(PUB) Investing 2015

INDEXING Another Stab at a Muni Index ETF

Emerging Market Stock ETF are the largest ETFs in those spaces, surpass- ing iShares Core U.S. Aggregate Bond (AGG) and iShares MSCI Emerging Markets (EEM), as investors gravitated to the lowest-fee option. Vanguard expects the lure of lower costs to work again. And yes, there’ll be regular, open-end

fund options available for minimums of $3,000 (Investor shares, 0.20% operat- ing expenses) and $10,000 (Admiral shares, 0.12%), but these funds will also be sold with a 0.50% front-end load. As a consequence, I would expect the bulk of the new index fund’s assets to be held in the ETF shares. n

LATE TO THE MUNICIPAL BOND indexing game, Vanguard is looking for another win with its ace-in-the-hole— lower costs. Four years ago, Vanguard gave the market a head fake, first filing to launch three municipal bond index funds and ETFs in June 2010, only to withdraw the filing six months later in January 2011. Now, Vanguard is back at it, hav- ing filed a few days after 2015 began to offer just one municipal bond index fund— Tax-Exempt Bond Index . The fund (and its ETF share class) is expected to go live in the second quarter of 2015 and will seek to track the performance of the S&P National AMT-Free Municipal Bond Index. The index has an average maturity of 14 years or so and covers the investment- grade muni-bond market. Within Vanguard’s stable, the new fund should look most similar to the actively managed Long-Term Tax- Exempt . Over the past decade, the actively managed fund returned 4.7% a year, just ahead of the 4.6% a year gain recorded by the S&P index. Risk was essentially the same as well, with both the active fund and the index experiencing drawdowns of 7.2% dur- ing the “taper-tantrum” of 2013. Keep in mind that the index numbers do not include fees—making the performance of Vanguard’s managers all the more impressive. The new fund’s most immediate com- petitor, however, will be the iShares National AMT-Free Muni Bond ETF (MUB) which tracks the same index and has over $4 billion in assets. The price war continues in the ETF space as Vanguard aims to come to market with an expense ratio half as much as the iShares ETF—0.12% versus 0.25%. Vanguard has proven that it doesn’t have to be the first to market to become the largest player. The firm wasn’t the first to the table in core taxable bonds or the emerging stock index space, but today Total Bond Market ETF and

Watch Those Vanguard Calculations THE INTRODUCTION OF A NEW, LOW-COST MUNICIPAL BOND FUND is a great time to crow that yields are always higher when costs are lower. And most of the time they are. But there’s higher yields, and then there’s Vanguard’s calculations of those yields—or rather, Vanguard’s cal- culation of the taxable-equivalent yields that its tax-exempt bond funds offer. No, they haven’t begun computing a taxable-equivalent yield or even an SEC yield for the new Tax-Exempt Bond Index yet, since it’s not in operation. But hold onto your hats when you hear that Vanguard thinks that the taxable yield on some of its longer-term muni funds are equivalent to more than double their tax-free yields. How’s that possible? Bad math. If you received it in the mail, check out the opening page to the 2014 annual report for Vanguard’s six tax-exempt bond funds, where a table lists those funds’ SEC yields at the end of their October fiscal year, as well as Vanguard’s calculation of the fund’s taxable-equivalent yields, or the yields you’d have to earn on a taxable fund to equal the tax-free yield of a muni fund. For instance, Vanguard says that an investor in the highest federal tax bracket would need to earn a taxable yield of 6.08% to equal the 2.64% tax-exempt yield on the Admiral shares of its High- Yield Tax-Exempt fund. Zowee! That’s junk bond territory. Even the Admiral shares of High- Yield Corporate were only good for a 4.87% yield at the end of October 2014.

Tax-Equivalent Yields or Fantasy Yields? Share SEC Actual

Vanguard Vanguard

Fund

Class

Yield

T-E Yield

T-E Yield

Error

Tax-Ex. Money Market Short-Term Tax-Ex.

Investor Investor Admiral Investor Admiral Investor Admiral Investor Admiral Investor Admiral

0.01% 0.02% 0.02%

—

0.28% 0.49% 0.65% 0.16% 0.36% 0.64% 0.83% 0.19% 0.70% 1.24% 1.61% 0.37% 0.78% 1.38% 1.80% 0.42% 1.54% 2.72% 3.55% 0.83% 1.62% 2.86% 3.73% 0.87% 2.22% 3.92% 5.12% 1.20% 2.30% 4.06% 5.30% 1.24% 2.56% 4.52% 5.90% 1.38% 2.64% 4.66% 6.08% 1.42%

Limited-Term Tax-Ex.

Intermediate-Term Tax-Ex.

Long-Term Tax-Ex.

High-Yield Tax-Ex.

Note: Taxable-equivalent yield is based on a 43.4% federal tax rate, as per Vanguard.

Does this seem strange? You bet it is. Vanguard got the calculation wrong for all of its tax- exempt bond funds, and the differences are pretty significant, as the table above shows. As of Monday, January 12, Vanguard had finally posted a new annual report to its website with cor- rected numbers, but of course there was no mention of the error in the prior iteration of the report. So, when Vanguard begins promoting the taxable-equivalent yield on its new muni index fund, let’s all give it a once-over and check the math. Or, you can simply turn to pages 9 and 10 in each issue of this newsletter for the taxable-equivalent yields in a host of federal tax brackets for your data.

12 • Fund Family Shareholder Association

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