(PUB) Investing 2015

The Independent Adviser for Vanguard Investors

•

October 2015

•

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800-211-7641

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

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

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.

Some Protection From

Falling Stock Prices…

Int.-Term Treasury

Int.-Term Invest.-Gr.

Int.-Term Tax-Exempt

0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1.50%

Avg. Monthly Return When

500 Index is Down

Avg. Monthly Return When

500 Index is Up

…But Less Sensitive

to Rates

Int.-Term Treasury

Int.-Term Invest.-Gr.

Int.-Term Tax-Exempt

-0.75%

-0.50%

-0.25%

0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1.50%

1.75%

2.00%

Avg. Monthly Return When

Yields Fall

Avg. Monthly Return When

Yields Rise

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

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.

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