Why Vanguard Killed a Good Fund

Performance Winner Yesterday, Vanguard announced that it was shutting down Vanguard Convertible Securities VCVSX. Fund companies routinely liquidate their offerings. What made this termination unusual, though, is that Vanguard Convertible Securities' performance has been solid, by any measure.

Compared with others in the convertible-bond Morningstar Category, the fund's 15-year total returns have been average and its volatility modest. Its expense ratio, of course, is the category's lowest. Overall, that's an attractive combination. Morningstar's analysts had assigned Vanguard Convertible Securities a Morningstar Analyst Rating of Bronze--indicating that the team has a "sufficient level of conviction that [the fund] will outperform its benchmark or peers … over a full market cycle." (Not if it's dead, it won't.)

The broader view is better yet. As a hybrid investment, carrying both stock and bond characteristics, Vanguard Convertible Securities is best compared with allocation and target-date funds. Over that same 15-year period, it outgained the average for almost all allocation and target-date categories. When it did trail, its returns were only slightly behind, while its volatility was much lower. It was superior.

The fund also bested that other hybrid competitor, hedge funds. Technically, it only matched the hedge fund averages from Morningstar’s database. But since all hedge fund databases are skewed, with the successful funds tending to report their numbers while the losers hide in the shadows, the true hedge fund results were worse than what was published. In addition, unlike Vanguard Convertible Securities, hedge funds occasionally go to zero. That possibility is an additional risk for which hedge funds should compensate with additional returns. They did not.

Sales Loser The fund's investment success did not translate into shareholders. After peaking at $2 billion in assets four years ago, the fund has steadily lost popularity, such that it now claims less than $1 billion. For Vanguard, that's spare change. There's no point in keeping such a fund afloat, particularly when sales are shrinking rather than growing. From Vanguard's perspective, the fund might never reach an acceptable size. It certainly wasn't headed in that direction.

Such is the nature of the fund business: The money talks. When fund companies eliminate offerings that have poor total returns (as is usually the case), those decisions are not, strictly speaking, caused by investment results--any more than an auto manufacturer stops producing a model because of how the car scored on a consumer-magazine test. Instead, the action occurs because the sales are insufficient. Assets are what counts--even for “customer-owned” Vanguard.

Redefined The question therefore becomes why Vanguard Convertible Securities' performance failed to attract enough buyers. I have three answers.

One is that convertibles are no longer regarded as an “asset class.” When convertible-bond funds were launched during the '80s, they were sold as providing exposure to a novel type of investment. That era’s mutual fund investors could own stocks and conventional bonds in various ways. But until convertible-bond funds were launched, they could not invest in hybrid securities.

New and different! Perfect for slotting into an asset-allocation scheme. However, as suggested by this column’s narrative, convertible-bond funds did not turn out to be particularly unusual. They behaved much like funds that achieved their hybrid characteristics by buying stocks and bonds separately, then blending the two into a single portfolio. That asset-allocation slot could be otherwise occupied.

In which case, it became difficult to argue for convertible securities. Their investment universe (roughly $220 billion these days) was too limiting. Why restrict portfolio managers to one segment of the securities market when so many other opportunities await? The funds' investment charters seemed needlessly restrictive.

Such was the explanation given by Vanguard. Its press release states that it “determined that investors could achieve similar risk-return exposures and long-term returns by investing in a diversified, balanced portfolio of global stock and bond funds.” I am not certain that is entirely true; as previously stated, the fund has beaten those competitors over the past 15 years. However, that clearly is what investors believe--and, ultimately, their vote counts.

Thinking Broadly The second, and related, answer is that the largest fund companies now favor broad "solution" funds. There was a time when the opposite was true. The bigger the organization, the likelier it was to promote niche funds. Fidelity, after all, invented the sector fund. (Technically, some specialty funds existed before 1981, but Fidelity was the first firm to launch a series.) Vanguard followed shortly thereafter. Being an industry leader meant offering choice.

While that hasn’t completely changed--Vanguard sponsors 131 funds, spread over 306 share classes--the focus has evolved. The major fund companies don’t compete against each other by claiming to have the most, or best, specialized funds. Those days are gone. What matters instead is the quality of the core funds and the ancillary services. The niche funds are beside the point.

Counting Costs The final answer is that scale has become more important. It always was to Vanguard, of course, which positions itself as the low-cost provider. But scale also matters greatly to BlackRock, State Street, Schwab, and Fidelity, among others. This is because expense ratios have become far more important to both financial advisors and direct investors. What once was acceptable no longer is.

At 0.35%, Vanguard Convertible Securities’ expenses are cheap by any actively managed standard. However, they are certainly above what Vanguard would wish, with little possibility of bringing that number down, given the fund’s shrinking asset base. In the old-school mutual fund business, which extended until early this century, a $900 million fund could charge 1% annually, thereby generating $9 million in revenue. Vanguard Convertible Securities collects only one third of that amount.

I have a soft spot for Vanguard Convertible Securities. It was one of my early assignments as a mutual fund analyst, when we were both young. (This month is my 30-year Morningstar anniversary. I am holding out for one of these*.) The fund has treated investors well throughout its history. But its demise makes sense. It reflects changes that have occurred in the mutual fund industry since the fund's creation--and by and large, those changes have been positive.

*Just kidding, Kunal. Well, mostly.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.