Reopened Vanguard Dividend Growth Shows Promise

Christine Benz: Hi, I'm Christine Benz for Morningstar. One of Morningstar's favorite large-cap blend funds has reopened to new investors. Joining me to discuss why investors might take another look at Vanguard Dividend Growth is senior analyst Alec Lucas.

Alec, thank you so much for being here.

Alec Lucas: Thanks for having me.

Benz: Alec, we got news just a couple of weeks ago that Vanguard Dividend Growth was reopening. It's a large-cap blend fund. I think when investors hear large-cap blend, many investors today are thinking, "OK, I'm just going to go total market index or S&P 500 index." Why might investors consider an active fund like this in place of simply owning the market?

Lucas: Well, in this case, you have a very experienced manager, a manager that's proven, a manager that is very well supported with world-class resources at Wellington Management. And the fees are very low for active management. The current expense ratio is 22 basis points. So, to put that in context, you're paying $22 for every $10,000 you have invested. So, the fee hurdle is low. You have a manager who's paying the fee hurdle himself. He has more than a million dollars of his own money in the strategy and you have results that are very impressive in a space that is very efficient, which is large-cap U.S. equities.

The fund during Kilbride's tenure, which began in February 2006 through the last market close, so yesterday, has returned 10% annualized. And it's beaten the S&P 500 by 1.5 percentage points. So, to put that in context, if you'd invested $10,000 in this fund, you'd have more than $36,000 and have more than $6,000 than if you'd put the equivalent sum in the S&P 500; that's not counting taxes. And for that extra money, you would have suffered less. In every downturn, this fund has preserved capital better than the S&P 500.

Benz: So, past performance, of course, is not predictive. But you think there are some structural factors that at least argue for that propensity to perform well on the downside to persist in the future. Let's talk about that.

Lucas: Yeah, past performance isn't predictive, but can be informative. And in this case, you have a manager who focuses on companies that reliably and consistently grow their dividends. So, these are companies that are profitable, and they've shown a commitment to reliably and consistently grow their dividends. And these are the kinds of companies that investors are less prone to give up on when things get very strange in equity markets. So, the fund has really good downside capture protection. It's got a good downside capture ratio. It's a concentrated portfolio--

Benz: And that means what just for people who aren't familiar with that data point?

Lucas: That means that when the market is down, say, 10 percentage points, a fund like this is going to be down--I don't know its exact downside capture ratio off the top of my head--but it's going to be down 8 percentage points. And over time, because of the asymmetry between losses and gains, losing less on the downside really helps you in the long run.

Benz: It helps keep people in their seats, too, right?

Lucas: Keep them in the seats and it helps you to compound your wealth. Absolutely.

Benz: So, if investors like this dividend growth strategy, and it sounds like there's a lot to recommend it, especially if I'm a little bit nervous about equity market volatility, it's not the only game in town. So, Vanguard Dividend Appreciation is an index product available as a traditional index fund or ETF that kind of pursues the same set of stocks. Can we talk about one versus the other? Because I know investors, especially Vanguard investors, may really be wondering which is the right product?

Lucas: Yeah. It's good to compare Vanguard Dividend Growth against the broad equity benchmark like the S&P 500, kind of a bellwether for U.S. stocks. But if you're looking at the benchmark that is most appropriate for this fund, it's the NASDAQ US Dividend Achievers Select benchmark, and that's the benchmark that Vanguard Dividend Appreciation tracks. The ticker for the ETF version is VIG. So, if you're thinking, do you want to go passive or do you want to go active, you could either invest in Vanguard Dividend Growth, which is now reopened, or VIG. The kinds of companies that both, the fund and the ETF, hold are consumer staples, industrials, healthcare stocks, less so in energy, which has, of course, been good of late.

And what Kilbride has in his favor is--so VIG is a screen for companies that have raised their dividends at least over the last decade, and that passed profitability screens. And so, these are the kinds of companies that are reliable stores of investor cash that can compound investors' capital. And that's the kind of companies Kilbride looks for. But what Kilbride brings is the benefit of active management. You're only paying 16 basis points more for Don Kilbride's skill as the manager. And what he's able to do is, in certain cases, take advantage of opportunities that don't fit the remit of Vanguard Dividend Appreciation. So, for example, in 2009, he bought Pfizer after a dividend cut because he thought that company would reignite dividend growth from a low base. He was correct on that.

More recently, in 2018's third quarter, he bought Baxter International, which had cut its dividends in 2015 when it spun off Baxalta. Again, he knew the CEO in this case, and had confidence in that new CEO, which had taken over in early 2016. So, you're able to benefit from an active manager who's shown an ability to take advantage of opportunities when they present themselves, and over Kilbride's tenure--or rather, since VIG started, which was April 2006, he's a percentage point annualized ahead of the ETF.

Benz: The ETF is also Gold-rated, we should say.

Lucas: It is also Gold-rated.

Benz: So, we like that one, too.

Lucas: And it's a great option. If you're going to go passive, it's a great option. Taxable accounts, obviously, you've efficiency from ETFs. But for a benchmark that's very hard to beat, the one that VIG tracks, Kilbride has shown that he can do that.

Benz: Let's talk about asset size. Because any time you see a fund that has closed in the past, it indicates that they're attuned to asset size potentially being an impediment to their ability to manage it well going forward. It's a good thing generally when we see a closure, but sometimes you think, okay, are they responding to the fact that assets have gotten too large? How does Vanguard Dividend Growth appear to you from that standpoint? Do you feel like its asset size is in check?

Lucas: The way I think of this strategy is, it's a strategy built for scale. So, if you look at the kinds of companies Kilbride has invested in, it's been very consistent throughout his career, even when the asset base was much, much smaller. And that is, he looks for large and mega-cap dividend-paying stocks. They tend to be very liquid and he tends to buy them when they're out of favor. The fund is quite large. It's $37 billion today. But when it reopened, it was about 20% smaller than it was when it closed to new investors, and investors had taken out a little over $7 billion since it had closed. So, Vanguard does a good job of watching the strategy and monitoring it for capacity. And if you get a flood of inflows over the next few years, it could well close again. And so, that's to the benefit of current shareholders. But if you do look at the strategy, if you look at average daily trading volume and that sort of thing, the kind of metrics that we look at as indicators of strain capacity, you don't see them here.

Benz: A couple of risk factors. While you don't think that they should dissuade investors from looking at the fund, just a couple of things that are in your mind when you're thinking about the fund. One you say is concentration risk. The other is kind of key-person risk, where you've got a solo manager. Let's talk about those one by one.

Lucas: So, Kilbride is very selective in his stock-picking, but the byproduct of that is that you have a fairly concentrated portfolio of 40 to 50 stocks. So, if one of those companies ran into unexpected trouble, then that could hurt the fund, certainly. And the other is, is you're casting your lot in with Don Kilbride himself. He's been a manager on the fund since 2006. I believe he is in his mid-50s or so. And when I talked to him most recently, he said he certainly saw himself managing it for the next five years. He was a little less committal over the next 10 years. He does have a backup manager in Peter Fisher, who's begun to join me on the calls and was very impressive when I talked to him. So, Wellington Management, it's a very good firm with good resources. So, that gives you some reassurance in terms of key-person risk. That is a factor as well.

Benz: Alec, always great to get your perspective. Thank you so much for being here.

Lucas: Thanks for having me.

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