A Capable, Quality Mid-Cap Growth Fund from Vanguard

Please note that this fund is now Under Review after parent Vanguard announced subadvisor changes as well as the planned merger of Morgan Growth into U.S. Growth in early 2019.

Hard-to-beat costs and at least one successful, long-tenured subadvisor earn Vanguard Mid Cap Growth a Morningstar Analyst Rating of Bronze.

It has a much lower hurdle to clear. Its expense ratio is about one third of the median for no-load mid-cap funds and within 11 basis points of the largest mid-cap growth exchange-traded fund,

Two subadvisors--one proven, one not--split the strategy. Both subadvisors look for higher-quality companies but in different ways. They each use bottom-up, fundamental research to identify companies that can steadily grow earnings over time. William Blair, however, tends to be longer-term-focused and, as a result, boasts below-average turnover in its own accounts, while RS has consistently had above-average portfolio turnover in its other funds. Stock selection also has been mixed, with William Blair demonstrating more success over the long haul. As of November 2018, roughly 18% of holdings overlapped between the two subadvisors’ other strategies, so investors still get diversification despite their similar approaches. Turnover remains above the mid-cap growth Morningstar Category average, driven by the RS sleeve, but should continue to be lower than it was under previous subadvisor Chartwell Investment Partners. Together, the subadvisors should provide improved downside protection.

William Blair’s growth team has shown it can offer downside protection over a full market cycle; the RS growth team’s track record is more mixed. Both have struggled to top the Russell Mid Cap Growth Index in their respective stand-alone funds. William Blair Mid Cap Growth WCGIX beat the typical mid-cap growth peer but trailed the index from February 2006 to November 2018.

This subadvisor duo hasn’t been together long, but their experience and the fund’s low costs should keep it competitive over the long term

Process Pillar: Neutral | Linda Abu Mushrefova 12/07/2018 Subadvisors William Blair Investment Management and RS Investments each emphasize higher-quality names with sustainable earnings growth potential, but it is still not clear if their approaches mesh well, limiting its Process Pillar to Neutral.

William Blair's team looks for companies with good management, solid business models, and attractive financials. It begins by screening for quality and growth characteristics, such as free cash flow margin and earnings growth, but spends the bulk of its time on bottom-up, fundamental analysis. The team will consider names with attractive fundamentals that meet its investment criteria and trade at discounts to estimated intrinsic values. Over time, stock selection has been strong.

The RS growth team also combines quantitative screening and fundamental analysis to identify stocks with steady growth potential. Following an initial screen on metrics such as company quality, growth sustainability, and attractive relative valuation, the team tries to find those whose share prices offer twice as much upside as downside. Bottom-up security selection determines positioning, but tight sector constraints ensure diversification. It is a higher-turnover approach that has exhibited mixed stock-picking at other funds and accounts where it has longer track records.

This is a higher-quality mid-cap portfolio. Each subadvisors’ quality-growth emphasis results in a portfolio with below-average debt/capital ratio relative to its peers and index and above-average long-term earnings and cash flow growth. Higher quality does come at a higher cost, though--the portfolio’s average price/earnings and price/cash flows ratios are higher than those of the index.

Vanguard does not disclose the holdings of each subadvisor’s sleeve, but, based on other funds it runs in the same manner, there was about 18% holdings overlap between the two portfolio halves as of October 2018. For example, both subadvisors held

Stock selection has been strong since RS Investments became a subadvisor in December 2016. Healthcare picks, such as

Performance Pillar: Neutral | Linda Abu Mushrefova 12/07/2018 The fund has posted a solid but short track record and has not been able to top its index under the current subadvisor arrangement. It still gets a Neutral Performance Pillar rating.

The fund has posted a 15.1% annualized gain since RS Investments joined William Blair as subadvisor here in December 2016. That trails the 15.4% gain of the index but tops the 14.9% rise of the category, but it is still a short period. Furthermore, the subadvisors’ longer-term records at similarly run stand-alone funds are mixed.

William Blair has a better record. Since February 2006 through November 2018, its William Blair Mid Cap Growth beats the typical mid-cap growth fund but trailed the Russell Mid Cap Growth Index. It demonstrated more downside protection and consistent stock-picking. The Vanguard fund has gained 9.0% during William Blair’s tenure relative to the index's 9.4%.

RS has a more mixed record in its stand-alone fund. Since the end of July 2008, Victory RS Mid Cap Growth, which is identical to RS’ sleeve here, hasn’t topped the Russell Mid Cap Growth Index through Nov. 30, 2018. Its above-average standard deviation also has led to even worse risk-adjusted results.

The goal of pairing William Blair with RS is to offer some downside protection. William Blair has proved it can do this, but RS still needs to show it can consistently deliver.

People Pillar: Positive | Linda Abu Mushrefova 12/07/2018 This strategy's two stable and experienced subadvisor teams earn it a Positive People Pillar rating.

William Blair has managed 50% of assets since 2006 while the RS Investments’ growth team replaced the previous, 10-year co-subadvisor, Chartwell Investment Partners, in December 2016.

William Blair Investment Management's mid-cap growth team includes founder Robert Lanphier, David Ricci, and Daniel Crowe. Lanphier has run the strategy since 1997, while Ricci and Crowe joined as comanagers in 2005 and 2015, respectively. Both Lanphier and Ricci have been named managers since William Blair started subadvising for Vanguard in June 2006, while Crowe joined in February 2017 as Ricci shifted more time to William Blair’s large-growth strategy, which is also a sleeve of Neutral-rated

RS Growth CIO Scott Tracy has managed the firm’s mid-cap growth strategy since July 2008. Comanagers Steve Bishop, Melissa Chadwick-Dunn, Chris Clark, and Paul Leung support him. Tracy, Bishop, and Chadwick-Dunn have worked together since 2001. Three research analysts round out the team, and together the team of eight average about 20 years of industry experience. The team hasn’t seen personnel turnover since 2011.

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 | Linda Abu Mushrefova 12/07/2018 Vanguard Mid Cap Growth's 0.36% prospectus net expense ratio for its only share class is the cheapest easily accessible share class within the mid-cap growth Morningstar Category. Its rock-bottom fee earns it a Positive Price rating.

By comparison, the median no-load mid-cap growth fund charges 1.04%. Vanguard adjusts the fee it pays to the fund's subadvisors based on their performance relative to the Russell Mid Cap Growth Index. As a result, the fund’s expense ratio may slightly rise and fall depending on how it does relative to the benchmark. This helps align manager and investor interests.