by Dan Wiener | April 8, 2013 1:07 pm
Some investment advisers are howling that Vanguard has done ’em wrong.
Vanguard has closed Vanguard Intermediate-Term Tax-Exempt Fund (MUTF:VWITX) to new accounts from advisers and institutions while leaving the fund open to retail investors. The same has been done at Vanguard Wellington Fund (MUTF:VWELX).
Are the investment advisers in the right to complain?
Well, Vanguard’s first order of business is to allow its fund managers to do what they’re contracted to do. If too much cash is cramping their style, then Vanguard’s task is to cut off the flow. If the biggest spigot is the one coming from investment advisers and institutions, then that’s where you spin the handle to “off.”
But Vanguard did leave itself the option to keep the fund open to some institutions and advisers — presumably those with long-term objectives and smaller trickles of new money flowing into the fund — and they’ve exercised that option.
Suppose, however, you are one of those who has been blocked from opening new accounts in the fund. Or maybe you’re an individual investor who’s wary of investing in a fund that’s so big it’s already getting difficult for the managers to manage, and you’d like an alternative.
Fran Kinniry, a principal in Vanguard’s Investment Strategy Group, offered up an alternative for investors on Vanguard’s “adviser” website. And uncharacteristically, he put some performance numbers behind his analysis. (Unfortunately, he didn’t describe how he arrived at those numbers until I got hold of Vanguard and started asking questions.)
Kinniry’s alternative, laid out in a short article titled “A dual fund approach for tax-exempt bond exposure,” rightly suggests that a portfolio composed of 30% Vangaurd Limited-Term Tax-Exempt (MUTF:VMLTX) and 70% Vanguard Long-Term Tax-Exempt (MUTF:VWLTX) would be a good way to mimic Intermediate-Term Tax-Exempt. Combined, the two funds’ assets totaled $25.4 billion at the end of February, compared to Intermediate-Term’s $39.2 billion.
However, what Kinniry doesn’t explain (or didn’t, until I asked the obvious question and he revised his report) is that his methodology involves rebalancing to the proscribed 30/70 mix every month — a plan that would not only involve a transaction each month, but would set you up for lots of short-term gains and losses if done in a taxable account.
Kinniry’s plan also runs afoul of the wash-sale rule on every loss-making transaction because of the monthly income distributions the funds make.
And, not to put too fine a point on it, but Vanguard’s computers might label you an “active trader” and freeze you out.
The other thing Kinniry doesn’t explain is that his two-fund alternative is actually riskier.
Research chief Jeff DeMaso and I ran the numbers using both Kinniry’s monthly approach, and an annual rebalancing methodology that would have you trading in January, thus giving you more than a year before you’d owe any taxes on any gains from the transaction.
What we discovered was that, compared to Intermediate-Term Tax-Exempt’s maximum cumulative loss (MCL) of -4.9%, the “combined” portfolio, rebalanced monthly, would have generated an MCL of -6.9%. Rebalancing yearly is a smidge less risky, with an MCL of -6.8%. Not only that, but you earn fractionally better returns using an annual rebalancing methodology than you do making your trades monthly.
While a 6.8% loss isn’t huge, it’s a pretty far cry from the 4.9% loss suffered by investors in the intermediate-only portfolio. Investors who are considering this alternative should be aware of the difference.
Kinniry does give himself an out (one that I’ve never seen Vanguard offer before), and that’s making a guess on the direction of interest rates. As he writes, advisers could adjust their allocations to the two separate funds depending on “your perspective on municipal bond exposure and outlook for interest rates.”
Betting on interest rates doesn’t sound like “Vanguarding” to me.
Big as it is, Intermediate-Term Tax-Exempt is a good, well-managed fund suitable for investors who are willing to take a bit more duration, or interest-rate risk, than they would in Limited-Term Tax-Exempt, for a yield that picks up from 0.52% to 1.56%.
And a final thought: If Vanguard had launched its municipal bond index funds and ETFs when it said it would, this cash-flow issue might never have happened, as many advisers probably would have rushed to buy the passive portfolios instead.
Will those muni ETFs ever see the light of day? Right now, I have my doubts.
Editor Dan Wiener and 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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