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Why We've Downgraded This Fine Vanguard Fund

Vanguard Health Care manager Jean Hynes is taking on a much larger role at subadvisor Wellington.

The following is our latest Fund Analyst Report for Vanguard Health Care VGHCX

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Vanguard Health Care's personnel advantage won't be as pronounced after its manager takes on a second role in mid-2021, so its People rating has been lowered to Above Average from High, and the Morningstar Analyst Ratings of both its share classes have been downgraded to Silver from Gold as a result.

Lead manager Jean Hynes, who took charge of this fund in 2013 after several years as a comanager, will become the CEO of subadvisor Wellington Management Company when current CEO Brendan Swords retires on June 30, 2021. She'll continue to serve as the sole manager of this fund afterward.

Hynes been spending a significant amount of her time on executive tasks for years. She recently gave up her role as head of the healthcare team, and she will relinquish all of her portfolio manager positions besides this one before she becomes CEO. And though Swords served as Wellington's president as well as its CEO, the firm is separating those positions going forward. Moreover, Hynes is experienced and talented, and she'll continue to have good support. This fund, therefore, will continue to have a personnel edge over most of its rivals after Hynes becomes CEO. However, serving as the CEO of Wellington comes with significant responsibilities, as does running a large healthcare fund like this one, so this fund's personnel advantage won't be quite as strong.

This strategy's process, which is distinctive as well as sound, won't change after Hynes becomes CEO. Hynes and Wellington's healthcare team will continue to look for innovative firms with differentiated products or services and attractive valuations relative to their growth prospects, and she and the team will continue to allow stock selection to drive industry exposures and pay ample attention to foreign stocks.

This process has earned good results during Hynes' seven-year tenure at the helm, and this fund is still an attractive option for investors who are seeking a geographically diverse healthcare offering and understand the risks that come with its sizable foreign stake.

Process | Above Average A sound, distinctive, and repeatable approach earns this strategy an Above Average Process rating.

Jean Hynes and the other members of Wellington's healthcare team seek diversified exposure across healthcare industries, and they look for innovative companies with differentiated products or services and attractive valuations relative to their growth prospects. The process capitalizes on the broad expertise of Wellington's healthcare team and focuses on different traits in different industries. Hynes and team focus on the usefulness of drugs in development and their probability of success for pharmaceutical and biotech firms, for example, while they emphasize quality of management and execution for healthcare-services companies.

They readily allow their stock selection to result in distinctive industry exposure. They also pay considerable attention to foreign healthcare stocks that meet their standards, and this fund normally invests roughly 20% to 30% of its assets overseas. That amount is not quite as much as its prospectus benchmark, the MSCI ACWI Health Index, but it is significantly more than Hartford Healthcare HGHAX (which the team also runs) and the average offering in the health Morningstar Category usually devote to international stocks. The S&P 1500 Health Care Index, which is the category benchmark, doesn't include overseas names.

People | Above Average Jean Hynes, who became a comanager on this fund in 2008 before taking over as the sole skipper in 2013, will become the CEO of subadvisor Wellington Management Company when current CEO Brendan Swords retires on June 30, 2021. Hynes will continue to serve as this strategy's only manager after she becomes CEO, but she will give up all of her other management positions--including her role as manager of one of the sleeves of Hartford Healthcare.

Hynes has been spending a significant portion of her time on executive functions for years. She has already given up her role as head of the healthcare team. And while Swords served as Wellington's president as well as its CEO, the firm is separating those positions going forward. (Steve Klar will become the firm's president in early 2021.) Meanwhile, Hynes is one of the more seasoned and skilled healthcare managers around, and she will continue to be supported by the same sizable and strong team of healthcare specialists.

All this means that this strategy will continue to be in better hands than most healthcare offerings after Hynes becomes CEO in mid-2021. However, Hynes' new role adds significant responsibilities to her work running this large healthcare portfolio, so this strategy's People rating is lowered to Above Average from High.

Parent | High The Vanguard Group entered a new era in early 2019 with the death of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its $5.6 trillion in global assets under management, as of June 2019, are in the United States; but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico.

Vanguard gained its stature by following Bogle's playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That's enriched Vanguard's investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard's passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate.

Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019, it disclosed plans to launch a digital-only counterpart. Vanguard's industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's cheapest quintile. Based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Silver.

Performance This fund posted fairly strong relative returns as most healthcare stocks prospered during the past year. Its investor share class gained 25.8% for the 12 months through Sept. 30, 2020. That return was much better than the 21.6% gain of the MSCI ACWI Health Index and the 20.1% gain of the S&P 1500 Health Care Index, but it was significantly worse than the 31.9% return of the average member of the health category. This fund's outperformance versus the indexes was largely due to strong stock selection in the pharmaceutical industry, while its underperformance versus its typical rival was mainly because of its underweighting in the biotech industry.

Meanwhile, from the time Jean Hynes took the helm on Jan. 1, 2013, through Sept. 30, 2020, this fund's investor share class earned a Morningstar Risk-Adjusted Return of 12.4%. That return was significantly better than the 10.2% and 11.3% risk-adjusted returns posted by the MSCI ACWI Health Index and the average member of the health category, respectively. It also was close to the 12.8% risk-adjusted return delivered by the S&P 1500 Health Care Index during the period, even though foreign healthcare stocks lagged far behind their U.S. peers and this fund normally invests roughly 20% to 30% of its assets in international equities while that index ignores such names.

Portfolio This portfolio remains quite geographically diversified. Indeed, British drugmaker AstraZeneca, Swiss pharmaceutical firm Novartis, and Japanese drug manufacturer Eisai are top-10 holdings, while Belgian biotech company UCB, Chugai Pharmaceutical of Japan, Dutch generic drugmaker Mylan, and Danish biotech firm Genmab are top-five holdings. This strategy has 31.3% of its assets invested abroad versus 34.8% for the MSCI ACWI Health Index, 17.5% for Hartford Healthcare, 17.1% for its average peer, and 0.0% for the S&P 1500 Health Index.

Meanwhile, stock selection continues to drive industry exposure. Jean Hynes and Wellington's healthcare team have invested in quite a few pharmaceutical companies overall, and this portfolio has a 39.7% stake in that industry. That's roughly the same amount as the MSCI ACWI Health Index (40.2%), but it is considerably more than Hartford Healthcare (25.0%), its average peer (23.9%), and the S&P 1500 Health Index (28.0%). Conversely, this strategy has significantly less exposure to the healthcare equipment and supply industry than the Hartford offering, its typical rival, and both benchmarks.

Finally, this portfolio has an average market cap of $55.7 billion, which is much larger than those of the Hartford fund and its typical rival but much smaller than those of both benchmarks.

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About the Author

William Samuel Rocco

Senior Analyst, Equity Strategies, Manager Research
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Bill Rocco is a senior manager research analyst, equity strategies, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He specializes in international-stock and emerging-markets funds and is the lead analyst covering asset managers Harding Loevner, Matthews and Seafarer. Rocco is a member of the Morningstar Analyst Ratings Committee for international-equity funds. He joined Morningstar in 1994 as a mutual fund analyst.

Rocco holds a bachelor's degree in political science from Duke University and a master's degree in comparative politics from Georgetown University.

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