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Analyzing the First Half of 2016 for Vanguard

Morningstar's Dan Culloton weighs in on the company's flows, new products, manager changes, and performance so far this year.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We have Dan Culloton, he's director of equity manager research here at Morningstar. We'll look at Vanguard's first half 2016.

Dan, thanks for joining me.

Dan Culloton: Thanks for having me.

Glaser: So let's start with fund flows. This has been a big story around Vanguard for years now, just the huge inflows of money into the firm. Any sign of that abating in 2016?

Culloton: No, the juggernaut continues. So, in the year ending June 30, Vanguard had about $151 billion in inflows, the most of any fund family in the industry.

Glaser: Now, is this just a passive story, everyone's going into index funds, or are there active strategies also attracting money?

Culloton: It's certainly primarily a passive story. The funds getting the majority of the inflows in Vanguard are passive strategies like Vanguard Total Stock Market, Vanguard Total Bond Market, Vanguard Total International Bond Market, these are all the components of their target retirement funds, which are all index-based. So, it still is very much a passive story. But interesting enough Vanguard's active funds saw positive inflows in the year ending June as well, about $5.8 billion in active flows. A lot of those in bond funds like Vanguard Intermediate-Term Tax-Exempt and Intermediate-Term Investment-Grade, but also some actively managed stock funds such as Wellesley Income stock and bond fund, dividend growth and equity income.

Glaser: So Vanguard is not known for launching a ton of new products, but there were few launches so far in 2016. What do these launches kind of tell you about the firm's strategy?

Culloton: It seems to be there are two themes. They are rounding out their fixed-income index lineup and expanding their actively managed fixed-income capabilities. So on the index side, they launched Vanguard Tax-Exempt Bond Index, the first tax-exempt bond index at least in their fund family, and they have an ETF that went along with that as well.

Then they also launched Vanguard Core Bond which will try to compete with Vanguard Total Bond Market Index, try to outperform, it will be internally managed by Vanguard's own managers and will be very conservative and make modest sector bets and yield curve bets, but really try to be a steady core bond fund that wins like all Vanguard funds do with expenses, it's going to charge about 25 basis points, which is very competitive in the actively managed bond category.

Glaser: Anything in the emerging-markets space?

Culloton: They quietly launched a Vanguard Emerging Markets Bond, actively managed bond fund. We don't know a lot about it yet, but it was proposed as a way to build their capabilities. If you are trying to find this fund on their website, you wouldn't be able to find it right now. It does show up on our database, but I think it's something that they are just trying to get their feet wet.

Glaser: And similar kind of quiet launch on this Alternative Strategies Fund. Not that they think alternatives are necessarily appropriate for all investors?

Culloton: Yeah. So in late 2015, they formally launched an Alternative Strategies Fund. This is something they had been incubating as far back as, say, 2008 in offshore in Dublin, they are experimenting with ways to create a fund that very cheaply replicated or offered the same risk/reward exposures as a hedge fund or an Alternative Strategies Fund.

They finally got comfortable enough with these strategies to roll it out late last year. But they are not making it widely available to investors; it has a very high minimum of $250,000. Once again, you can't find it on their website if you try to go there and look for it to invest yourselves. And this is primarily designed as a component of the Vanguard Managed Payout Funds, which are, an endowmentlike fund of funds that they use for people who want to essentially turn their nest egg into a stream of income.

Glaser: You mentioned those active strategies a little bit earlier. Are there any notable manager changes there that investor should be aware of?

Culloton: There were a number of manager changes, say, in the last six or 12 months. The one that really stood out to me though was the retirement of Jim Barrow, the manager of, one of the mangers of Vanguard Windsor II. It was not a secret that he was going to retire. He had made his intentions known to Vanguard for a very long time. And in 2013, actually brought on two comanagers which became his anointed successors on the 60% of the fund that they still ran, that his firm Barrow, Hanley, Mewhinney & Strauss ran. And these comanagers were very experienced with about 20 years of experience each in the industry. And however, Jim Barrow was one of the longest tenured managers at Vanguard's actively managed funds. He had managed their funds since 1985 and had put up and extremely strong record over his tenure. So, his retirement resulted in us downgrading Vanguard Windsor II's Morningstar Analyst Rating from Silver to Bronze.

Glaser: So let's take a look at performance now. You know when you look across the kind of Vanguard lineup, were there any kind of leaders that really kind of stood out versus their category?

Culloton: What really stands out so far in terms of leaders so far this year are really defensive flight to safety-type funds. So Vanguard Precious Metals and Mining was the strongest performing Vanguard fund in absolute returns gaining 77% through the end of June for this year. Now that's a lot, but it was still only good for it to rank in the bottom quartile of the equity precious metals category which had seen average returns of 80% or better so far this year. Also very long-dated fixed-income funds, so Vanguard Extended Duration fund, Vanguard Long-Term Treasury, Vanguard Long-Term Government funds, all did very, very well as interest rates stayed very, very low and in some parts of the world as we know are negative.

Glaser: And then on the kind of laggard side, what was underperforming?

Culloton: Well, Vanguard International Explorer did very poorly, small-cap and being focused on Europe, didn't help very well. Vanguard European Index. So Europe, international were areas that performed poorly. Also funds that had exposure to healthcare, Vanguard Healthcare and Vanguard Capital Opportunity, run by the PRIMECAP folks out of Los Angeles area. They've liked biotech and healthcare for a while, and the selloff in that sector hurt them.

Glaser: And finally what about some of the kind of just widely held Vanguard funds, like Wellington. How did those did do in this year so far?

Culloton: I've been very impressed by the way tried-and-true balanced funds like Vanguard Wellington and Vanguard Wellesley Income have continue to put up strong competitive performance in a variety of markets over the last few years. They continued to do that this year. Vanguard Wellington has gained about 5% through the end of June and Vanguard Wellesley Income about 7.5%, 7.6% through the end of June. That's because in January and February when the markets are very volatile, they held up very, very well, and they participated enough since then in order to maintain a lot of those returns. That's really what they are designed to do, and we talked about the alternative strategies fund and investors' continuing interest in alternative strategies, and yet here are these 60/40, 40/60 funds that continue to do very, very strong despite some people writing their obituary.

Glaser: Dan, I certainly appreciate your take on Vanguard's first half.

Culloton: Thank you very much.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

Dan Culloton has a position in the following securities mentioned above: VGHCX, VGPMX. Find out about Morningstar’s editorial policies.