The disabled list: It can be the bane of a professional athlete’s career. And because there are so many injuries in professional sports, players who play in every game tend to stand out and be applauded for their efforts and commitment by their coaches, the fans, the media, and their peers.

In some ways, the bond traders in Vanguard Fixed Income Group (FIG) are like the iron men and women of professional sports. When it comes to managing our bond index funds, our traders are very diligent and highly committed to the task at hand. They continuously seek to tightly track our benchmark indexes and, where possible, add value incrementally to offset some of the costs of managing index funds.

 

Our approach to bond trading in our index funds

FIG manages our bond index funds using sophisticated sampling techniques to approximate the fundamental investment characteristics and performance of the funds’ benchmarks. (It’s not just impractical to buy and sell all the bonds in the diversified indexes we track—in most cases, it’s impossible.) Like ballplayers who scour video seeking even the slightest opportunity to improve or gain an advantage, in FIG we’re always looking to refine our sampling approach so we can better approximate the key characteristics of our benchmark indexes.

Besides careful sampling, a key part of our disciplined, risk-controlled process is our use of float-adjusted indexes. Since float-adjusted indexes exclude bonds that don’t trade on the open market, they reflect actual, investable markets—rather than theoretical ones.

And to help ensure that FIG is a team of experts, we use a specialist model—as opposed to a generalist model—that allows our traders and portfolio managers to dig deep into narrow slices of the market (for example, breaking up corporates into communications, energy, etc.). This specialist approach is not unlike any great sports team where every player knows his or her role and executes it flawlessly; in FIG’s case, it means we use the indexing expertise, discipline, and experience of our traders to seek to tightly track each small piece of the bond market—while keeping the cost of index fund management to an absolute minimum.

There are a number of other strategies our traders use to stay on top of their game:

  • By not subtracting value. Trading very efficiently is a basic indexing tenet. Smartly managing cash inflows and outflows and minimizing unnecessary trading are just a couple of examples of avoiding unnecessary costs in the indexing process.
  • Proceeding with caution. In seeking to offset some of the costs of fund management, the team focuses on value-added trades that it believes have a high probability of paying off—in other words, we are looking to hit a lot of singles. Performance attribution tools, in combination with a rigorous focus on risk control, help us determine which trades make sense and won’t compromise our ability to seek to tightly track our benchmarks.
  • Investing in new issues, which are similar to equity IPOs. Purchasing bonds in the new-issue market tends to be an opportunity to add positive performance. Under the right conditions, these bonds can outperform the broader market from when a new issue hits the market and when it enters the benchmark.
  • Using Vanguard’s size and diversity to our advantage—because our scale tends to present us with opportunities to trade at favorable prices.

 

FIG: We’ve changed—Yet we’ve stayed the same

I’ve been at Vanguard for close to 20 years, and I’ve seen our fixed income trading evolve over the years. Electronic trading is more prevalent than ever before, and it’s almost certain to continue to expand. Another big change is globalization. Between London, Australia, and our home base in the United States, FIG has become a worldwide operation—with indexing mandates for each of the three sites and with each site trading in its particular time zone and currencies.

Ultimately, I’m glad to say these developments haven’t changed the way we think about our business: We still strongly believe in delivering competitive returns without undue risk and in keeping costs low.

The FIG philosophy aligns with Vanguard’s ownership structure.* Having the freedom to be completely aligned as a fiduciary with our clients is part of what differentiates FIG from bond traders at many other companies. Like professional athletes who help their teams win by giving maximum effort in every single game, our bond traders are passionate about positioning our funds to deliver the return of the market—and they’re working to incrementally add value beyond the index for the fixed income investors whom we serve.

 

*Vanguard is owned by the Vanguard funds, which, in turn, are owned by their shareholders.

I’d like to thank Wayne Moser for his much-appreciated contributions to this piece.