This Vanguard Fund Hasn't Been Worth the Extra Volatility

The following is our latest Fund Analyst Report for Vanguard U.S. Growth VWUSX. 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 U.S. Growth looks like a higher-risk version of its benchmark--but one that hasn't quite been worth the extra volatility. The fund retains its Morningstar Analyst Rating of Neutral.

This fund has quite a bit in common with the Russell 1000 Growth Index. Since the current subadvisor lineup was put in place in October 2010, the fund had a R-squared, a measure of correlation, of 94.4 versus the index through May 2018. The fund also had a fairly low 3.1% tracking error, which measures deviation from the benchmark. Finally, the fund's March 2018 portfolio had a relatively low active share of 54.2% versus the index.

To the extent that the fund distinguishes itself from the Russell 1000 Growth, it has done so by taking on greater risk. The portfolio's 45.1% technology stake is meaningfully above the index's 40.0% weighting, which is itself the greatest it has been since April 2001. Plus, the fund's average price/earnings, price/sales, and price/cash ratios are all greater than the index's, which, again, are already historically high. The portfolio's 40.1% average debt/capital ratio was well below the index's 46.0%, but this quality metric was offset to a degree by a below-benchmark return on assets and average net margin.

The fund has narrowly beaten the index during its current incarnation but only because of these added risks. Since early October 2010, the fund's 16.03% annualized gain edges the Russell 1000 Growth's 15.87%. But because of its higher volatility, the fund's 1.26 Sharpe ratio, a measure of risk-adjusted results, trails the index's 1.39. That extra volatility led to upside capture of 104.9 versus the index but even higher downside capture of 111.4. On balance, this extra volatility hasn't been a good trade-off for fundholders.

The best thing going for this fund relative to its actively managed peers is its low 0.43% expense ratio, which is 46 basis points lower than the large-cap no-load median. But that is still 20 basis points or so more expensive than index funds or exchange-traded funds that track the Russell 1000 Growth.

Process Pillar: Neutral | Kevin McDevitt, CFA 06/28/2018 This fund's five subadvisors are all bottom-up stock-pickers, but they vary in their growth emphasis. The net result is not terribly distinctive, leading to a Neutral Process rating.

Jeff Van Harte's team from Jackson Square manages 36% of assets and uses a value-conscious, low-turnover strategy, investing in 25-30 stocks with solid business models and high returns on capital. That concentration has made

Wellington's Andrew Shilling, who likewise manages 36% of assets, also insists on economic moats, but he's willing to buy pricier stocks with above-average growth prospects. That's led to above-average volatility at the separate account he's overseen since April 2000, Wellington Growth, despite investing in a more diffuse portfolio of 50-80 stocks.

The last three subadvisors have less of an impact as they manage only about a fourth of the combined portfolio. William Blair's managers focus on firms with high margins in overseeing 13% of assets. Jennison's Kathleen McCarragher pays up for firms poised to grow sales faster than the S&P 500, while Baillie Gifford's Gary Robinson takes a value-conscious approach in trying to pick steady growers. The two manage a combined 13% of assets.

Although the fund's heavily diversified portfolio mostly mirrors the Russell 1000 Growth Index in terms of market-cap exposure, it has been more growth-focused with above-average price multiples. The March 2018 portfolio's average price/earnings ratio was recently 32.6 versus 25.6 for the benchmark. From a risk standpoint, the portfolio's high multiples are offset somewhat by a below-benchmark debt/capital ratio, 40.1% versus 46.0% for the index.

The portfolio's high price multiples stem partly from an overweighting in technology, in particular. As of March 2018, the fund had 45.1% of assets in tech, 5.1 percentage points more than the index. Eight of the portfolio's top 10 holdings are tech companies, with consumer discretionary retailer Amazon.com arguably another.

The portfolio looks more growth-oriented than the benchmark across other sectors, more based on what it doesn't own. It has minimal exposure to nongrowth areas such as energy, materials, industrials, telecom, and utilities. These five sectors combined claimed just 8.8% of assets, versus the index's combined weighting of 14.8%. Instead, consumer discretionary and healthcare stocks provide two additional pillars at 14.3% and 11.3% of assets, respectively.

This fund stays fully invested, and cash rarely goes much above 3%; this helps it to participate fully in rallies but leaves less of a buffer during corrections.

Performance Pillar: Neutral | Kevin McDevitt, CFA 06/28/2018 Following an early October 2010 management makeover, this fund's performance has improved under William Blair's new leadership and the addition of Wellington's Andrew Shilling and Jackson Square's team (formerly of Delaware Investments). Nevertheless, the fund's 13.94% annualized gain since its makeover barely outpaces the Russell 1000 Growth Index's 13.93% return through June 2016.

On a risk-adjusted basis, the fund lags its benchmark. Because of its higher volatility, the fund's 1.26 Sharpe ratio, a measure of risk-adjusted results, trails the index's 1.39. The fund's underperformance on a risk-adjusted basis keep its Performance rating at Neutral. With the portfolio's above-average price multiples, overweighting in technology, and little cash cushion, it has little protection when markets turn south.

That extra volatility led to downside capture of 111.4 during the fund's current incarnation. It dropped more than the index during the last two corrections. It shed more than the index during the mid-2011 correction, losing 17.4% versus the benchmark's 15.5%. During the 2015-16 correction, the fund fell 15.7% peak-to-trough versus the index's negative 13.4%.

On the other hand, the fund has generally outpaced the index during rallies, which is reflected in an upside capture of 104.9 versus the index. It is easy to see this pattern of performance continuing during future rallies and corrections.

People Pillar: Neutral | Kevin McDevitt, CFA 06/28/2018 This incarnation of the fund took shape in October 2010, when managers from the three main subadvisors--Wellington, Jackson Square, and William Blair--joined the fund. At that time, Vanguard fired AllianceBernstein and added Wellington's Andrew Shilling and Delaware's focus growth team, which in April 2014 spun off as its own firm, Jackson Square Partners. Both manage 36% of assets. Between them, they manage 85% of the fund's assets. While William Blair has been a subadvisor for longer, James Golan replaced its previous managers in 2010 and David Ricci joined Golan in December 2011.

In February 2014, the lineup grew to five subadvisors as Vanguard merged Vanguard Growth Equity's assets and managers into this fund. Baillie Gifford’s Mick Brewis retired and Ian Tabberer took his place. Tabberer left unexpectedly in early May 2015 and was replaced by Gary Robinson. Tom Slater joined the Baillie Gifford team here in November 2015. Jennison’s Kathleen McCarragher is joined by Blair Boyer. While these changes add some uncertainty, the impacts of Baillie Gifford and Jennison are somewhat muted as they manage a combined 13% of assets. Manager investment is fairly negligible, with Van Harte and Shilling the only ones with direct ownership in the fund. Overall, while the fund's lineup has stabilized, it is not clear that there is much synergy among the subadvisors. The People rating remains Neutral.

Parent Pillar: Positive | 06/05/2018 The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar: Positive | Kevin McDevitt, CFA 06/28/2018 This fund's low fees are a big advantage, earning it a Positive Price rating. The Investor shares had a 2017 net expense ratio of 0.43%, which fell 1 basis point since 2014. This is 46 basis points below the 0.89% large-cap no-load group median. The Admiral share class VWUAX has a 2017 net expense ratio of 0.30%.

The fund's price tag will move, however. The expense ratio includes a performance adjustment, calculated and paid quarterly, which is based on the cumulative total return of each advisor's portion of the fund versus the Russell 1000 Growth Index (S&P 500 for Baillie Gifford) over the past three years (five years for William Blair).

Financial professionals are accessing this research in our investment analysis platform, Morningstar Cloud. Try it today.