by Dan Wiener | December 16, 2012 6:19 am
Vanguard and its investors got along just swimmingly for more than two decades with just one bond index fund — Vanguard Total Bond Market Index Fund (VBMFX) — which debuted in 1986.
But three years ago, Vanguard launched the Scottsdale Sector Bond Index funds. You remember the Scottsdale funds, right? That was the name under which Vanguard registered seven new bond index funds and ETFs — three government, three corporate and one mortgage-backed — in 2009. Aha! Now we’re speaking the same language.
A three-year birthday is a reasonable time to ask, at least preliminarily, how these bond index funds have fared in the marketplace and as investments. And the answer: Some have done better than others. As you can see in the table below, the corporate bond index funds have been much more popular — all have garnered over $1 billion in assets — while investors have nearly ignored the government bond indexes. And though I thought Vanguard Mortgage-Backed Securities ETF (VMBS) had potential to be a big winner for Vanguard, $500 million in assets is nothing to get excited about. However, it’s not too bad, considering that investors pulled roughly $2.5 billion from Vanguard GNMA Fund (VFIIX) over the same period.
The bulk of assets invested in these funds — 90% or so — has gone into the funds’ ETF shares. And with front-end loads ranging from 0.25% to 1.00% still in place on the corporate bond funds, I expect this trend to continue.
Why have investors favored the corporate bond index funds, which invest in investment-grade taxable bonds, over the government bond indexes, which hold U.S. Treasury bonds as well as other debt guaranteed by the U.S. government or agencies? It all comes down to yield.
Consider Vanguard Short-Term Corporate Bond ETF (VCSH) and Vanguard Short-Term Government Bond ETF (VGSH). As the table below shows, the corporate index fund has a slightly longer duration (more interest-rate risk) but with a yield of 1.23% versus a paltry 0.17% on the government fund; investors are choosing the higher yield. Investors face a similar trade-off — longer duration but a higher yield — when weighing the two intermediate-maturity funds. On the long-maturity end, investors can find a higher yield and lower duration in Vanguard Long-Term Corporate Bond ETF (VCLT).
So far the ETFs do not appear to be cannibalizing much business from their older and larger sibling funds. I am sure some of the roughly $4.5 billion that investors put into Short-Term Corporate ETF would have otherwise found its way into Vanguard Short-Term Bond ETF (BSV) or Vanguard Short-Term Investment-Grade Fund (VFSTX). But as those two funds actually pulled in more money over the past three years — nearly $10 billion and $7 billion, respectively — than the corporate index fund, it doesn’t look like investors have been dropping the old for the new. Plus, Vanguard continues to use open-end funds, rather than ETFs, in its various fund-of-funds products, many of which are staples in countless 401(k) and other retirement plans.
Although the newer bond index funds haven’t been stealing assets from their in-house rivals, they have held their own when it comes to performance, with one notable exception. The graphs below showing relative performance group the funds by maturity. In these charts, a rising line means the newer bond ETF is outperforming.
Looking at the short-maturity funds, Short-Term Government ETF and Vanguard Short-Term Federal Fund (VSGBX) are comparable, and though the federal fund has a slightly longer duration and higher yield, performance has been nearly identical. Short-Term Corporate ETF has held a performance and yield advantage over both Short-Term Bond Index and Short-Term Investment-Grade. These advantages have been driven by virtue of being a 100% corporate fund as opposed to small differences in duration. (I still prefer the actively managed Short-Term Investment-Grade fund for its proven ability to navigate different market environments, though for ETF adherents the corporate offering is a strong one.)On the intermediate-maturity side, comparisons are made a bit more difficult as Vanguard does not have a “Federal” fund in this space, but Vanguard Intermediate-Term Government ETF (VGIT) and Vanguard Intermediate-Term Treasury Fund (VFITX) have been very similar in terms of duration, yield and performance. Turning to the corporate index fund, the story is similar to the short-maturity space as a yield and performance advantage for Vanguard Intermediate-Term Corporate Bond ETF (VCIT) has resulted from being a purely corporate bond fund.While there has been more parity amongst Vanguard’s long-maturity funds, the mortgage-backed space holds the most distinction. As the chart above shows, manager Michael Garrett of Wellington Management has led GNMA ahead of Mortgage-Backed Securities ETF despite fishing in a smaller pond. Remember, the index holds Fannie Mae (FNMA) and Freddie Mac (FMCC) issued mortgage pass-through securities in addition to those issued by Ginnie Mae. As I noted last month when discussing the trade into GNMA, the two funds also have very different yields. GNMA, with a duration of 3.4 years, has a yield of 2.15% compared to a yield of 0.02% and duration of 2.7 years for the ETF. While Vanguard did manage to bring Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIPX) to market in October, I’m still waiting for Vanguard to launch its foreign and municipal bond funds and ETFs. Maybe the inability of the government ETFs to gather assets has made Vanguard a bit more gun-shy?
I think it could be a tough road ahead for the government ETFs. I expect assets will remain light in this low-yielding environment as investors continue to pick the higher-yielding corporate ETFs or one of Vanguard’s actively managed bond funds. And a move higher in yields will mean the funds will suffer price declines. A rise in rates will hurt the corporate ETFs as well, but their already higher yields should help cushion the blow a bit more. Mortgage-Backed Securities ETF may also struggle to grow if its yield remains so far behind GNMA, especially if Garrett continues his index-beating ways.
These index funds are still young, but they’re holding their own when it comes to performance. I’ll be watching as they mature.
Senior Editor Dan Wiener and Editor/Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.
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