(PUB) Investing 2015

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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.
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
Vanguard Rolls Out Muni Index Funds
Income Strategist | Elizabeth Foos