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Vanguard actively managing index funds.
Old 08-22-2011, 11:09 PM   #1
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Vanguard actively managing index funds.

I am seldom truly surprised by financial stories, but this one about Vanguards intermediate bond index was a shock.

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On Aug. 11, Morningstar's Christine Benz noticed something quite peculiar--the single best-performing intermediate-bond fund over the trailing month, out of 1,238 funds in the category, was Vanguard's Intermediate-Term Bond Index (VBIIX).

This wasn't indexing according to The House That Jack Built. The theory behind indexing is that low expenses coupled with an average portfolio gradually leads to above-average results. Each month, the index fund tends to be only very slightly above the norm, just a few basis points. But month after month that modest advantage becomes compounded, so that the index funds over time climb the rankings ladder.

But landing in top thousandth? After one month? What in the name of Bogle had happened? And what can we learn from this oddity?
What happened is unambiguous, and obvious upon reflection: The index fund invests quite differently than do the other funds in the category. Specifically, Vanguard Intermediate-Term Bond Index has one of the longest durations of any fund in the category (34th on the list), and one of the highest allocations to Treasuries (15th). With bond prices rallying sharply amid a flight to quality, in a flashback to 2008, the fund rode the bull. It gained 4.6% for the one-month period through mid-August, more than triple the category's average, and a full 50 basis points ahead of any nonindex fund. (In what likely was the worst stretch of relative performance in Bill Gross' long career, the Vanguard fund beat titan PIMCO Total Return (PTTAX) by 400 basis points during that time period.)
The article goes on to discuss how this happened. Then it explains that it isn't really that rare that index funds are actively managed, and benchmarks aren't all created equal. Well worth reading for those of us who own "index" funds.

My biggest question is if Bogle was still managing Vanguard, would he talk to the manager of VBIIX and give him a stern lecture for not really indexing, or would give the guy a bonus for outperforming his competitors?
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Old 08-23-2011, 06:25 AM   #2
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Interesting article. I have some VBIIX. I don't mind a month or two out of sync but I hope I am not trusting just another active manager.
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Old 08-23-2011, 07:47 AM   #3
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Most index funds do not contain all assets that the official index contains. They tend to approximate the index.

MS stating the obvious that is outlined in all of the prospectuses and policy statements.

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The fund invests by sampling the index, meaning that it holds a range of securities that, in the aggregate, approximate the full index in terms of key risk factors and other characteristics.
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The fund may temporarily depart from its normal investment policies and strategies when doing so is believed to be in the fund’s best interest...
https://personal.vanguard.com/us/Fun...FundIntExt=INT


Indexes change regularly (because of a variety of reasons)... not to mention that in open ended funds, investor move in an out of the fund. Someone had to make day to day decisions have to be made (buying and selling) and do it efficiently.


But an Index fund Manager that manages buys and sells or other mechanics to operate the fund is a little different than speculating or loading up (concentrating) on a few securities to try to make a big win... and window dressing.
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Old 08-23-2011, 08:55 AM   #4
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Quote:
Originally Posted by clifp View Post
I am seldom truly surprised by financial stories, but this one about Vanguards intermediate bond index was a shock.



The article goes on to discuss how this happened. Then it explains that it isn't really that rare that index funds are actively managed, and benchmarks aren't all created equal. Well worth reading for those of us who own "index" funds.

My biggest question is if Bogle was still managing Vanguard, would he talk to the manager of VBIIX and give him a stern lecture for not really indexing, or would give the guy a bonus for outperforming his competitors?
Morningstar is looking at one month returns? Wow those guys are helpful.......
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Old 08-23-2011, 05:22 PM   #5
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The idea behind indexing isn't that active managers destroy value by making consistently bad investment decisions. It's that they destroy value by charging fees and incuring expenses in excess of whatever value they add through security selection. With that in mind, I'm not overly concerned if an "index" that charges less than 76% of similar funds dables a bit in security selection.
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Old 08-23-2011, 05:52 PM   #6
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The VG I-T index fund (VBILX version) is one of my main FI assets. I am OK with the fund beating out every other fund in it's group in the short term just as long as the ER does not reflect a managed fund.

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Morningstar's Christine Benz noticed something quite peculiar--the single best-performing intermediate-bond fund over the trailing month, out of 1,238 funds in the category, was Vanguard's Intermediate-Term Bond Index (VBIIX).
Another Q arises for me~ if I am holding the Admiral version (VBILX), not the Investor version (VBIIX), should this article apply to my investment also as it's legally a different fund?
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Old 08-23-2011, 07:59 PM   #7
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Another Q arises for me~ if I am holding the Admiral version (VBILX), not the Investor version (VBIIX), should this article apply to my investment also as it's legally a different fund?
Only difference in the funds is the expense ratio.
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Old 08-23-2011, 08:27 PM   #8
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Morningstar is looking at one month returns? Wow those guys are helpful.......

I would think it is tough to be up 4.6% in any intermediate bond fund in one month. But to outperform by 4%, seems virtually impossible of only 20% of the funds assets are allowed to be something outside of the index seems virtually impossible.

To me the equally interesting part of the article was the discussion of the Benchmark fallacy. When I first started buying international funds 20 or so years ago the conventional wisdom is that active management was better than passive for international funds. So I bought top ranked international funds, which outperformed the index, for a while and than had bad years. It turns out the whole premise I had was based on bad data.

It seems me the moral of the story is two fold, in real life things are less pure than the seem on paper, and second plenty of academic studies about the market are flawed.
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Old 08-24-2011, 02:28 AM   #9
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I would think it is tough to be up 4.6% in any intermediate bond fund in one month. But to outperform by 4%, seems virtually impossible of only 20% of the funds assets are allowed to be something outside of the index seems virtually impossible.
Ia orana from Moorea.

I believe that you are misreading the Morningstar article. The article is stating that the Vanguard fund which indeed attempts to replicate the Lehm Agg is the top performer in the Morningstar intermediate bond fund universe in the past month not because the Vanguard fund is actively managed but because the bond market is at a peculiar moment these days.

First of all, comparing active management in the bond world vis-a-vis the equity world is pretty much the apples to orange thing - there are basic issues of index characteristics, composition of active managers, issue sizes, new issue allocations, etc. which make bond management a different universe versus equity management. Now, with regard to the article, the author points out in initial amazement that the index (Vanguard fund) has beaten the active managers in the universe by a minimum of 50bps and specifically Bill Gross by 400bps in the past month. The question is why, or how?

The answer the author properly realizes is that it is due to the current dynamics in the bond market. The Lehm Agg - and the Vanguard index fund - are market weighted portfolios which are agnostic as to how the bond market is comprised. Therefore, the Vanguard portfolio does not care that the US Tsrys are not only increasing in relative size within the index due to less issuance from the MBS and Corp sectors but also offering record low yields due to the tremendous flight to quality bid from all global investors from all asset classes. The lower Trsy yields also have the perverse nature of increasing the index durations on a monthly basis which further makes them less attractive to active managers which compounds the performance difference whenever the flight to quality trade erupts as it has the past couple of weeks.

The article actually reads as a thesis on why investors should not invest in bond index funds since it concludes that the index is blindly driven by less than pragmatic and technical issues such as having to increase duration as yields go lower! In bond math, the term negative convexity is a very bad thing in individual bonds - but one can argue that the entire US Trsy market is trapped in a bad negatively convex trade. The worse it gets, the more one has to buy. In effect, the Vanguard fund is doing extremely well exactly because it ISN'T actively managed in this currently crazy global market. (All you folks out there who are in bond index funds are buying a lot more US Trsys than you prob wish to these days.)

Anyway, the bond index is crushing the active managers recently because no active manager in his right mind would be loading up on more Trsys as the Trsy market is bid higher by all the investors out there who are sick of their stock portfolio volatility and capitulating...then parking the cash in US Trsys. The market can remain stupid longer than many can remain liquid...but it can't remain stupid forever.
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Old 08-24-2011, 03:18 AM   #10
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Originally Posted by GusLevy View Post
Ia orana from Moorea.

I believe that you are misreading the Morningstar article. The article is stating that the Vanguard fund which indeed attempts to replicate the Lehm Agg is the top performer in the Morningstar intermediate bond fund universe in the past month not because the Vanguard fund is actively managed but because the bond market is at a peculiar moment these days.
After reading your explanation, I think you are right and I am wrong.

Quote:

First of all, comparing active management in the bond world vis-a-vis the equity world is pretty much the apples to orange thing - there are basic issues of index characteristics, composition of active managers, issue sizes, new issue allocations, etc. which make bond management a different universe versus equity management. Now, with regard to the article, the author points out in initial amazement that the index (Vanguard fund) has beaten the active managers in the universe by a minimum of 50bps and specifically Bill Gross by 400bps in the past month. The question is why, or how?

The answer the author properly realizes is that it is due to the current dynamics in the bond market. The Lehm Agg - and the Vanguard index fund - are market weighted portfolios which are agnostic as to how the bond market is comprised. Therefore, the Vanguard portfolio does not care that the US Tsrys are not only increasing in relative size within the index due to less issuance from the MBS and Corp sectors but also offering record low yields due to the tremendous flight to quality bid from all global investors from all asset classes. The lower Trsy yields also have the perverse nature of increasing the index durations on a monthly basis which further makes them less attractive to active managers which compounds the performance difference whenever the flight to quality trade erupts as it has the past couple of weeks.

The article actually reads as a thesis on why investors should not invest in bond index funds since it concludes that the index is blindly driven by less than pragmatic and technical issues such as having to increase duration as yields go lower! In bond math, the term negative convexity is a very bad thing in individual bonds - but one can argue that the entire US Trsy market is trapped in a bad negatively convex trade. The worse it gets, the more one has to buy. In effect, the Vanguard fund is doing extremely well exactly because it ISN'T actively managed in this currently crazy global market. (All you folks out there who are in bond index funds are buying a lot more US Trsys than you prob wish to these days.)

Anyway, the bond index is crushing the active managers recently because no active manager in his right mind would be loading up on more Trsys as the Trsy market is bid higher by all the investors out there who are sick of their stock portfolio volatility and capitulating...then parking the cash in US Trsys. The market can remain stupid longer than many can remain liquid...but it can't remain stupid forever.
Terrific explanation better than M*.
I only have a fuzzy understand of convexity, I gather you have either an academic or practical understanding of the bond market.

I just put some of my Mom's money in BND is that dumb? Would corporate bond index be better (she already has 50% equities which is a bit crazy for a 85 year old..)

I take you don't recommend moving to 100% individual US treasury bonds either .

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Moorea is gorgeous, but if you get a chance to go to Huahina it is truly unspoiled.
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Old 08-24-2011, 09:28 AM   #11
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Vanguard 3 year average return: 9.47%, 5 year return: 8.08%

Total Return 3 year average return: 8.97%, 5 year return: 7.91%

Seems to me that they are both good funds, although VG is beating it handily this year. I put little to no trust in 1 year or less returns in a mutual fund, anyone can have a good year.........
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Old 08-26-2011, 03:13 PM   #12
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I just put some of my Mom's money in BND is that dumb? Would corporate bond index be better (she already has 50% equities which is a bit crazy *for a 85 year old..)

I take you don't recommend moving to 100% individual US treasury bonds either .
If BND is Vanguard's Lehm Agg ETF then there are obviously no fundamental differences with the open end fund - the same portfolio characteristic issues would apply. In terms of recommendations, I'm just some knucklehead with my own financial problems and concerns so I stay out of the personal finance or AA advisement business: IMO, however, people focus too much on what to invest in rather than honestly assessing the truly important thing which is to determine what their true risk appetite is, which then should guide them to their general AA decisions. For me to tell anyone what to set a percentage of their AA at is to presume that I know what their risk appetite is - I don't and I'm glad to keep it that way!

In general tho, I like some bonds these days since the odds of recession are significant enough. It's hard to like Trsys, of course, but there is no free lunch in the markets so to load the boat on Corp bonds runs the risk of recessionary spread widening which would overwhelm the gambit to steal some yield in this environment - all investment roads have hazards and dangers henceforth. I am young and foolish enough to keep most of my portfolio in cash these days and trade the volatility but that's not fun or easy either - it's real work.

Fortunately for your mother, she may be old enough to be able to maintain a strategy of staying in diversified bonds while keeping a reasonably short leash on duration since the yield curve is relative flat anyway - it won't make her rich but it may keep her from moving into your home library in her lifetime! The attached article has been making the rounds in the past few days: A dramatic read for all market participants and retirees which isolates the stock market's returns for the next generation with demographic analysis. The San Fran Fed produced the report so it's not an inherently quacky source - the conclusion is sobering for equity investors to say the least.

FRBSF Economic Letter: Boomer Retirement: Headwinds for U.S. Equity Markets? (2011-26, 8/22/2011)

P.S. Huahine is def in my target for the future. I have heard for yrs that that island is a lost paradise. For the near future tho, will be tuff with a young child so need to keep travel as simple as possible.
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