Morningstar still likes Vanguard Market Neutral Fund despite lagging in 2017

Vanguard’s Market Neutral Fund may have been an underperformer in 2017, but that hasn't stopped Morningstar from recommending the low-cost investment vehicle.

In a blog post, Jason Kephart, a senior manager research analyst at Morningstar, said the fund's preference for cheap companies hurt returns last year but its quantitative strategy and “rock bottom” fees, are reasons to consider owning the fund. Vanguard's Market Neutral Fund invests in stocks that receive top scores when it comes to valuation, growth, quality, momentum and management decisions when compared with peers. The idea is to find stocks that can grow faster from an earnings perspective but trade at a discount to rivals. The fund also shorts stocks that score lowest in the criteria.

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Given that valuation plays a big role in what stocks are selected for the fund, Morningstar said it's not surprising that the fund is long value stocks and short growth stocks. But in a year like 2017, when stocks were setting new highs seemingly every month and both large-cap and small-cap growth stocks were outperforming value stocks to the tune of 15 percentage points, it is not surprising that Vanguard's Market Neutral fund was down. According to Morningstar, the fund was down 4.8% for the year, trailing 90% of its rivals.

"There's still a lot to like about this fund. For one, its fees, which are 141 basis points below the market neutral Morningstar Category norm of 1.63%, give it a clear advantage," wrote Kephart. "Management has also shown it can tweak the process for the better over time." Kephart noted that the fund doesn't rebalance as often as rival funds because three of its stock-picking criteria are tied to quarterly earnings reports. With what Morningstar said is an annual turnover of 64%, the fund has among the lowest turnover rates in the market neutral fund category. That gives the fund another advantage over rivals when it comes to costs.

What’s more, Kephart said that Vanguard's Market Neutral fund can be a good way to diversify a portfolio given it has no correlation to major U.S. stock indexes over the trailing three and five years as of Dec. 31. "It remains a strong choice for investors looking for diversification from an alternative strategy," said Kephart in the post.

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