A colleague recently asked me, “What’s the big deal about our new muni bond index fund/ETF?” It’s a fair question (it is an index fund, after all), and the answer has a lot to do with the $3.7 trillion municipal bond market and its accessibility to investors. But before I get to that point, let’s review why we launched this fund/ETF.
For a long time, advisors have asked Vanguard for a municipal bond index product that could serve as the core portfolio for the fixed income exposure of their high-net-worth clients with taxable accounts. Why? While Vanguard has a reputable actively managed municipal bond lineup,¹ many advisors are unable to access our lineup on their platforms. Furthermore, many of you seek an index approach or prefer to use ETFs or both. Indexing bonds, particularly municipal bonds, is challenging, and our Fixed Income Group wanted to be sure it could offer a high-quality fund before launching this product.
Vanguard’s 40-person active municipal bond team, in concert with our Risk Management Group, uses proprietary technology to analyze numerous risk factors for municipal bonds, which, in turn, influences the strategies employed in our actively managed funds. This team is now using the same rigorous risk management process to help minimize the Tax-Exempt Bond Index Fund and ETF’s differences versus the benchmark. Not something a dart-throwing monkey could handle.
But back to the main point of my story. The Tax-Exempt Bond Index Fund/ETF brings an index option to an area of the market that historically has been led by higher-cost, less diversified strategies such as separately managed accounts (SMAs) and individual bond portfolios. The customization of SMAs has its place with clients, but at what cost? Investors, especially those who directly hold $1.5 trillion in muni bonds continue to pay too much for tax-exempt income.²
The U.S. muni market has a market capitalization of $3.7 trillion, according the Federal Reserve as of March 2015. More than $1.5 trillion of that figure is directly held by households. An additional $500 billion is held at banks and invested in separate accounts. Only about 25% of the total is invested in pooled funds.
The same point can be made for advisors who have built their practices on managing muni bond ladders. I often hear, “I prefer actively managed funds since indexing doesn’t work in less liquid markets.” Actually, Vanguard research shows that indexing has worked across all markets, as substantiated by S&P’s SPIVA report. A lot of the long-term performance shortfall of actively managed funds can be linked to higher management fees.
By spending too much of your valuable time on managing bond ladders, you may be missing out on other activities that produce client results and loyalty, such as asset location, rebalancing, spending strategies, and behavioral coaching (what we refer to as Vanguard Advisor’s Alpha®).
We believe this will change with the launch of our first muni bond index fund. Vanguard is taking a stand for more investors in one of the highest-cost segments on the markets.
So why the big deal about our new muni bond index fund/ETF? Simple: It’s provides a better solution for the majority of muni bond assets held by investors who are paying too much.
1 More than 30 years managing municipal bond portfolios, with nearly $135 billion in 12 tax-exempt bond and 6 tax-exempt money market funds as of June 30, 2015.
2 The U.S. muni market had a market capitalization of $3.7 trillion as of March 2015, according the Federal Reserve. More than $1.5 trillion of that figure was directly held by households. An additional $500 billion was held at banks and invested in separate accounts. Only about 25% of the total was invested in pooled funds.
All investing is subject to risk, including possible loss of principal.
Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
We recommend that you consult a tax or financial advisor about your indivdiual situation.
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