were previously about equal weight. Now the screen slightly overweights or underweights certain factors based on the momentum of the factors themselves. The transparency, repeatability, and management's ability to continue making adjustments support this fund's Positive Process rating.

Management applies its screen to the MSCI U.S. Small + Mid Cap Index, which excludes the 300 largest U.S. companies. Its benchmark distinguishes the fund from the mid-blend category by excluding those large companies. On average, peers held close to 15% in large caps over the three years ended in 2017, while this fund typically held 5% or less. This fund has a similar allocation to mid-caps as peers (both have averaged close to 55% weightings over the last three years), but it has more of a small-cap tilt. As of the end of 2017, it had a 39% allocation to small-cap companies, whereas the category norm was 32%. The portfolio also looks cheaper than the average peer on a variety of value metrics, including price/prospective earnings, price/sales, and price/cash flow.

This means that during short periods of time, the fund could have a small headwind or tailwind depending on the performance of large caps versus small caps and value versus growth. Over time, it should even out.

Management targets a 4% tracking error for this fund versus the index, so it will overweight or underweight a stock only by up to 80 basis points.

The fund is more broadly diversified than the average peer. Only 10% of assets are invested in the fund's top 10 holdings, compared with an average of 25% for the typical mid-blend fund. This helps to reduce stock-specific risk.

Performance Pillar: Positive | Jason Kephart 01/24/2018 This fund has stood out in the long term but is prone to rough patches over short periods, particularly ones with sharp market reversals. Its long-term record shows investors will be rewarded for their patience. Its earns a Positive Performance rating.

The fund posted respectable results during the most recent market cycle. From the market's pre-financial-crisis peak in late 2007 through the end of 2017, it returned 8.1% annualized, which topped the mid-blend category norm’s 7.2% but slightly lagged the MSCI U.S. Small + Mid Cap Index benchmark by 20 basis points.

To capture those gains, investors had to have patience. Like many quantitative offerings, this fund's models struggled during the years surrounding the 2008 financial crisis. The fund lagged its typical mid-blend peer in each of the calendar years from 2007 through 2010 and fell to the category's bottom decile during that period. The fund's 2.1% annualized loss during that stretch lagged the category's 1.7% gain. In 2017 the fund's tilt toward smaller and more value-oriented companies led to an off year.

Since 2011, however, this fund's quant models and low fees have led to topnotch performance in the mid-blend category through 2017. That includes top-quintile returns in a mix of market conditions, including 2011's volatility and 2013's strong rally. Patient investors can expect to be rewarded.

People Pillar: Positive | Jason Kephart 01/24/2018 This fund is managed by Vanguard's experienced quantitative equity team. It earns a Positive People rating.

The quantitative team at Vanguard totals 29, five of them senior investment professionals. All of the team members are involved in monitoring and improving the quantitative screens, and so far they've shown they are capable of doing so. 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.

One area the team does fall short is in manager investment in the strategy, which would be a sign of managers aligning their incentives with shareholders.

The team also manages Silver-rated

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 01/24/2018 This fund is offered in one share class, and it is the cheapest actively managed mid-cap blend fund. It earns a Positive rating for Price. The Investor shares have an expense ratio of 0.18% and a minimum investment of $3,000. The average fund in the category charges 1.00%. That 75-basis-point difference gives the fund a significant advantage versus peers. It's also cheaper than the average U.S. mid-blend strategic-beta exchange-traded fund, which are similarly quantitatively run. The average price tag for those ETFs is 0.45%.