(PUB) Investing 2015

ending in June. The second chart shows the average returns for the three bond funds in months when the yield on Intermediate-Term Treasury rose or fell. As you can see, muni bonds look more like corporate bonds than Treasurys. The muni bond fund provided some protection when stocks fell, but not as much as Treasurys. However, like the corporate bond fund, Intermediate-Term Tax-Exempt was less sensitive to swings in interest rates. One risk that Vanguard investors don’t have to lose much sleep over is manager risk. If Vanguard’s bond research department and fund managers did pick the wrong bonds, this could hurt performance. While Vanguard’s team isn’t error-proof, they are darned close. Their portfolios are diverse and Vanguard managers don’t stick their necks out “reaching for yield.” The general philosophy is, “Don’t do any- thing that will embarrass us or hurt shareholders.” So, funds are run conser- vatively, allowing Vanguard’s low-cost advantage to drive the funds’ competi- tive returns.

…But Less Sensitive to Rates

Some Protection From Falling Stock Prices…

-0.75% -0.50% -0.25% 0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00%

1.50%

Int.-Term Treasury Int.-Term Invest.-Gr. Int.-Term Tax-Exempt

Int.-Term Treasury Int.-Term Invest.-Gr. Int.-Term Tax-Exempt

1.25%

1.00%

0.75%

0.50%

0.25%

0.00%

Avg. Monthly Return When Yields Fall

Avg. Monthly Return When Yields Rise

Avg. Monthly Return When 500 Index is Down

Avg. Monthly Return When 500 Index is Up

Rico’s troubles on Vanguard’s funds was imperceptible. If default risk is low but headline risk is high, how should we think about the risk-reward tradeoffs of muni bonds. Let’s revisit two charts above that we looked at in the August issue, but this time bring Intermediate-Term Tax- Exempt into the mix. The first chart shows the average return of Intermediate-TermTreasury , Intermediate-TermInvestment-Grade and Intermediate-Term Tax-Exempt dur- ing months when 500 Index was either positive or negative over the 15 years

lost 3.1%, compared to a decline of only 1.1% for Total Bond Market. The alarm ultimately proved to be one of the worst market calls in decades, and muni bonds recovered. I do not see Detroit or Puerto Rico as a harbinger for wide-scale defaults of municipal bonds. These are areas that were particularly hard hit during the last recession and have been basket cases for years. Defaults in the muni market tend to be more akin to slow-motion train wrecks—a long time coming and often well-anticipated by savvy inves- tors. The impact of Detroit and Puerto

SEE FOCUS PAGE 12

>

There’s an expense to trading. You don’t trade stocks for free. The expense on trading is borne by the client, not the portfolio manager. I’ve always believed strongly in low turnover for two reasons. First of all, I think rapid turnover builds up that expense that is borne by you. I know personally I don’t create a lot of value trading. So to the extent that I can eliminate lots of rapid trading, that eliminates an expense to the share- holder. Second, when you make a decision to trade—say you decide to sell something—you have created a new decision. Well, I’ve sold this, now what do I do? Do I take those proceeds and buy something else? Do I do nothing? So every time you create a new decision for yourself, you’ve created reinvestment risk. It may be the right decision to sell something, but if it’s the wrong decision to buy the other thing, then those two things wipe each other out. There are times clearly where you have to transact, where you have to trade, but constantly trading and turning over stocks is expensive and creates a lot of reinvestment risk. Since I first added Dividend Growth to my Model Portfolios in mid-December 2007, you’ve generated a return of 73.1%, while your index competitor is up 58.3%. How come? I thought active management didn’t work? I’ll tell you what I think works. What works in investing is having— and hopefully you think I have this—a very, very clear philosophical touch-point. You start with a very strong belief in what you think works as an investor, and maybe you refine it, you enhance it, but you never

waver from it regardless of the environment. You believe it and you live it personally through your own investments—which I do—and you live it professionally. If you have a very strongly held belief system and you are consistent with it, and your process is repetitive and constant, through long periods of time, you are going to produce good results. What else do we need to know right now, that we don’t already know? One of the things that is really important to me when I look at this fund is that it behaves in the way that you and all the other fund shareholders— and importantly me—expect it to behave. I recognize that there are some markets where certainly on a relative basis the fund’s not going to look that great. That doesn’t bother me at all. There are some markets where the fund will do really well. That doesn’t mean much to me, either. But what is impor- tant is that it behaves in a way that is consistent with our expectations. For the most part, with a day or two here or there, the fund has really consistently been performing as I would have hoped and anticipated. To the extent that that’s happening, I think I’m doing right by shareholders. To me, the worst outcome is to have the fund behave in a way that is inconsistent with what you expect as a shareholder. Even through the period of volatility, the fund is behaving largely as I would expect, and hopefully that is important to you.

Thanks, Don.

The Independent Adviser for Vanguard Investors • October 2015 • 7

FOR CUSTOMER SERVICE, PLEASE CALL 800-211-7641