How to Replicate the Vanguard Wellington Fund with ETFs

Sure, I’m all about ETFs, but I can certainly tip my hat to a well-managed mutual fund, especially one as venerable as the Vanguard Wellington Fund (VWELX).

This fund is practically an institution, having weathered every major market crisis since its inception on July 1, 1929, including the Great Depression, the dot-com bubble, the 2008 financial meltdown, and the recent COVID-19 market crash.

What's impressive about Wellington is its balanced strategy, maintaining a roughly two-thirds allocation to U.S. stocks and one-third to investment-grade bonds. This mix has delivered a respectable annualized return of 8.31% since its start.

While it may not have beaten the S&P 500 in total returns, its risk-adjusted performance shines brighter, boasting a Sharpe ratio of 0.52 since 1984 compared to the S&P's 0.4.

Despite its merits, VWELX isn’t perfect—there’s a $3,000 minimum investment and a 0.26% expense ratio due to its active management. This led me to ponder: could we mimic VWELX’s approach using low-cost, passive index ETFs?

While there might be a touch of data overfitting in this experiment, it’s a useful demonstration of how ETFs can serve as effective, flexible building blocks in portfolio construction. Let's take a look!

VWELX: the equity component

About two-thirds of VWELX's assets are invested in U.S. equities, focusing on a relatively concentrated group of just 76 stocks. Although it's actively managed and doesn’t divulge its precise stock selection methodology, Vanguard gives us a few hints.

VWELX targets high-quality large- and mid-cap companies in sectors that may be temporarily out of favor. The fund seeks stocks offering above-average dividend yields, low valuation multiples, and signs of improving fundamentals, typically leaning towards a "large value" style.

To replicate this equity component with ETFs, we can start with the Vanguard Dividend Appreciation ETF (VIG). This ETF follows the S&P U.S. Dividend Growers Index, which requires stocks to have increased their dividends for at least ten consecutive years and excludes REITs.

It also omits the top 25% of stocks with the highest yields, instead applying a market cap weighting with a maximum of 4% per stock, aligning with the quality factor by focusing on dividend growth.

For additional exposure to the value factor, another third of the equity allocation can be directed towards the Vanguard High Dividend Yield ETF (VYM).

This ETF tracks the FTSE High Dividend Yield Index, selecting stocks from the upper 55% of the yield distribution within its selection universe and weighting them by market cap.

Both VIG and VYM are cost-efficient with a 0.06% expense ratio and collectively cover both the quality and value aspects of investing. Here's what Vanguard has to say about them:

"The performance of these strategies has been time-period dependent and largely explained by their exposure to a handful of equity factors: value and lower volatility for high-dividend-yielding equities and lower volatility and quality for dividend growth equities."

Notably, they have 181 overlapping holdings, which is desirable for our replication strategy. These shared stocks have passed the stringent filters of both ETFs, marking them as possessing both robust dividend growth and yield qualities, alongside notable value and quality characteristics. This overlap ensures that we are focusing on stocks that strongly embody the core traits VWELX seeks in its equity component.

VWELX: the fixed-income component

When it comes to the fixed-income portion of its portfolio, VWELX allocates about 34% to bonds. As with the equity portion, this segment of the fund does not track a specific benchmark like the Bloomberg Aggregate Bond Index but is actively managed to include a variety of bonds, described as:

"Intermediate-duration portfolio that may include short-, intermediate-, and long-term investment-grade corporate bonds, with some exposure to U.S. Treasury, government agency, and mortgage-backed securities."

To emulate this part of VWELX using ETFs and maintain a focus on high-quality corporate bonds, I recommend the iShares Aaa - A Rated Corporate Bond ETF (QLTA).

As the name suggests, QLTA invests exclusively in corporate bonds rated between Aaa and A, including securities from exceptionally creditworthy issuers like Johnson & Johnson and Microsoft—two of the only companies with a AAA rating.

QLTA offers a yield to maturity of 4.66% and an average duration of 7.12 years, which aligns closely with the bond characteristics of VWELX. With an expense ratio of 0.15%, it's also fairly cheap.

Putting it together

Putting together our DIY ETF version of the Vanguard Wellington Fund, we can see how it stacks up against the actual VWELX over a significant period from February 16, 2012, to August 23, 2024.

It was a close race, but VWELX still came out slightly ahead with a Compound Annual Growth Rate (CAGR) of 9.41% compared to our DIY ETF's 9%, and a Sharpe ratio of 0.73 versus 0.70 for our version.

Part of the slight underperformance of our ETF replication can be chalked up to the unique "secret sauce" of Wellington's active management and their far more concentrated portfolio. There's an inherent challenge in trying to mimic the nuanced stock selections and bond allocations of a seasoned fund manager through a few broad index ETFs.

However, despite the small performance gap, the lower weighted average expense ratio of our ETF setup, at only 0.0891% compared to Wellington’s 0.26%, offers an advantage. Over the longer term, I think this lower cost could help to narrow the performance gap, as fees play a crucial role in net returns.

The verdict? The DIY ETF approach a decent alternative for those looking to emulate the Wellington Fund's balanced strategy with the added benefit of lower fees and greater accessibility.