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Vanguard Dividend Growth's Promise and Portfolio De-Risking

We look into funds that are worse than they look and examine Wyndham Hotels shares.

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.


Susan Dziubinski: In a video that aired a couple of weeks ago, we examined three funds that were better than they looked. All three had lousy star ratings but strong fund analyst ratings. Today, we're doing just the opposite. We're looking at three funds that aren't as good as they might first look. These funds all earn 5-star ratings but just Neutral fund analyst ratings.

Robby Greengold: Fidelity OTC is a large-cap growth fund that currently earns 5 stars. That's a reflection of excellent historical performance relative to its category. For example, the fund beat 95% of its category over the past five years. And that outperformance is mostly attributed to bold bets made at the stock level. For example, the fund held a hefty stake in Tesla from 2016 to mid-2017. That was an excellent time to be in the stock.

And there have been been other examples of stellar stock-picking as well, but the manager responsible for those picks is no longer at the firm. The strategy is now in the hands of Chris Lin, who is a seasoned tech analyst but lacks experience running a diversified portfolio. And this is a big strategy with more than $20 billion tied to it. That explains our Morningstar Analyst Rating of Neutral. Lin hasn't proven himself yet on a strategy of this size and scope. We're waiting to see how he tackles portfolio construction, how well he manages risk, and how he executes day to day on this mandate that is still new for him.

Connor Young: Neutral-rated MFS Core Equity is an analyst-run fund. The analyst team that picks stocks here is deep in experience, but the investment approach in place has no clear advantage. The portfolio's industry weightings are kept in line with those of the Russell 3000 Index. While the analysts, who each focus on particular industries, select stocks to fill their industries' weightings in the portfolio.

This industry-neutral approach limits the strategy's sources of excess return when compared with other offerings that benefit from skilled managers and more flexible mandates, including many offered by MFS that tap this research team to a great degree.

And to be sure, the strategy has delivered great results but has a pronounced growth tilt, and that's been a significant advantage as growth stocks have led the way recently. It's uncertain whether this fund could replicate its success in a less growth-oriented environment. Plus, middling fees provide no advantage.

Nick Watson: Neutral-rated Delaware Smid Cap Growth has delivered impressive absolute returns over lead manager Alex Ely's tenure. But its aggressive growth portfolio has delivered it's share of ups and downs. Ely and his team invest in fast-growing firms and have a tolerance for high valuations. It's significantly more growth-oriented than the Russell 2500 Growth Index and the typical small-growth Morningstar Category peer.

And with 30 to 40 names, it courts a considerable amount of stock-specific risk. The fund's growth orientation has helped it recently, but that hasn't always been the case. In the second half of 2016, for instance, when value stocks were in favor, the fund lagged the Russell 2500 Growth Index by 15 percentage points. That sort of volatility has been characteristic over Ely's tenure, especially in down markets, where the fund has tended to lose significantly more than the index. The volatile pattern of performance suggests that this is a fund that would likely struggle to navigate an inflection point in the market.


Susan Dziubinski: Hi, I'm Susan Dziubinski from The market has taken a volatile turn recently with strong up days punctuated by periodic swings downward. Joining me to discuss some simple ways to de-risk your portfolio is Christine Benz. She's Morningstar's director of personal finance.

Christine, thank you for being here today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, let's discuss de-risking at a very basic level. What does it mean, and why would you do it?

Benz: Well, the basic idea is that you're going to look at your portfolio where it stands today and see if you aren't, in fact, courting too much risk relative to where you are in your life stage. So, typically, the biggest way that we court risk in our portfolios is by having too much equity exposure, given our proximity to needing to draw upon that portfolio. Having a very high-risk, equity-heavy portfolio makes a lot of sense for younger investors but if you're getting close to drawdown, you'd probably want to start to peel back on the equities.

Dziubinski: Do you think most people these days should be scaling back their equity exposure?

Benz: It really does come back to life stage. So, I would say for people 20s, 30s, 40s, maybe even young 50s, who still think they'll have another 15 to 20 years of work, probably not a reason to get in there and monkey around too much. They might want to focus a little bit on their intra-asset-class exposure, so maybe steer some money to foreign and away from U.S.

On the other hand, people getting close to retirement or people who are already in drawdown mode in their portfolios, those are the ones who I think should take a look at de-risking. If they haven't done so, if they've been hands-off with their portfolios, they've enjoyed nice equity gains, but their portfolios might be courting a little bit more risk than would be ideal.

Dziubinski: And making any changes or monkeying around does have tax consequences often, right?

Benz: It does. So, if you are making changes within the confines of your tax-sheltered accounts, your IRAs, your company retirement plans, you can make changes to your heart's content and not have to worry about triggering tax consequences as long as those assets stay within the confines of those accounts. But once you're touching your taxable accounts, and specifically if you're stripping back appreciated securities, well, there you could have capital gains. So, generally speaking, if you need to make changes, if you need to de-risk, focus on those tax-sheltered accounts, first and foremost.

Dziubinski: Now, let's say, I've looked at my portfolio, and I say, "OK, yes, this is a little too aggressive, this is a little too risky for where I am in my life stage." Let's talk about some simple ways I can de-risk a little bit. One is to direct new money to underweight positions in my portfolio.

Benz: That's right. So, if you are making ongoing contributions, you might say, well, I'll just send the new money to the safer securities. Maybe I'm underweight bonds. So, I'm going to turn off my contributions to the equities and send them all into the bonds and cash going forward. That can be a good strategy, although it may be difficult to move the needle if your new contributions are small as a percentage of your total portfolio. But another feather in the cap of that strategy is that if you're talking about taxable accounts, well, there's a good tax-efficient way to try to get your taxable account moving in the right direction--that by directing those new contributions to the safer securities, that's not going to trigger in any sort of taxable event in the way that selling would do.

Dziubinski: Now, what about looking at our asset-class exposures? It's not always a matter of directing new money or making changes at the asset-class level; it can be within asset classes, right?

Benz: That's right. So, in addition to de-risking at the asset-class level, you could look at the complexion of your equity holdings and of your bond holdings. So, for example, if you've been letting things ride, you maybe got a little more going in the large-growth, mid-growth, small-growth squares of the style box than would be ideal. You might have a little bit of a bet going on those aggressive areas. You may consider restoring balance and sending some money to the value side of the style box, which hasn't performed as well. You might also look at funds that just tend to do a good job of playing defense within their categories. So, I would call out some of the dividend growth strategies we've been talking a lot about on our team in the wake of Vanguard Dividend Growth reopening. Those are strategies that have historically outperformed other equities in weak markets. So, you can think about making some tweaks around the margins of your portfolio to try to reduce risk in that fashion.

Dziubinski: Another strategy would be to simplify and focus on maybe a target-date fund or a balanced or asset-allocation fund in an effort to de-risk?

Benz: Right. This can be a way to certainly get a temperature check on what an appropriate asset allocation looks like for someone at your life stage. Now, target-date allocations aren't right for everyone. But they can be really nice hands-off holdings for investors who aren't comfortable maintaining the risk exposures in their portfolios on an ongoing basis. They can also be really nice choices for smaller portions of your portfolio. So, for example, maybe most of your assets are in your company retirement plan. But you have this small IRA over here, and you've been kind of maintaining separate stock and bond positions. Well, there's a really good use for a target-date fund to simplify that portion of your portfolio. So, you don't have to put your whole portfolio in a target-date or an all-in-one fund. But it is a nice way to get yourself in the right ballpark in terms of asset allocation and also ensure that those risk exposures are kept in check on an ongoing basis, because the manager is doing that work for you.

Dziubinski: Right. Now, another technique that sort of does something similar in a 401(k) plan are these automatic rebalancing features, which we're seeing more and more of in plans?

Benz: That's right. We are seeing them more, but they aren't in every 401(k) plan. But the basic idea is that you're delegating the responsibility for keeping your risk exposures in check to your plan manager. So, you want to read the fine print about how they're doing that rebalancing. But it is a nice way to make sure that the equity exposures in your portfolio don't get away from you--that they're periodically streamlining the equity risk and they're also doing some of that intra-asset-class positioning as well.

Dziubinski: And the last strategy that you say we should be thinking about--in our taxable accounts--is not necessarily reinvesting our dividends and our capital gains but maybe taking those and reallocating them elsewhere to restore some balance in our portfolios.

Benz: That's right. And this has been top of mind for me lately, Susan, as funds are probably going to be making big capital gains distributions again later this year. This is a good way, if you've looked at your portfolio and said, "My asset allocations are a little out of whack, and this holding that's overweight is probably going to make a distribution anyway, I might as well redirect that distribution to a holding that I'd like to top up rather than sending it to this one that may be on the large side to begin with." So, this is a strategy that I think is underdiscussed. But I think it's a way that investors can plump up some of their underweight positions while stripping back things that they would rather not be adding to at this juncture. Incidentally, I would expect to see another year of hefty distributions coming from some other growth-leaning mutual funds. They've performed really well. But we continue to see redemptions from some of the active large-cap growth funds in particular. So, that might be an area if you own such a fund to consider redirecting those capital gains distributions into some other holding.

Dziubinski: Nice of you to try to find a silver lining in possibly large capital gains distributions. Great practical advice, Christine. Thank you so much.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski from Thanks for tuning in.


Seth Goldstein: The USDA reported that this year will have the lowest total acres planted in the U.S. in over the last decade as heavy rains in the spring left many fields flooded and unable to be planted. As a result, there will be lower near-term demand for U.S. agricultural inputs such as seeds, crop chemicals, and fertilizer. However, we view this as a temporary headwind and expect a full recovery in agricultural input demand in 2020. 

The lower plantings have weighed on ag stocks, providing attractive opportunities for long-term investors. We highlight Corteva and Nutrien as two of our favorite ways to play the agriculture recovery in 2020.

Corteva sells seeds and crop chemicals. The company was formed earlier this year as the agriculture spin-off of DowDuPont. Our wide moat rating is underpinned by the company's patented seeds and crop chemicals products that command pricing power and generate healthy profits. Over the next several years, we expect the crop chemicals business to benefit from the launch of eight new products. We also forecast that the seed business will benefit from the launch of Enlist GMO corn and soybean seeds, which China has already been approved for import. With shares trading firmly in 4-star territory, we see attractive risk-adjusted upside relative to our $41 per share fair value estimate.

Nutrien sells fertilizer and runs the largest agriculture retail business in the U.S. The company was formed in 2018 as a result of the merger between PotashCorp and Agrium. Our narrow moat rating is due to the firm's cost-advantaged potash and nitrogen production. We forecast potash prices to remain stable at roughly $300 per metric ton as larger players such as Nutrien and Mosaic will adjust production to keep the market balanced in the short term. Over the next couple of years, Nutrien should benefit from stable potash prices as the company reduces its unit production costs from operating synergies as the PotashCorp and Agrium operations are integrated. 


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.


Dan Wasiolek: Most are likely familiar with the hotel brands Super 8 and Days Inn, but probably fewer are aware that Wyndham Hotels is the operator of these and 18 other brands and possesses powerful intangible-asset and switching-cost advantages.

We expect Wyndham to gradually expand roomshare in the hotel industry and sustain a brand-intangible asset. This view is supported by the company's roughly 40% share of all U.S. economy and midscale branded hotels, and the industry’s fourth largest loyalty program by membership with 77 million, all of which encourage third-party hotel owners to franchisee with the company.

In addition to Wyndham's brand-intangible advantages, the company also has a switching cost moat. With all but two of its 9,000-plus hotels managed or franchised, Wyndham has an attractive recurring-fee business model with healthy returns on invested capital. Moreover, this asset-light model creates switching costs, given the 10- to 20-year contracts associated with these relationships.

With shares trading at a meaningful discount to our $76 fair value estimate, we view Wyndham shares as a place investors should travel to.