(PUB) Investing 2015

Tax-Exempt. Over the past decade, Intermediate-Term Tax-Exempt’s aver- age return of 4.8% over rolling five- year periods is not far behind Long- Term Tax-Exempt’s 5.2% average five- year return. However, the intermediate muni fund’s worst five-year return of 3.4% is better than its long-term sib- ling’s 3.2% gain. Given this history of balancing risk and reward, it is no surprise that Intermediate-Term Tax-Exempt has been a go-to fund for Vanguard inves- tors. At times it has become too popular and too big, leading Vanguard to close the fund to advisers and institutions to slow inflows. With nearly $44 billion in assets, it is the largest muni bond fund in the U.S. and is currently open to any and all investors. For taxable investors, Intermediate- Term Tax-Exempt remains a good com- promise for those who want higher levels of current income and are willing to take a modicum of risk with their principal.

above Short-Term Treasury, 0.98% vs. 0.62%, this fund has appeal even before considering the tax-exempt benefits. Why do you think Vanguard founder Jack Bogle has, in the past, stashed more than $3 million of his own money here? Intermediate-TermTax-Exempt Buy. Intermediate-term bond funds often give fixed-income investors the biggest bang for their bucks while taking moderate risk. This fund has stacked up well against its intermediate-term tax- able brethren, delivering an average of 70% to 90% of the returns of Vanguard’s taxable intermediate funds over rolling one-year, three-year and five-year peri- ods. Before taxes, Intermediate-Term Investment-Grade offers a higher yield and should be your fund of choice in retirement accounts. But investors in the 33% tax bracket and above will find Intermediate-Term Tax-Exempt’s tax- equivalent yield more attractive. Intermediate-Term Tax-Exempt also holds its own against Long-Term

Tax-Exempt Bond Index Hold. See last month’s issue for an in-depth review of this new index fund. It took Vanguard years to open a muni index fund and ETF for investors, but we now have a horse race between this fund and its actively managed Long- Term Tax-Exempt sibling. My money would be on Vanguard’s active manage- ment to win that race in the long run, but I’m not eager to buy either fund today due to the long-maturity bonds domi- nating their portfolios. Long-TermTax-Exempt Hold. Though you might expect a sell rating here given my disdain for long-maturity bonds, this fund is not nearly as long as Vanguard’s taxable long funds. A duration of 6.3 years is pretty long, but it falls well short of Long-Term Investment-Grade (13.0 years), Long-Term Bond Index (14.7 years) and Long-Term Treasury (16.5 years). In fact, it’s much closer to Total Bond Market’s 5.7-year duration. I >

Consider that Capital Opportunity ’s 6.7% turnover is lower than the 10.6% turnover at MidCap Index and the 9.7% turnover at SmallCap Index , and it isn’t much greater than 500 Index’s 2.7% turnover. Warren Buffett is extremely low-cost and tax-efficient—actually buying Berkshire Hathaway has been lower cost (there’s no annual management fee) and more tax- efficient (it hasn’t paid out a dividend) than buying 500 Index—but he’s the poster child for active management. (By the way, why do you think he encouraged his heirs to buy an index fund when he dies? He doesn’t think they’ll be able to repeat his own successes buying stocks, nor does he think they’ll be able to pick good managers, though Buffett himself chose two. Their records running Berkshire money are too short to be judged just yet.) The truth is, I fully expect a low-cost index fund to outperform the aver- age actively managed fund over time and after fees. Bogle’s math wasn’t wrong. That said, as you know, my money is invested in actively managed funds. Why? I don’t think I’m buying an “average” manager, but rather, I’m partnering with top-notch managers I’ve spent a lot of time vetting. Over the past 20 years, there has been only one five-year stretch (out of 240 periods) when the original PRIMECAP failed to outperform 500 Index. And by the way, it underperformed by 0.04% per annum over that period—a laughable difference. If I own PRIMECAP, what do I care about how the average fund has done versus 500 Index? I don’t. It’s a distraction. Trying to predict whether 2015 is the year the average active manager beats the indexes is just another form of market timing, and one that isn’t all that fruitful in the first place. Find what works for you—index or actively managed—tune out the noise, and stick with it. But don’t for a second believe that great active managers can’t be found, and that those “indexers” aren’t making active bets with their investments—they are. They just don’t know it. Who said “ignorance is bliss”?

ing when they continue adding layers and layers of managers to their actively managed funds. More managers on a fund leads the fund to look more and more like the market or an index. At that point, Vanguard’s cost advantage all but guarantees that the fund will outperform its average, more costly peer, but probably won’t outperform its index benchmark— though it should come close to matching the index. But so what? I don’t buy or own the average active manager, and nei- ther do you. In fact, we only own a handful of active managers, like Don Kilbride, the PRIMECAP team, Jim Barrow and Mark Giambrone, and yes, Vanguard’s fixed-income group, which runs funds for us at low costs and at an index-beating pace. And as for the multitude of efficient-market fanatics who spout off about being “passive” investors, claiming you can’t beat the market so you might as well own the market, well, they aren’t walking their own talk. Not even Vanguard walks its talk, and it can’t stop talking! If you own just 500 Index (or say Total Stock Market Index ), you might consider yourself a passive investor, but relative to the global oppor- tunity set, you are actually very active. By holding just U.S. stocks, you are ignoring foreign stocks and other financial assets like bonds or real estate. You’d actually be taking the same active bet as someone who owned an actively managed U.S. stock fund, or someone who bought just one U.S. stock. Jack Bogle is the ultimate active investor in that he says he doesn’t want to own foreign stock funds—indexed or otherwise. He thinks he’ll be just fine, thank you very much, sticking with a domestic index fund. Jack is no indexer, by any means. He also owns actively managed funds as well as shares in his son’s hedge fund, the epitome of active funds. The benefits of indexing—low costs, low turnover and relatively good tax-efficiency—can be found in funds run by active managers as well.

The Independent Adviser for Vanguard Investors • October 2015 • 13

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