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Vanguard in 2021--and Beyond

Vanguard in 2021--and Beyond

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Vanguard's funds remain popular choices for investors this year. Here to review the year in Vanguard and talk about what we might see from the firm in 2022 is Alec Lucas. Alec is a strategist with Morningstar's Manager Research group, and Vanguard is among the fund families he follows.

Hi, Alec. Thanks for joining us today.

Alec Lucas: Hi, Susan. Thanks for having me.

Dziubinski: Let's start out talking a little bit about flows to Vanguard funds in 2021, how it compared to other asset managers, and in particular, which types of funds were resonating most with investors.

Lucas: Yeah, another good year for Vanguard, and if you can put it this way, a bit of a rebound. In 2020, BlackRock, including its iShares business, took in more money than Vanguard, and it was on pace to do that through the first half of 2021, though that's no longer the case. Our flows data at the firm level is only through October. But so far, through October, Vanguard is ahead of BlackRock and iShares. It's taken in about $292 billion versus about $258 for BlackRock and iShares. That fact itself, combined with the fact that JPMorgan and Fidelity are far behind in the $80 billion for inflows, says something about investor interests, namely, it continues to shift toward passive. What's quite interesting is when you drill down and look at the funds taking in new money, the top fund taking in new money is an international-bond fund for Vanguard that just launched, and bond funds make up three of the top four funds in terms of new money year-to-date, and that data is through November.

The other big one that stood out was a Treasury Inflation-Protected short-term securities fund, so it says something about investors' worries about inflation. If you look at active equity funds, Vanguard Equity-Income is the one that's taken in the most new money. So, again, the low-yield environment and investors' hunt for yield, it speaks to that.

Dziubinski: Let's pivot and talk a little bit about performance in 2021. A couple of funds in particular that had strong performances relative to their peers this year were Wellington and Windsor II. Let's drill down a little bit and talk about why they did as well as they did.

Lucas: Yeah, another good year for Wellington, and that's a good sign. Dan Pozen took over for longtime manager Edward Bousa pretty recently, and it's been a top-decile performer in its Morningstar Category. It's helped by having an above-average equity weighting. It's typically had around 65% of its assets in equities, and that's the case through September as well. Had some good stock picks: Alphabet, Microsoft, Charles Schwab, Home Depot. All of them have gained more than 50% year-to-date, and that's helped the fund.

Dziubinski: And then, what about Windsor II?

Lucas: Windsor II has had a subadvisor change that took place in December of 2019 when Aristotle Capital was added, and they removed Barrow, Hanley, which was a longtime manager of the fund that had more of a value orientation. What's interesting about Windsor II is its portfolios really shifted more toward the border between blend and value and is on pace perhaps to change into the Morningstar large-blend category if current trends persist. Having a bit of a blend orientation has helped it in a year like this. It's had some good stock picks, too. Microsoft has been a winner for it, Alphabet, Danaher is one that also stands out.

Dziubinski: Let's look at the other side of things, maybe a couple of funds that are popular at Vanguard but maybe have disappointed a little bit relative to their peers this year--first being Primecap and then Vanguard Dividend Growth.

Lucas: Yeah, Primecap and Vanguard Dividend Growth, interestingly enough in their investor shares have almost matched each other with year-to-date returns of about 20.5%--in absolute terms, that's great. Relative to the large-blend category, that puts them bottom quintile. So, a little bit different in terms of the drivers for each fund.

With Primecap, it, of course, was for a long time in large growth, and it shifted to blend last year, I believe, and it's really been hurt by having a top 10 position in Alibaba. The managers like Alibaba and began to build a position, I think, it was in 2020. But Alibaba has come under fire as have a lot of Chinese stocks because of regulatory scrutiny. It's lost about 50%. So, that obviously has hurt the fund.

With Vanguard Dividend Growth, what's quite interesting is, as granular as our Morningstar Categories are, they're still not perfect, and it requires some nuance to interpret results, and Vanguard Dividend Growth is a great example of that this year. Though it places in the bottom quintile of its category, it has a dividend growth focus that's quite distinctive, that has good downside protection, and tends to lag in rallies like this one, and it's actually ahead of its benchmark year-to-date. So, it's actually had a good year, not a bad year.

Dziubinski: And then, Vanguard International Growth, there's a little bit of a flip-flop, it seems, from a performance standpoint that's gone on there. Did really well relative to its peers in 2020 and hasn't been doing quite as well relative to its peers in 2021. What's been going on there?

Lucas: The story here is similar to what's going on with Vanguard Primecap except this is, of course, an international fund. It's about 70% allocated to Baillie Gifford and about 30% to Schroders. Baillie Gifford has long liked Chinese stocks, and those have been the culprits here, Alibaba being one of them, some other ones, NIO, an electric carmaker, Meituan, which is e-commerce food delivery, Tencent, which is social networking and gaming. Those Chinese stocks have really hurt the portfolio this year. Gained about 60% in 2020, so an off year this year. Shouldn't be a huge surprise. Long term, we continue to like the fund.

Dziubinski: And then, let's talk a little bit about some changes Vanguard made to some of its funds this year, including a subadvisor change at Vanguard US Growth. Walk us through what happened there and what we think about it.

Lucas: Vanguard relieved Jackson Square Partners of their duties on March 1, had been a subadvisor for a little over a decade there, and then reallocated assets among the existing subadvisors. We continue to like the fund. The investor shares get a Bronze rating. We give the people an above-average rating. We're not sure that the combination of processes on the fund gives it an edge. So, it's got an average rating there. But it continues to score highly because of our regard for Vanguard, and obviously the low fees help a lot.

Dziubinski: Now, Vanguard also changed the indices on two of the funds, two of its index funds--Vanguard Dividend Appreciation Index and Vanguard International Dividend Appreciation Index. So, what were the changes, and what do we think of those?

Lucas: This is a very interesting development on the part of Vanguard. It shows that Vanguard isn't content to rest on its laurels. So, VIG, Vanguard Dividend Appreciation, is an ETF that had tracked the Nasdaq US Dividend Achievers benchmark. That was the same benchmark for Vanguard Dividend Growth. And they decided to go with an S&P Dividend Growers benchmark that has just debuted. The reason they did that is because they wanted to have a little bit more flexibility in terms of a three-day rebalance, so they couldn't be front-run on securities. It's free-float-weighted. I don't believe the other one was. So, modest improvements in terms of the methodology of the benchmarking. And what that really goes to show is it's not that Vanguard Dividend Appreciation had been doing poorly, but they're always looking for incremental ways that can improve things. And I think that's a good example of Vanguard acting on investors' behalf, and it's also quite possible, though Vanguard doesn't disclose it, that the licensing fee drops. So, that saves investors more money there, too.

Dziubinski: And then, is it the same story with the International?

Lucas: Same story with International, yeah.

Dziubinski: So, interestingly, in 2021, Vanguard launched or announced plans to launch several new actively managed funds. Let's talk about, first, the new fixed-income funds that they launched.

Lucas: They launched a multisector fixed-income fund and a core-plus fixed-income fund. What's significant about that is Vanguard's approach to fixed income in terms of in-house equity, which is both of these funds are managed by Vanguard's in-house equity group. Jack Bogle had described it as "virtual indexing." So, in other words, we are going to give you active fixed income, but it's not going to take too many deviations from a standard benchmark. It's not going to be too aggressive. In this case, it signifies a shift. This is the kind of strategy that they might have in the past outsourced to a firm like Wellington, but this one is being developed in-house. They've added talent. Michael Chang is a new high-yield expert at Vanguard who joined them from Goldman Sachs in November of 2017. So, it really does signal a shift on Vanguard's part in terms of trying to have world-class capabilities in fixed income that can compete with the best, and we'll see how do.

Dziubinski: And then, they also debuted a set of high-conviction active funds. Who are these funds for? And again, what do we think of them?

Lucas: They're for personal advisor services, businesses, clients. The funds are run by some of Vanguard's most trusted subadvisors and managers at those subadvisors. So, what they did is they debuted a dividend growth fund. It's run by Don Kilbride, who also runs Vanguard Dividend Growth. It's a more concentrated version of the strategy he uses for Vanguard Dividend Growth that he's run since about 2008. It has a better record than Vanguard Dividend Growth. A global value fund run by David Palmer, who manages money for Vanguard Windsor. And then, they also have an international growth fund run by Baillie Gifford. Lawrence Burns and James Anderson--James Anderson is retiring in April 2022--so, Lawrence Burns will become the key person there following James Anderson's retirement. We think highly of all of those managers. The funds are, as you would expect, cheap. And even if you add on a 30-basis-point advisory fee, which is what you need, they would be still pretty competitively priced relative to other active options.

It is important to mention that these are funds that are only available to Vanguard Personal Advisor Services clients. So, that is a bit of a shift for Vanguard, and it's something that--I think that from a capacity standpoint, it shows that if you want to be high-conviction, if you want to be active, you're going to have limited capacity. These strategies are designed to take that into account. And so, to some extent, there's some limitations on that. So, it is an attractive offer if you're a client or if you want to opt for Vanguard services and advice, I think that these offer a competitive, compelling, active option to be paired with a passive core perhaps, or even to go all active if you have the temperament to do that.

Dziubinski: And then, just a few weeks ago, Vanguard announced that it was launching an active fund focused on Chinese equities, is that right?

Lucas: That's an interesting development because, in mid-March, Vanguard had decided to jettison its plans to launch Chinese index funds. And then, they announced plans, Baillie Gifford being the subadvisor, to launch an active Chinese equities fund. Their research shows them that--or suggests to them rather--that there's a lot of inefficiency in the Chinese equity market. Of course, efficiency helps you when you're doing an indexing approach, and it provides opportunity if you're an active manager. So, they just announced that, and it will debut next year. So, it's an interesting development and unique because it's not typical for Vanguard to debut an active fund devoted to one particular region. It shows the influence of China. And it's actually good timing. You don't want to launch a fund devoted to a particular country when it's done real well recently because it could obviously regress to the mean. In this case, it could regress to the mean positively. So, the timing could be good here.

Dziubinski: And then, lastly, Alec, gaze into your crystal ball. What might we see from Vanguard in 2022?

Lucas: I've been thinking about this. It's become common to refer to Vanguard as an index provider. If you look at the development of Vanguard's business, passive assets really only started to dominate in terms of the firmwide assets in the aftermath of the financial crisis. Vanguard's business historically was built on the back of active management, Vanguard Wellington being the key fund in that respect, Windsor as well.

I think that if we look into the crystal ball here and think 10, 15, 20 years hence, we'll probably be referring to Vanguard as an advice provider. And I think the developments that we've seen this year foreshadow that. Vanguard has really led the way in terms of democratizing investing through indexing and lowering fees, and to such an extent that it's now facing fee competition from its biggest rivals, which is an interesting turn. But if you think about that, Vanguard has democratized what finance people like to call "beta," which is to say tracking indexes, tracking exposures to asset classes, and then it really becomes can you do that, provide high-quality active options, and blend that together in an advice context that helps investors do the right things for the right reasons at the right time. And that's what they're trying to do with their advice business. We mentioned Vanguard Personal Advisor Services. Vanguard Digital Advisor is a robo version. They're making improvements on that. They're going to add tax-loss harvesting, for example, in 2022. So, I think that 10, 15 years from now, we'll be talking about Vanguard, the advice provider.

Dziubinski: Alec, thank you so much for your time and your perspective today. It was a busy year for Vanguard. 2022 will probably be another busy year for Vanguard. So, I'm sure we'll be talking about it some more next year.

Lucas: I look forward to it. Thanks so much.

Dziubinski: Thanks. I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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