An Upgrade for This Fine Real Estate Fund From Vanguard

The following is our latest Fund Analyst Report for Vanguard Real Estate Index VGSLX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Real Estate Index is by far the largest real estate fund, with just over $70 billion in assets. It is also one of the cheapest. The fund's broadly diversified market-cap-weighted benchmark captures the full breadth and depth of the opportunity set available to Morningstar Category peers and closely mimics the manner in which they build their portfolios. It features experienced management and an excellent record of tracking its index. Within our new ratings framework, which puts even greater emphasis on fees, the fund's Institutional, Admiral, and exchange-traded fund share classes have earned an upgrade to a Morningstar Analyst Rating of Gold from Silver. Owing to its higher fee, the fund's Investor share class retains its Silver rating.

Until recently, the fund had tracked the market-cap-weighted MSCI US REIT Index, which holds domestic-equity REITs. That index doesn't include non-real-estate specialty REITs such as timber or cell-tower REITs. Beginning in February 2018, the fund began to migrate from the MSCI US REIT Index to its new benchmark, the MSCI US Investable Market Real Estate 25/50 Index. The new index is a broader representation of the real estate sector and thus the opportunity set available to category peers. Most notably, it includes the aforementioned non-real-estate specialty REITs that were absent from its prior benchmark.

Lead skipper Gerard O'Reilly has managed the fund since its 1996 inception. He also runs the $900 billion Vanguard Total Stock Market Index VTSAX, as well as numerous other big index funds. That experience has helped O'Reilly and his team do an excellent job of tracking the fund's benchmark and has helped it outpace most other real estate funds over time. Its 15-year return ranks in the top fourth of real estate funds, largely thanks to its low expense ratio, which gives it a durable edge. The only funds in the real estate category with lower costs are Fidelity Real Estate Index FSRNX, Schwab U.S. REIT ETF SCHH, Fidelity MSCI Real Estate ETF FREL, and iShares Core U.S. REIT ETF USRT. All in all, there's plenty to like here.

Process | Above Average
The fund's goal is to provide broad exposure to the U.S. real estate sector by tracking the MSCI US Investable Market Real Estate 25/50 Index. This index weights its holdings by market capitalization, which reflects the market's view about the relative value of each holding. It seeks to mimic its benchmark as closely as possible. The fund's scale allows it to fully replicate its target index, which helps it hew closely to its bogy. Broad diversification, low turnover, and a proven process for precision index-tracking earn this fund an Above Average Process Pillar rating.

The fund's index is reviewed semiannually and rebalanced quarterly. Its portfolio is diversified across property sectors. This is a good benchmark for core real estate exposure, and the managers have historically done a good job of tracking their index. There's no reason to believe that this will change now that the strategy has transitioned to its new benchmark. That said, there is a risk that the fund's heft could result in increased market-impact costs. At over $70 billion in assets, it represents approximately 5.5% of the total market cap of its benchmark. Its managers must tread lightly to avoid adversely affecting performance when trading the portfolio.

In February 2018, the fund began to migrate from its prior benchmark, the MSCI US REIT Index, to the MSCI US Investable Market Real Estate 25/50 Index. Its new benchmark casts an even wider net than its former bogy. The aggregate market cap represented by its new target is $266 billion (27%) greater than its prior index. American Tower AMT, Crown Castle CCI, and SBA Communications SBAC are three new names among the fund's roster of top 10 holdings. Together, these three specialized REITs currently account for about 14% of the index's value. Their addition has resulted in a much larger allocation to specialized REITs, which account for a third of the value of the fund's new benchmark, versus roughly of a fifth of its former index. This will likely increase the fund's risk profile, as these firms' cash flows are relatively more volatile versus other types of REITs. Other segments of the REIT market with sizable allocations within the portfolio include residential (14.6% of the fund's portfolio as of Dec. 31, 2019), retail (12%), healthcare (9.6%), office (9.5%), and industrial (8.3%) REITs.

People | Above Average
Gerard O'Reilly has managed this strategy since 1996. He has been with Vanguard since 1992 and became this fund's lead manager in 2006. Walter Nejman was named O'Reilly's comanager on May 25, 2016. He has been with Vanguard since 2005. Their experience and the breadth, depth, and resources of the teams that support them earn an Above Average People rating.

O'Reilly and Nejman are part of Vanguard's Equity Index Group, which is headed by Rodney Comegys. Portfolio management is ultimately a collective effort across this group, which specializes in efficient trading and portfolio construction techniques designed to deliver precision benchmark tracking across Vanguard's lineup of equity index funds.

Although neither manager invests in this strategy, Vanguard aligns their interests with investors' by linking their compensation to operating efficiency. Because minimizing costs and tracking error are the managers' primary objectives, manager ownership is a less important indicator of alignment than for active managers.

Parent | High
The Vanguard Group entered a new era in early 2019 with the passing of its founder and conscience, John C. Bogle. Unlike its mid-1970s origins, when outflows were the norm and its survival was in question, Vanguard now wears the crown as the world's biggest retail asset manager. More than 90% of its $5.6 trillion in global assets under management, as of June 2019, are in the United States; but the firm has designs to grow its non-U.S. business, especially in the United Kingdom, Australia, Canada, Japan, China, and Mexico.

Vanguard gained its stature by following Bogle's playbook: pairing relatively predictable strategies, both passive and active, with minimal costs. That's enriched Vanguard's investors, and those outside its flock who have benefited from industrywide fee compression. While Vanguard's passive business now faces stiff price competition from its biggest rivals, inflows into its U.S. strategies still dominate.

Not content, Vanguard aims to transform investment advice, too. In May 2015, it launched Personal Advisor Services, a burgeoning discretionary asset-management business that pairs automation and human advice; and in September 2019, it disclosed plans to launch a digital-only counterpart. Vanguard's industry leadership readily merits a High Parent rating, but the firm must stay on its guard to prioritize investor interests over merely expanding its kingdom.

Performance
This fund's annualized return has trailed its benchmark's by an amount less than its expense ratio over the past decade, which speaks to the quality of the team and process behind it.

This strategy has been a top performer in the real estate category, beating the category in eight of the 10 calendar years through 2019. Over the 15-year period through January 2020, it ranked in the top fourth of its category. This may seem counterintuitive to those who associate REITs with active management, because REITs once were seen as a less-efficient asset class. However, very few actively managed REIT mutual funds have topped this fund's return since its 1996 inception. The percentage of actively managed REIT funds besting this strategy's index over trailing five-year time periods from 1996 to 2002 was relatively high (about 60%) but has fallen since then to less than half that level. Most actively managed REIT funds have underperformed passively managed peers during the past decade, as many were broadsided during the global financial crisis.

On a risk-adjusted basis, returns have also been strong. Most notably, the fund's downside capture ratio has tended to fall below the category norm. That said, the nontraditional REITs now included in the fund's portfolio may introduce an additional increment of volatility.

Price
It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's cheapest quintile. Based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we think this share class will be able to deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Gold.