(PUB) Investing 2015

will make the muni fund slightly more attractive, but for most investors, it won’t change the story in a meaning- ful way. Fortunately, you don’t have to go through all of the math yourself each time you are deciding between muni and taxable bond funds. The easiest way to compare tax-free and taxable bond yields is to calculate a taxable- equivalent yield, which is the taxable yield you’d have to earn before taxes to equal the fund’s tax-free yield. You’ll find tax-equivalent yields each month on page 9, and in the table on page 5 I’ve added taxable fund comparisons. As you can see in the table, Short- Term Investment-Grade’s 1.88% yield is greater than Limited-Term Tax- Exempt’s taxable-equivalent yield of 1.73% for someone in the top tax brack- et. So, as the exercise above shows, buying Short-Term Investment-Grade over Limited-Term Tax-Exempt makes sense, even after paying taxes. As I said, I cherry-picked this example to dem- onstrate the difference between mini- mizing taxes and maximizing after-tax gains. For the most part, Vanguard’s municipal bond funds are, on a yield >

basis, quite competitive with their tax- able siblings—particularly their govern- ment-oriented siblings. One reminder when comparing yields on Vanguard’s funds: Don’t make the mistake of comparing Short-Term Tax-Exempt with the short-term tax- able funds like Short-Term Treasury or Short-Term Bond Index. The tax-free fund, with a maturity of 1.5 years, is more of a “money market on steroids,” in my opinion, and finally has a taxable fund sibling in Ultra-Short-Term Bond. Other Considerations Taxable-equivalent yields make a number of Vanguard’s tax-exempt funds look like “gimmes.” Does that mean you should run out and switch all your taxable funds for tax-exempts? Hardly. As we discussed last month, there is more to fixed-income investing than yield alone. Historically, though there have been some high-profile defaults of late, the risk of default in the investment-grade municipal bond market has been close to zero. And with a deep research team at Vanguard, bond defaults are low on my list of concerns.

But the municipal market is sub- ject to what is called “headline risk.” Heavily favored by individual retail investors, who tend to be conservative, it’s often the case that at the first sign of bad news or whisper of concern over a state or city’s finances, they sell first and ask questions later. This can add more volatility to the asset class than the fundamentals warrant. It also means that the municipal bond market does not always move in lockstep with other bonds. Recent defaults by Detroit and an agency in Puerto Rico, as well as finan- cial stress in Illinois, have raised the level of headline risk. But my favor- ite example of headline risk occurred in December 2010, when a prominent analyst appeared on 60 Minutes and predicted a coming cascade of defaults in the municipal bond market. At the time, I told you I thought the prediction was way, way off base. Still, it sent the market tumbling and was responsible for Vanguard’s long delay in launching a municipal bond index fund. From December 2010 through January 2011, Intermediate-Term Tax-Exempt lost 2.2%, and Long-Term Tax-Exempt

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What about big-cap tech? In the past you talked about seeing opportunity there. Is that an area that you still find attractive? I know Microsoft is a big position now, and Oracle, too. The sweet spot for technology tends to be those companies where we think—and more importantly, they think—that they have won the day. It’s a pretty good argument that [Microsoft] has effectively won their space. One thing about large-cap technology is that at some point there becomes less urgency to spend and to grow, and that they become really great annuities. When these large legacy tech companies who have solid competitive positions slow down, their free cash flow generation is enor- mous, and that leads to dividend growth. That’s sort of the sweet spot for us; we try to find companies that look like that. We try to avoid companies that are really exposed to product life- cycle stuff—a product that can be quickly replaced by a new one a year and a half later. Typically hardware companies are like that, so we have historically not done much in that area. When I first recommended your fund, you had less than $1.4 bil- lion in assets. Today, the fund is around $24 billion, give or take, and you are one of the very few active funds at Vanguard that nets new money month after month with barely a blip. Does the size change how you approach your task? I’ll tell you what’s changed and what hasn’t. Fortunately, the things that haven’t changed are the things we started talking about 10 years ago: The

philosophy is no different; the process is no different; the way in which we vet ideas is no different; the team is largely the same—none of that has changed. We have refined things along the way. As you might imagine, experience is a great teacher, and so when we make mistakes—and we make lots of them—we use those as a way of refining how we do our jobs every day. Ultimately, what has changed is in the actual mechanics. The fund gets a little bit bigger—or maybe a lot bigger—and that has implica- tions for liquidity—how easy it is to buy and sell things. It has implications for what you can look at, right? So it is very hard for us to buy small-caps or even mid-cap companies given their lack of liquidity. I want to be really prudent when it comes to liquidity. I do not want to get in a situation where it is very, very difficult and therefore very expensive to buy something. And then if we make a mistake, which we do, it would be very difficult and very expensive to sell it. As the fund gets bigger, that becomes a bigger consid- eration. So the universe has probably shrunk a little bit by virtue of that. We have to be more careful traders. We do not trade very much, but we have high turnover in our heads. We are always thinking about how to make the portfolio better, what we can be doing on the margin. So we are always thinking about what we should be doing—we are just not very active for a lot of reasons, not the least of which is that we think it is too expensive and too risky to be trading a lot.

You mention that trading is too expensive and too risky—can you expand on that?

6 • Fund Family Shareholder Association

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