Vanguard Goes Active With New Core Bond Fund
Underpinned by low fees, this new offering is designed to beat the Barclays index and be the centerpiece of portfolios.
In every issue of Morningstar magazine, Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar's manager research group.
Investors weighing a Vanguard bond fund to anchor their portfolios may instinctually head in the direction of its big, broad-based index funds. But Vanguard's newest core bond offering is actively run, and its team of veteran, inhouse portfolio managers make clear they are out to beat the index.
In late March, Vanguard opened the doors on its Vanguard Core Bond Fund (VCORX), a strategy that aims to top the Barclays U.S. Aggregate Index. It's a high-quality bond fund that can range between U.S. Treasuries and mortgage-backed U.S. and foreign corporate debt.
Vanguard Core Bond has a two-pronged strategy for beating the index: structural and strategic.
Structurally, the fund gains a significant tailwind in the form of its extremely low 0.25% expense ratio on the investor class shares. That expense ratio clocks in at less than one-third the average fee charged by intermediate-term bond funds.
On the strategic side of the fence, the portfolio is built through what Vanguard calls its "hub and satellite" approach.
The hub--composed of its senior fixed-income investment strategy group--makes the big picture macro and market segment calls. Those are then translated into more granular asset allocations at the rate and credit team levels. Then the "satellite" specialist teams do the bottom-up research and make the buy-and-sell decisions on individual securities.
"The portfolio is very dynamically managed," says Gregory Nassour, who co-heads Vanguard's investment-grade credit group and is one of the managers on the Core Bond fund. "Changes do happen and they happen often."
Morningstar added the Core Bond fund to the Prospects list of up-and-coming or under-the-radar strategies in the second quarter. Since Morningstar launched the Prospects list in the third quarter of 2014, only a handful of funds with short track records have been added for possible full coverage by Morningstar's manager research team. But the Core Bond fund joins Vanguard Tax-Exempt Bond Index Fund (VTEBX) as among those added within months of their launch.
"It's a nice option for those looking for diversification potential," says Sarah Bush, the director of fixed-income strategies with Morningstar's manager research group. "It's a fairly straightforward, plain-vanilla fund."
Bush notes that with Vanguard's low-fee advantage, the fund can stay away from high-yield bonds or emerging-markets bonds that competitors need to boost returns but also can end up increasing a portfolio's correlation to stocks. The high-quality bias, she says, could tend to lead to some underperformance compared with other funds during periods when junk bonds are doing well, as has been the case for bonds recently.
But, Bush says, "the core advantage is very, very low fees."
The fund returned 3.3% since its March 28 launch through Oct. 21, compared to 3.0% for the Barclays Aggregate Index and 3.8% for Intermediate-Term Bond Morningstar Category.
While Core Bond is brand new, the team behind it is far from green.
Nassour is a 24-year-veteran at Vanguard, whose responsibilities include the $58 billion Vanguard Short-Term Investment-Grade Fund (VFSTX), which carries a Morningstar analyst rating of Silver. The Short-Term fund ranks in the top quintile of its category for its one-, three-, and five-year returns as of Oct. 21.
Also on the team is Gemma Wright-Casparius, who runs Vanguard's Treasury and inflation-protected group and has 30 years of investment experience, including five years at Vanguard. Among her charges is managing the Gold-rated, $25 billion Vanguard Inflation-Protected Securities Fund (VIPSX), which landed in the top quintile of its Morningstar Category over the trailing three-, five-, 10- and 15-year periods as of Oct. 21.
A third co-manager is Brian Quigley, head of the agency mortgage and volatility team. Quigley has 11 years of investment experience under his belt and runs the Silver-rated, $6 billion Vanguard Short-Term Federal Fund (VSGBX). That fund's returns have landed it in the top quartile of the short government category over the trailing five-, 10-, and 15-year periods.
Investors have been quick to jump into the Core Bond fund despite its lack of a track record. As of October, assets were more than $640 million.
Vanguard's internally run, actively managed bond lineup has been overshadowed by the firm's 17 index-tracking fixed-income portfolios, which have assets totaling about $500 billion.
Even on the actively managed bond fund side, the spotlight at times is diverted from in-house-managed funds by Vanguard's longtime partner, Wellington Investment Management. Wellington, whose relationship with the firm ties into the roots of Vanguard's founding by John Bogle, runs the $27 billion Vanguard GNMA Fund (VFIIX) and the $20 billion Vanguard High-Yield Corporate (VWEHX).
A third active offering mainly run by Wellington managers is the $16 billion Vanguard Long-Term Investment-Grade Fund (VWESX). That fund is partially managed by internal Vanguard teams. Vanguard's remaining 23 active bond offerings hold roughly $300 billion.
"We offer low-cost indexing, but also complement that with low-cost active," says Gregory Davis, global head of fixed income. "We're proponents of both. Our main story is all about low cost."
For Vanguard's fixed-income funds, in particular, the low costs mean the bond funds can be managed more conservatively than competitors' and still aim to generate the same returns.
This meshes with Vanguard's overall philosophy toward the role that bonds play in a diversified portfolio. "The way we think about fixed income for our investors is that it's a defensive asset class for diversification," Davis says.
For the Core Bond fund, low expenses are an integral part of what Vanguard executives believe will make the strategy work. The fund charges 25 basis points for the Investor share class and 15 basis points for its Admiral shares for larger investor accounts. Davis does the math on how this helps the fund: Core Bond has a long-term performance target of 60 basis points above the Barclays U.S. Aggregate Index, he says.
Subtracting out the 15-basis-point expense ratio on the Admiral share version of the fund would return 45 basis points annually to investors over time. That kind of performance, Davis says, would be good enough for the fund to beat 90% of funds in the intermediate-term bond category. "Even if we come up slightly short, we should end up in the top quartile," he says.
Behind the Strategy
Most of Vanguard's actively managed funds are sector-focused. Part of the idea behind launching the Core Bond fund was to make use of the resources from those narrower mandates--the firm has some 145 investment professionals in fixed income--and create a broad-based portfolio.
At the center of the firm's "hub and satellite" approach is Vanguard's senior strategy group, composed of Davis and chief economist Joe Davis, along with the global heads of interest rates, credit, tax-exempt bonds, and risk management. This group develops the overall strategic outlook and investment policies for Vanguard's internally managed bond funds. Based on those outlooks, the strategy group then sets the "risk budgets" for the various portfolios, which determine how aggressively or conservatively positioned the funds should be relative to their benchmarks.
But the process isn't a one-way street. The sector-focused "satellite" teams provide the strategy group with their bottom-up outlooks on valuations and potential returns, which help shape overall calls and risk budgets.
As of late summer, the Vanguard house view at the macroeconomic level was that it will be difficult for the Federal Reserve to raise interest rates too aggressively, Wright-Casparius says. In part, that's because with economic growth still sluggish around the world, any significant U.S. interest-rate rise would likely lead to a higher dollar. That in turn would create a negative feedback loop for the U.S. economy of even tighter financial conditions, she says.
"We think rates are pretty much range-bound," Wright-Casparius says. Demand from non-U.S. investors for Treasuries should keep rates pressed lower, but without a sustained turn in inflation, rates also shouldn't head much higher, she says. As a result, the fund has underweighted its interest-rate bets relative to the benchmark. The portfolio had 27% of its assets in U.S. Treasuries as of Sept. 30 compared to 40% in the Barclays Aggregate. However, Core Bond also had 7% in Treasury Inflation-Protected Securities, while there are no TIPS in the benchmark.
On the credit side of the equation, the fund can turn to investment-grade teams in Europe and Australia, as well as the United States. It hedges all foreign currency risk on non-U.S. positions. But for now the fund has a bias toward U.S. corporate debt. "The U.S. environment looks very attractive," Nassour says. "There's a lot of foreign demand for U.S. corporates because of their higher yields. There is so much central bank stimulus that the hunt for yield will continue."
As of Sept. 30, the overall weight of the corporate debt stake in the fund was 27% compared to 29% in the Barclays Aggregate. However, the corporate bond position has a longer duration than that of the index, which has the effect of being modestly overweight.
When it comes to residential agency mortgage-backed securities, Quigley says the group doesn't see much in the way of longer-term excess return opportunities, especially compared to other sectors. But with a large liquid market like agency MBS, the fund will make tactical trades when the team sees short-term dislocations.
Commercial mortgage-backed debt, by contrast, was overweight by 2.4 percentage points with a roughly 4% weighting in the fund. The fund was also overweight asset-backed securities, with an 8% position in the fund compared to less than 1% in the index.
It all adds up to a "benchmark aware" strategy, the managers say, but one that isn't out to be a closet index fund. "There are some considerable differences versus the benchmark," Nassour says. "This is an actively managed fund."
This article originally appeared in the October/November 2016 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Tom Lauricella does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.