(PUB) Investing 2015

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6 • Fund Family Shareholder Association
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?
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