(PUB) Investing 2015

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Vanguard Rolls Out Muni Index Funds Income Strategist | Elizabeth Foos

Until the launch of Vanguard Tax-Exempt Bond Index, passive investment options for muni investors consisted exclusively of ETF s. The largest of these is iShares National AMT-Free Muni Bond MUB . Launched in September 2007 , MUB has gathered over $5 . 5 billion in assets. Like Vanguard’s muni index, MUB tracks the S & P National AMT -Free Municipal Bond Index, providing national exposure to the investment-grade muni space and with an expense ratio of 25 basis points. Although that’s roughly double the fee of VTEB , both are relatively low com- pared with most actively managed muni funds. And its initial track record is encouraging. Since incep- tion, MUB ’s average total return of 4 . 4% per year (through September 2015 ) carries a modest average annual tracking error of 12 basis points. Those looking for broad, high-quality exposure to the national investment-grade muni market would be well-served in considering a muni index fund that aims to replicate this market. VTEB and MUB mitigate many of the perceived challenges of indexing munis by sticking to larger, higher-quality, and more-liquid muni bonds. And as with other index-based strate- gies, the passive nature of the structure eliminates manager risk and offers investors access to rock- bottom fees. Alternatively, investors could consider Vanguard Intermediate-Term Tax-Exempt VWITX . Like Vanguard’s muni index fund, the Investor share class is offered at a low fee of 20 basis points, yet its investible universe is less constrained. Although this fund tends to stay fairly close to its Barclays 1 - 15 Year Municipal Bond Index benchmark, managers can dive more heavily into out-of-index offerings or make modest interest-rate bets in an effort to outperform their targets. This fund’s average annual return since MUB ’s inception is basically on par with that ETF and both beat the category average. K Contact Elizabeth Foos at elizabeth.foos@morningstar.com

In August 2015 , Vanguard launched the market’s first municipal-bond index mutual fund, Vanguard Tax-Exempt Bond Index VTEAX , and Vanguard Tax-Exempt Bond Index ETF VTEB , an exchange- traded share class of the mutual fund. Vanguard is synonymous with indexing and is also the largest manager of active open-end municipal-bond funds, so it’s well-prepared to execute a muni index strategy. The muni market poses several challenges to those seeking to track an index. The first set of challenges isn’t unique to muni bonds. Broad-market fixed- income indexes contain thousands of bonds, making it impractical for a fund to own every bond in its benchmark. Instead, these funds employ sampling techniques to build portfolios that they feel best represent the characteristics of the bonds in their index. How well a fund replicates the characteristics of its target benchmark is reflected in its tracking performance. In addition, the municipal-bond market is particularly diverse and fragmented, making sampling tough. The $3 . 7 trillion muni market includes over 1 million individual bonds outstanding that are offered by more than 50 , 000 entities. In contrast, the Barclays U.S. Aggregate Bond Index tracks a market of roughly $17 trillion with fewer than 1 , 500 issuers. Furthermore, trading volumes in the municipal market are lower than in the taxable space, limiting the liquidity of even more frequently traded issues. To mitigate these challenges, the Vanguard fund tracks the S & P National AMT -Free Municipal Bond Index, a broad, market-value-weighted index designed to mirror the performance of the investment-grade municipal-bond market in the United States. By design, this benchmark focuses on the muni market’s most- liquid issuers by setting minimum credit rating and lot size requirements.