Vanguard's Hidden Gems

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many Vanguard funds are large and getting larger, but a handful of the firm's funds are still relatively small. Joining me to discuss some of the better ones is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: We've been observing this Vanguard juggernaut where it seems like every time we talk about fund flows, we see more and more flows going to Vanguard funds. But there are a small handful of funds that haven't yet accumulated a lot in assets. You took a look at medalist funds that don't have huge asset bases at this point. All of the funds that you pulled actually have asset bases of less than $3 billion. I want to talk about some of them with you, Russ.

The first is Vanguard International Dividend Appreciation. I think a lot of our viewers are probably familiar with Vanguard Dividend Appreciation, the U.S. equity version; this is an international spin on the same general idea, right?

Kinnel: That's right. This fund was launched about two years ago and so far, it hasn't taken off the way the U.S. version has. It really has a lot of the same characteristics. They look for companies that have paid rising dividends seven years in a row. It's a large-cap index, obviously, with a nice yield, very low cost despite it still being a pretty small fund. It's got a lot of promise. So far, performance has been nothing special, nut it's only two years out of the gate and it's an index fund. I'm not too worried about that part of it.

Benz: This is one, as is Vanguard's tendency, where we've got the index traditional mutual fund and you also have an ETF that's run as a share class of the traditional mutual fund. The ticker of the ETF is VIGI. Do we have a preference about whether investors go for the traditional index mutual fund or the ETF?

Kinnel: Not at all. They are both very cheap. It depends on a little bit about transaction costs, who you are buying it through, and whether doing additional investments will cost you money. Obviously, if it does, then I would go with the open-end. But they are both very cheap. I don't really have a preference, no.

Benz: That one is Bronze-rated, correct?

Kinnel: That's right.

Benz: OK. Another fund that is actively managed--well sort of actively managed and you are going to talk about that--is Vanguard US Value. This one is Silver-rated. It's large-cap value. Let's talk about this fund.

Kinnel: It's an actively managed fund under 30 basis points and under $2 billion in assets, a really good deal. Vanguard doesn't wait for a fund to get huge before they start giving you a good deal on fees.

The story here is, this is run by Vanguard's quantitative equity group which looks at five equity factors with a value tilt obviously. They have done very well. Since the fund switched to this strategy after 2010, the fund has beaten the Russell 1000 Value as well as its peer group. Very strong, stable strategy. As you often have with quant funds, very diversified, because they don't want one stock overwhelm performance. But it's done really well, low-cost. I think quant funds are just by their nature, no one warms up to them. It's like is it an index fund, is it an active fund? The answer to both is well, it's not really an index fund. But people don't like quant funds, but I think there's a lot of appeal here.

Benz: Maybe investors would be less likely to performance chase or something if there's not a star manager who is running the show?

Kinnel: That's right. There's isn't a star manager. It's very much a team of quants running the strategy. And we recently raised it to Silver because we really have a lot of conviction in the fund, especially at these costs. They don't have a lot of ground to make up just match an index.

Benz: Some investors might be looking at their portfolios and see that the value component of their portfolios hasn't performed so well, so maybe they want to add some money to that value column of the style box. Is this kind of pure play value fund, would you say?

Kinnel: Relatively. There's momentum factors and others. I would say it's definitely value. It wouldn't call it deep value though.

Benz: The next fund that is not yet large is Vanguard Global Minimum Volatility. This is Silver-rated. It's not an index fund either, but it is pretty hands-off in terms of its management style. Let's talk about this one.

Kinnel: That's right. It's technically not an index because it doesn't exactly seek to match its benchmark, which is FTSE Global Index. Essentially, you're looking at big companies, but because they are looking to reduce volatility, they go from within that index to slant to the companies that they think will be less volatile. Not just looking at beta but other factors as well that seem to line up with less volatility. Then on top of that, they hedge back the currency risk because of course currency has a fair amount of short-term volatility. Though from a long-term perspective, it doesn't really add a lot of risk. What you get is this nice global, very low-cost, nearly passive fund that I think is a really great idea especially if you have someone in a retirement account because I think at that point you want to reduce volatility as much as you can, but I also don't think many investors can afford to avoid foreign equities. I think foreign equities have a lot of return potential, and they really don't have more risks than the U.S. outside of that currency issue. I think this is a really good fund that's been kind of overlooked.

Benz: You stated the case for this low-volatility strategy. There's also some data to point to low-volatility strategies outperforming which seems kind of counterintuitive. You might expect them to hold down risk, but actually, in some market environments they look better on a returns basis.

Kinnel: That's right. These low-volatility strategies have been tested and people found good returns. But I think even if the absolute returns are not superior, on a risk-adjusted basis they should be good. But also, when you think about our investor returns research, we know that less volatile funds work better for investors because it doesn't give them those highs and lows. It doesn't make them panic or get greedy. There are a lot of things to like about a low-volatility strategy.

Benz: Russ, thanks for sharing your insights. Thanks for being here to share a short list of Vanguard hidden gems.

Kinnel: You're welcome.

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