Choosing mutual funds that outperform the market can be difficult, leading many investors to opt for low-cost passive funds. While passive investing garners considerable attention, active investing offers unique benefits that should not be overlooked. Vanguard’s long-term accomplishments demonstrate the advantages of hedging, risk management and flexibility utilized in active management. Talented fund managers with strong track records generally outperform, particularly in less publicized market segments, such as small-caps or international markets.
Low management fees that are competitive with passive investments are possible when active managers apply a disciplined approach. Investors should, however, allow for a longer horizon since they are investing in a manager and a strategy that may see periods of underperformance. The compound returns generated during the up years can offset losses incurred during years of poor performance. This philosophy has enabled Vanguard to attract significant capital inflows into actively managed funds over the past year.
Vanguard’s Growth and Income Fund (VQNPX) is a strong offering with historically modest returns that has consistently outperformed its S&P 500 Index benchmark. The fund has also demonstrated lower downside risk than that of its category peers.
Investment Strategy
VQNPX breaks the portfolio into several sleeves to attain a broadly diversified portfolio of stocks with investment characteristics similar to those contained in the S&P 500, but designed to outperform it. The current managers have been in place since September 2011. Managers and sub-managers work within tight constraints to keep the tracking error low and the beta in line with the index.
When selecting an investment, sub-adviser Los Angeles Capital emphasizes market-cap size, growth and the stock’s beta. The firm also determines whether the market is placing a premium on the prospective company’s shares. The team is led by managers Thomas Stevens and Hal Reynolds.
With Anne Dinning at the helm, a team of eight analysts at sub-adviser D.E. Shaw utilizes models designed to find price inefficiencies. They seek to offset traditional quantitative factors likesuch as value, size and momentum in their analysis by employing other investment criteria, such as trading volume and price movement. They also consider such factors likeas acquisitions and the strength of the company’s balance sheet.
Vanguard’s in-house quantitative equity group manages the third sleeve. Their goal is to create a high-quality portfolio characterized by moderate valuations, positive momentum and strong earnings growth. Two of the three sub-advisers match the S&P 500’s sector weightings, while sub-adviser Los Angeles Capital sometimes deviates.
Portfolio Composition and Holdings
VQNPX falls into the large– blend category because it must invest at least 65 percent of assets under management (AUM) in stocks contained within the S&P 500. Typically, the percentage of AUM invested in the index exceeds 90 percent. At the end of September 2016, the fund was almost entirely invested in domestic stocks and held 1,074 individual investments, more than double the benchmark.
The portfolio has 42.6 percent of AUM invested in giant-cap shares as well as a 33.3– and 21.95– percent exposure to large- and mid-cap shares, respectively. Along with a marginal exposure to micro-cap shares, less than 2 percent is allocated to small-caps. The fund’s 10 largest holdings represent 15.9 percent of AUM. In descending order, top holdings are Apple, Johnson & Johnson, Microsoft, Exxon Mobile and Amazon. These are followed by Alphabet, General Electric, AT&T, Proctoer & Gamble and Citigroup.
The management team’s doctrinal approach has produced a portfolio with a valuation that is slightly lower than the benchmark. At 20.4 times earnings, the portfolio has a P/E ratio below the S&P 500’s 22.2. The 2.8 price-to-book ratio is also slightly lower than the benchmark. The average market cap of VQNPX is $44.6 billion, which is approximately half of the S&P’s average. VNQPX is overweight energy, industrials, health care and consumer defensive sectors, and underweight financial services, real estate and technology. Although there is some deviation from the index, sector weightings are usually within 2 percent of those found in the benchmark index.
Historical Performance and Risk
The fund has consistently delivered on the managers’ goal of inching ahead of the benchmark index. Since September 2011, the current management team beat the S&P 500 by an annualized 44 basis points. Although it is not a passive fund designed to completely mimic the benchmark, the fund’s tracking error is less than 1 percent over the past five years.
With a four-star Morningstar rating, VQNPX has delivered average annual one-, three- and five-year returns of 3.93, 9.08 and 13.97 percent, respectively. These compare towith the S&P 500 returns of 4.51, 8.84 and 13.57 percent, respectively. The fund has a high return and a below– average risk rating from Morningstar.
VQNPX has a three-year beta of 0.98 compared towith the large-blend category beta of 1.00. The fund’s three-year standard deviation of 10.5 is lower than the category average of 11.07.
Fees, Expenses and Distributions
No-load VQNPX is one of the least expensive actively managed funds in the large-blend category. The fund’s 0.34 percent expense ratio is competitive with its passively managed peers despite its high annual turnover costs and performance fees paid to D.E. Shaw and Los Angeles Capital, a testament to Vanguard’s acumen in keeping costs low.
The fund distributes long- and short-term capital gains annually in December. Semiannual income distributions occur in June and December. The most recent income distribution occurred June 2016 for $0.402 per share with a reinvestment price of $40.17. The fund is scheduled to pay a capital gain of 4.63 percent on December 22, 2016. Investors in taxable accounts may want to wait until after this gain is paid before buying.
There is a $3,000 minimum initial investment.
Suitability
VQNPX provides a diversified low-cost portfolio in a single fund that may be an appropriate core holding. VQNPX may weather a period of rising interest rates better than a typical bond fund as it generates current income and potential capital appreciation and holds stocks that regularly increase dividends. Currently, we rank the fund as a Strong Buy with a Ranking of 88.