Is Vanguard Changing Course?

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Vanguard has been making headlines during the past few weeks, naming a new CEO and boosting fees on some of its accounts. Seems like a good time to sit down and talk with Morningstar’s lead Vanguard analyst Dan Sotiroff about some of this news as well as get an update on the firm’s funds.

Thanks for being here, Dan. It’s great to see you.

Daniel Sotiroff: Great to see you. Thanks for having me on.

Vanguard’s New CEO

Dziubinski: All right. Well, let’s start with the big news, the CEO news. Vanguard named a successor to CEO Tim Buckley, who I think is stepping down in July. And the new CEO is a former executive from a competitor, BlackRock. Were you surprised that Vanguard brought in someone from the outside to run the firm? I think this is the first time that’s ever happened.

Sotiroff: Surprise is probably an understatement there. Everything about it was surprising. First, we didn’t expect Buckley to retire. I go back to the conversation we had in December. This was the last thing on my radar. Second, usually when Vanguard announces these types of things, at least in the past, they’ve always mentioned who is going to come in and take over. So, you had that assurance that there was going to be some continuity there. They left it open. They didn’t name a successor right away. And then third, they kind of left that successorship open a little bit. They said we were going to start considering an external candidate in our search. So, all of that didn’t follow their playbook that they had at least executed historically.

It was all very, very surprising. And ultimately, they went down that road of an external candidate. We know they appointed Salim Ramji a few weeks ago to take over CEO, as you mentioned, that’s going to be effective on July 8. So, all of this is very, very surprising. We’re still trying to get caught up with it here and trying to figure out what’s going on. But it’s definitely a new direction for Vanguard. Let’s put it that way.

Dziubinski: Let’s talk a little bit about the new CEO. What was his experience at BlackRock? And what do you think he is bringing to the table here?

Sotiroff: We know a little bit. He was an executive of BlackRock for about 10 years. He spent the last five years of that tenure really as the global head of iShares and their indexing. So, you think about that, that fits kind of perfectly with what we think of when we think of Vanguard. They have a huge lineup of index-tracking funds. That’s what they’re really known for. So, he knows that side of the business very, very well. Prior to his work at BlackRock, he spent about 16 years at McKinsey as a consultant. But that was really on the asset-management and wealth-management industry. So, he kind of had a lot of exposure to everything that was going on and saw ETFs grow from this really kind of a baby to the behemoth that they are now. So, he’s very, very familiar with the industry, very familiar with indexing strategies and ETFs. That’s a big area of Vanguard’s business, like I said, and it’s only growing. That’s the big thing is that’s where a lot of the money is going these days. And then the other thing that he brings to the table, I think you kind of alluded to it is he kind of knows the competition, at least the biggest competition out there. It’s probably not a bad idea to have someone like that in your corner.

What Challenges Will Vanguard’s New CEO Face?

Dziubinski: What do you think the biggest challenges that Ramji will be facing stepping in the door at Vanguard?

Sotiroff: There are a few challenges. First, I think it’s safe to say he’s going to be held to a higher standard, at least that’s the way I look at it. You can go to a lot of asset managers, you can get low-cost index funds, you can even get very well-managed, actively managed mutual funds, if that’s what you’re into. But Vanguard’s main selling point has always been client-first. And there are a lot of asset managers that say that; Vanguard really walks the walk. So, he’s going to really have to uphold that.

If you want like a concrete example like that, I always look at their fund launches. Vanguard is very disciplined and puts out great long-term investment solutions. BlackRock has been more willing to play in the short-term game. You think of things like the bitcoin ETF and a lot of thematic funds they’ve been launching over the last couple of years. So, it’s a very different business, and he is going to have to have that client-first mentality and really walk the walk.

The second thing I think that’s going to be a challenge for him is that Vanguard is a much bigger and much more complex company than it’s ever been. Especially when you go back to the years when Bogle and Brennan were running it, it’s much bigger. You’ve got much more clients, much more crew, and much more AUM. So, with all that size and complexity, there are obviously more costs for running that business. And if you still want to be the low-cost provider at the end of the day, you’re going to have to manage those costs in the background.

And then the third thing I look at is where does Vanguard want to go from here? Their business is doing very well, they’re taking in a lot of money. The index funds are doing great. The actively managed funds are still chugging along. But what do you want to do next? Where do you want to go and disrupt? And how do you want to do that in a client-friendly manner? I think those three things are kind of really the big questions I’ve got at this point.

What Flows Should Vanguard Investors Be Aware Of?

Dziubinski: And you alluded to fund flows and that really isn’t going to be one of the new CEO’s challenges. If I looked at Morningstar’s April fund flows report, BlackRock has pulled in more assets during the past 12 months than Vanguard, but Vanguard is still the leader by a large margin in terms of the overall US fund assets. But are there any trends in Vanguard’s flows or the industry’s flows that Vanguard investors today should maybe be aware of?

Sotiroff: One thing we should be aware of here is when Ryan and Adam [Morningstar analysts Ryan Jackson and Adam Sabban] put that report together, the line item there says iShares. So, we have to be careful that we’re comparing Vanguard’s mutual funds and ETFs to the iShares mutual funds and ETFs. But yes, to your point, Vanguard has been winning there, at least this year in terms of flows. And when you look at iShares AUM versus Vanguard AUM, Vanguard is out in front by a lot. When you look at BlackRock as a whole, I think BlackRock still has a little bit more money than Vanguard. But we don’t have the full rollups. We don’t get everything reported to us.

But to your point, yes, there’s a much wider industry trend that is still taking place. What I mean by that is we’ve seen a lot of money flow out of higher-cost, actively managed mutual funds into lower-cost, more-tax-efficient passively managed ETFs. And it doesn’t seem like anything is slowing that down. And the big point here with Vanguard is they manage a little bit of both. They’ve got a lot of really big actively managed mutual funds that we think pretty highly of. They also do excellent in index tracking. But when you look at the flows underneath that, you’re seeing money move out of those actively managed mutual funds and into their passively managed ETFs. So, they haven’t been immune to this trend. If you want to put a number to it, their actively managed mutual funds collectively lost about $160 billion over the two years through April. So, it’s a pretty big number. I don’t think it really threatens their viability or anything like that. But it’s something to watch out for.

So, if you wanted some specific names: Vanguard Dividend Growth VDIGX lost about $7 billion over those two years. Wellington VWENX, which is kind of a balanced fund, mixed with stocks and bonds, that lost about $15 billion. Wellesley Income VWIAX lost about $14 billion. And then Primecap VPMAX, the original Primcap fund from 1984, that lost about $9 billion over the last three years. There are some big funds out there that had some pretty big outflows. Again, viability, I don’t think is an issue. But if you’re in one of those, maybe just be aware that if you have this in a taxable account, you might be on the hook for some capital gains at the end of the year, depending on the circumstances.

The one thing I would add is it’s not all red ink. There are some pockets of light here. So, Vanguard Core Bond VCOBX, that’s a relatively new mutual fund they launched, that took in about $5.3 billion over the last two years. And then Vanguard Emerging Markets Bond VEMBX, that’s also sort of a newer emerging-markets bond mutual fund they launched a few years ago, that took in around $636 million over the last two years. So, there are pockets of hope, but it’s some of those older mutual funds that just aren’t resonating. And some of it, I think, is maybe retirees pulling money out, too. That’s always a factor.

What Vanguard’s Fee Hikes Mean for Investors

Dziubinski: Vanguard is still known as the low-cost leader in the industry. So, the firm got some flak lately for raising some fees on some of its brokerage services. Can you outline some of those changes for us and then detail what these fee hikes really mean in real-world terms or investors?

Sotiroff: Sure. So, there was a document they released, and there were a number of fee changes to the brokerage document. They take effect on July 1. I sort them into two categories. So, there’s the big one, and that’s the $25 fee that’s going to be charged to anyone trying to trade a Vanguard ETF or mutual fund over the phone. Now, you can still go online and use the app and the trading is free, but this is for people who are calling and using the phone. And that’s applied to smaller accounts, so accounts less than $1 million is how Vanguard defines that.

I didn’t read too much into it. I think what Vanguard is trying to do is discourage people from using the phone to conduct routine transactions. I think it’s somewhat of a cost-savings thing. But the other piece of information we know is that Vanguard has had problems with customer-service-type stuff on the line. So, I think what they’re trying to do is push people away from using the phone lines for these routine transactions, free those associates up to handle more difficult situations that require a little bit more of a human touch. That’s what I really think is going on there.

The other ones, I just kind of lump together in this odd-lots bucket. To just give you an example, a $100 fee to close or transfer an account that’s less than $5 million; a $250 fee for removing restrictions on a security; a $100 fee for depositing physical share certificates—there were physical shares at one point in time, we forget that. But these don’t seem like day-to-day routine transactions that your typical investor is going to be conducting. So, I don’t think this is Vanguard’s executives scheming to make money on their clients at the end of the day is the point I’m trying to make. So, I didn’t read too much into this.

Best Vanguard Funds in 2024

Dziubinski: Let’s pivot and talk a little bit about Vanguard’s funds so far in 2024, starting with talking about performance, perhaps. Are there a few standout performers this year from your perspective?

Sotiroff: One that really shot to the top of the list was Vanguard U.S. Momentum Factor ETF VFMO. It outperformed its category index by 5%. It’s smaller, and it kind of that strategic-beta-type sort of fund. It straddles the line between active and passive, I guess is what I’m saying. So, it’s managed by Vanguard’s quant equity group and follows a set of rules, but it’s still technically actively managed. So, they have some discretion at the edges, but it’s basically a momentum strategy. It outperformed its category index by 5% year to date, but that’s really because it sits in the mid-cap category. It’s a mid-cap growth fund. So, it’s not competing against all these funds that are holding the “Magnificent Seven.” It didn’t have that working against it.

Along those lines, though, Vanguard Growth and Income VGIAX, it’s outperforming its category index by about 2.2% year to date through April. That one was kind of interesting. But again, you look at the underlying holdings, and a lot of those Magnificent Seven names were at the top of the list. So, at least that’s part of the reason it’s doing great. But it kind of flips around when we start looking at the underperformance. I don’t want to go and do the next question.

Which Vanguard Investments Are Underperforming?

Dziubinski: No, go right ahead. Dan, let’s talk about some of the things that are maybe surprising you on the downside from an underperformance perspective.

Sotiroff: It’s a similar story but the flip side of the coin. So, the worst performers are trailing because they aren’t holding those Magnificent Seven stocks. So, they’re not holding the big tech names, think of the Teslas, the Nvidias, that type of stuff. And the ones that really stand out in that regard are a lot of the Dividend Growth or the Dividend Depreciation Fund. So, Vanguard Dividend Appreciation ETF VIG, International Dividend Appreciation ETF VIGI, and then they’ve got the actively managed Vanguard Dividend Growth, International Dividend Growth VIDGX that Wellington is managing. We like all of those strategies. We think they’re all great.

But this is exactly the type of environment you would not expect them to perform well in. A lot of those companies aren’t paying dividends. If they are, they just recently started paying them, and they’re pretty meager at that. When you look at those funds, they’re down about 2.5% to 5% depending on the situation and which fund you’re looking at relative to their category index. But again, this is par for the course. I expect them to underperform.

Dziubinski: Right. So, no surprises necessarily?

Sotiroff: No, no, exactly.

Vanguard’s New Active Bond ETFs

Dziubinski: The last time you and I talked, Vanguard was just about to launch some active bond ETFs. Now the funds have launched. They’ve been out there for a little while. I’m not expecting that we have a full-blown analysis on all of them yet. But now that they’re out into the world and you’ve observed them a little bit, what do we think?

Sotiroff: I think that’s an important point to lead with. We don’t have an official opinion on these in terms of a Medalist Rating. I did write an article about them a little while back, sort of outlining what they are and explaining them. The basic way to think of them is they’re reasonable for what they are. It’s just you have to understand what they are and what that active really means. So, the way I think of them is they’re adding some incremental risk in search of incremental return on top of a broad bond market index. They’re very much a core bond holding at the end of the day. So, the active Core Bond ETF VCRB is going to be tied to the Bloomberg Aggregate Index. The Core-Plus Bond ETF VPLS is benchmarked to the Bloomberg Universal Index. And really where the managers can get their edge from is they can do two things, at least in the way I see it. They can take on a little bit more credit risk so they can allocate a little bit more to high-yield bonds or maybe the lower rungs of the investment-grade credit ladder. And then they can do some bond selection within the constraints of what those funds are allowing them to do. I guess the bottom line is don’t expect a ton of alpha from either one of these. They’re still very much core holdings, although there is that opportunity for incremental performance improvements.

But the other thing to point out is that they’re really cheap, and that’s a big part of their billing. So, you’re not paying a lot. You might not get a lot, but you’re not paying a lot at the end of the day. They’re doing pretty well in terms of AUM. They’re kind of chugging along. Nothing really flashy to point out there. The Core Bond ETF is at about $270 million. Core-Plus is a little smaller at around $140 million, but they’re moving along. They’re to the point where they look viable now. And again, the way I would use these, think of them as a core bond holding. So, if you were holding a core bond index in your portfolio, these would be reasonable substitutes for an investor who wants to take on a little bit more risk and search for a little bit more return. That’s the great use case for these.

Will There Be Any Other New Fund Launches in 2024?

Dziubinski: What about any other new fund launches in 2024? Has Vanguard announced anything?

Sotiroff: You know, it’s been crickets. Not a whole lot right now, at least as of June 5. They launched two muni-bond ETFs earlier this year. Those are both index-tracking funds. I think we briefly talked about those when I was here back in December. So, you got the Vanguard California Tax-Exempt Muni Bond ETF. The ticker on that is VTEC. That’s really aimed at sort of those tax-sensitive investors in California. And then they got an Intermediate Tax-Exempt Bond ETF, ticker VTEI. Both charging 8 basis points, very cheap. So, if you’re into muni bonds, you got some new bonds to shop with.

Changes to Vanguard Funds’ Morningstar Medalist Ratings

Dziubinski: And then lastly, any notable manager changes at Vanguard that we learned about since the last time we talked, or any Morningstar Medalist Rating changes that you think are noteworthy on any of Vanguard’s funds?

Sotiroff: Well, your question was very timely because just two days ago, effective June 3, Vanguard announced they were going to change the advisor lineup on Vanguard Explorer Value Fund VEVFX. We don’t have a rating on that now. We don’t have a human analyst rating on the fund right now. So, there isn’t going to be a note that goes out to call attention to it. So, I thought for investors out there, it’s a reasonably big fund, about $1 billion. Currently, it’s managed by Ariel Frontier Capital and Cardinal Capital. Vanguard is going to be taking Cardinal Capital off and adding Wellington to the subadvisor lineup there. So, Wellington and Ariel are going to be splitting the sleeve that Cardinal was managing before. So yeah, it’s a little bit of a change there. If you do have money in that fund, it might be something worth paying attention to and looking into.

Dziubinski: And then any rating changes notable this year? Nothing yet, right?

Sotiroff: There might have been some that move up and down, but it’s nothing hugely meaningful or anything like that.

Dziubinski: Got it. Well, Dan, I’ll talk to you at year-end unless Vanguard does something else before then.

Sotiroff: At this point, I wouldn’t put it past them.

Dziubinski: Great talk to you. Thank you so much for your talk.

Sotiroff: You’re very welcome. Thank you.

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

Watch 3 Great Active ETFs for Bond Investors for more from Daniel Sotiroff.