Vanguard's 2018 Winners and Losers

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Has Vanguard been feeling competitive pressure in the wake of Fidelity's launch of free index funds? Joining me to discuss and other news at Vanguard over the past year is Alec Lucas, he's a senior analyst in Morningstar's manager research group.

Alec, thank you so much for being here.

Alec Lucas: Thanks for having me.

Benz: Alec, let's talk about the year very briefly before we get into some of the specific news items. It's been a tough year for both stock-pickers as well as bond-pickers.

Lucas: It's been pretty volatile, especially of late. We've had a correction early in the year and a near correction toward the end of the year.

Benz: In the equity market.

Lucas: In the equity market. Bonds, the agg is down about 1% year to date. The S&P 500's gained about 0.5 percentage point through roughly mid-December. So, a tough year but not a terribly year necessarily.

Benz: Let's get into the fund flows news at Vanguard. it seems like every time we've done these sit downs we've been talking about this Vanguard juggernaut, how they just are getting so many new inflows. It does seem that inflows have slowed a bit so far in 2018.

Lucas: They've slowed. Their strongest month was January, and if you recall January was a month where the market really shot up and investors were pouring money into it, at least into Vanguard so it seems.

Benz: It's often a good, I think a good month for asset managers in general.

Lucas: That too, for sure. There is lot of factors that figure into that. They continue to dominate in terms of flows nearly $140 billion in inflows. But that's quite a bit less, they saw over $200 billion in inflows in 2017. This year they are on pace for roughly $166 billion if things stay where they've been; that's through October our data so far.

Benz: And the real strength in terms of flows, inflows that they have been getting have been mainly in the passively managed offerings, right?

Lucas: Yeah, it's interesting to just keep in mind that Vanguard coming out of the financial crisis was roughly half actively managed funds in terms of assets and half passive. It's now roughly 80% passive. They still have a very large actively managed business, but inflows have been predominantly in passive. You see that with their competitors; the next biggest recipient of inflows is iShares, their passive ETF products there. A secular shift away from active management continues.

Benz: Let's talk about Fidelity's launch of free index funds. How has Vanguard responded?

Lucas: Well, the phrase "turnabout is fair play" comes to mind. Vanguard's putting pressure on the industry for year's to lower fees, and now Fidelity has offered free index funds with no minimum investment. They debuted a couple in August and two more in September. In November, Vanguard announced that it was lowering the minimum investment for its admiral shares to $3,000, so that's lowering the cost of 38 index funds. That's been their competitive response.

There's a couple of caveats that are important. One is that this lowering does not apply to investors in their fund to funds. They won't benefit from the lower investment level and lower fees that come along with it.

To give context, the Vanguard Total Stock Market Index Fund now costs 4 basis points or 0.04%, but that's not free and you still have to have $3,000 minimum investment. Fidelity is offering a big challenge to Vanguard's hegemony, if you will, in indexing. But its important for investors to keep in mind that in opting for a free index fund, they maybe paying money elsewhere that they don't necessarily have to. For example Vanguard's money market funds offer a higher yield in general than Fidelity's. The two I compare there is 20 basis point differential.

Benz: And is that expenses mainly?

Lucas: I think that's mainly the fees. I didn't actually drill down to the fees, but my guess is that it is the fees.

Benz: Let's talk about another issue that has been top of mind for lot of Vanguard investors which has been some of the technology, the customer service. We have been hearing anecdotes from our users about this issue for the past couple of years. In part because flows have been so robust and so many investors have been gravitating to Vanguard there was an issue with some of the technology, though, this fall when we saw the market get rough.

Lucas: Oct. 10 the S&P 500 dropped 3.3%, its biggest drop in roughly eight months I believe, and a report came out in Financial Times that there were number of Vanguard clients who are unable to access their accounts. Obviously, it might be a time where you want to pour money in if you are trying to buy on the dip, and it can be very frustrating if you are not able to access your account.

Vanguard's experienced it's growth pains that it's had the past few years in terms of client service problems. In March of this year they announced a new client experience group, lab tests that they are doing. I think there is 12 lab tests that they were launching by the end of the year, that was the plan. They are planning to go global in 2019. They are very active in trying to address the client service problems, and I think its fair to say that any asset manager that's experienced the kind of growth they have would have probably similar struggles. I think they are spending as far as we can tell, through our report, that they are spending about 20% of their budget on technology and improving things. It's a substantial amount, I think things will improve there, but obviously they have a way to go.

Benz: Let's talk about performance, you put together a list of some of the best performing funds within the Vanguard lineup as well as some of the funds that haven't performed so well relative to their category peers. One fund that looks really good, it's a closed fund, Vanguard Dividend Growth. Let's talk about what's going on there and why it has done pretty well in what has been a tough market.

Lucas: Its managed by Don Kilbride, and it's kind of fund it's really distinguished itself in falling markets. It tends to be very resilient. Dividend growth stocks in general have done well this year, but Vanguard Dividend Growth has done even better. It closed to new investors because he's had so much success, he invests in multinational companies that have shown commitment to growing their dividends. These are kind of companies, investors flock to when markets turn south. Its continued to do very well. Wellington, another Vanguard standard, has done very well and have been pretty resilient this year.

Benz: Both Gold-rated funds. U.S. Growth is another one that you pointed out. I am less familiar with this one. Let's talk about the story there.

Lucas: Kevin McDevitt covers Vanguard U.S. Growth, it's a multimanaged fund in terms of subadvisors. We have a Neutral rating right now, Kevin's concern was that it was a fund that had a pretty aggressive profile, but that seems to have worked well for it this year. It's doing quite well and very high up in its category.

Benz: Even though technology stocks and the high growth stocks have been ground zero of this recent market sell-off for the year, that's been a pretty good place to be.

Lucas: Yeah.

Benz: Let's talk about the other side of the ledger some funds that haven't done as well. Vanguard Windsor and Selected Value, both value leaning portfolios. Let's talk about what's worked against them in 2018.

Lucas: Windsor bought GE earlier in the year, and obviously GE's had a lot of problems and its stock has continued to plummet. That's been a challenge for that fund. Selected Value to mid-cap value fund and small cap value stocks have really been the laggards this year in terms of thinking across the market. That's a headwind for that fund and they bought Adient I think a couple of years ago. Adient is a stock, that when I looked at it yesterday it was down 75% year to date roughly. It's a stock that's been hit on, it had company-specific issues, but it's also been hit on trade concerns with China.

Benz: Selected Value though is still a fund that we like, it's just in the midst of a tough patch.

Lucas: It is, it had been a Gold-rated fund and we downgraded it I believe last year to Silver out of concerns that it would be probably more volatile going forward and at least that thesis has played out thus far.

Benz: Alec, I know a lot of our viewers are keenly attuned to the goings on at Vanguard. Thanks so much for being here to provide this recap.

Lucas: Thanks for having me.

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