Vanguard's Problem Child

Investors in Vanguard U.S. Growth fund have good reason to be frustrated. Aside from one good year (2005), the fund has languished for a decade, with below-average returns. A series of management teams has failed to revive it. Such ongoing, unresolved performance woes are unusual for Vanguard, a huge organization known for its supermarket of low-cost (and usually well run) funds.

First, the numbers. Over the past ten years through May 31, U.S. Growth lost an annualized 2%, trailing Standard & Poor's 500-stock index by an average of six percentage points per year. Including the first five months of 2008, the fund (symbol VWUSX) has been in the bottom 40% of its peer group of funds that invest in large, fast-growing companies in nine of the past ten calendar years. For 2008 through June 13, U.S. Growth's return of -5.8% was 0.6 percentage point ahead of the S&P 500.

The fund can't claim to have erred in the direction of safety, either. Far from protecting its investors' money in the 2000-2002 bear market, it lost 70% of its value, compared with the S&P 500’s return of -47%. Returns (or lack thereof) would have been even worse but for the fund's low expense ratio, now at 0.50% annually.

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A lot of investors have simply left. According to Daniel Wiener, editor of The Independent Adviser for Vanguard Investors newsletter, shareholders have yanked nearly $1.9 billion from the fund on a net basis since 2005. Assets currently stand at almost $4 billion, down from $19 billion in 1999. Wiener calls the exodus a clear signal that "Vanguard needs to acknowledge the fund's problems and act on them" by hiring new managers. "What are they waiting for?" asks Wiener, who blames the fund's poor showing on bad stock picking.

Not so fast, says Joe Brennan, Vanguard's liaison with the outside money managers who run its funds. He says he's "comfortable with U.S. Growth's management team" despite the fund's track record. Brennan agrees that the fund has disappointed investors, but defends its stewards, saying "all managers, even the great ones, go through periods of underperformance." He says that's why Vanguard does not change managers based on fund returns alone.

U.S. Growth is currently co-managed by Alan Levi of AllianceBernstein (since 2002) and John Jostrand of William Blair & Co. (since 2004). Both have years of experience in fund management and stock analysis. Alliance was the fund's sole manager from mid-2001 until mid-2004, when Vanguard gave Blair about a third of the assets to invest.

Each shop employs its own method for choosing investments. Alliance has a large team of 78 analysts who review stocks for this fund and others. They rate companies based on earnings growth expectations and balance sheet strengths.

The Blair team of 20 analysts hunts for consistent earnings-growers with high returns on equity (a measure of profitability) and low debt. They seek to distinguish between an average company and a high-quality company that can achieve higher growth rates for longer time periods than the markets expect. And they look for industry leaders with experienced executives and distinctive products and services.

So far, their joint efforts haven't panned out. Large-company growth stocks fueled the internet bubble in the 1990s, and they've spent most of this decade paying for it in the form of substandard returns. Even when growth stocks flourished during the second half of 2007, many of the winners were out of step with U.S. Growth's strategy.

Another part of the problem is clearly the fund's emphasis on a group of distressed sectors. The fund dramatically underweights the financial sector, but its emphasis on large health care and technology hasn't helped lately. Also, compared with the S&P 500, it has relatively small positions in energy-sector stocks -- one of the best games in town these days.

Vanguard's Brennan says he's confident the management team will "add value over time." He also notes that the fund's previous losses present a potential advantage for those who hold it in taxable accounts because those losses can be used to offset future realized gains. That means the fund can minimize taxable distributions -- perhaps even avoid them -- for some time.

That's why we think that if you're in search of a growth fund specializing in big companies, this isn't it yet -- not yet, not until U.S. Growth logs a few years of consistently acceptable results versus its peers.

One large-company growth fund that need make no apology is Brandywine Blue (BLUEX), which we recently profiled. Over the past ten years through May 31, the fund returned an annualized 9%, beating the S&P index by an average of five percentage points a year. Year to date through June 13, it’s down 4.1%, beating the S&P 500 by 2.4 percentage points. The worst we can say about Brandywine Blue is that it takes $10,000 to open an account, versus $3,000 for U.S. Growth.

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