A muni ETF that targets the shorter end of the curve
June 29, 2023
June 29, 2023
Steve McFee, Vanguard senior portfolio manager in Vanguard Investment Management Group, chats about the current state of the municipal bond market, the explosive growth of ETFs, and how interest rate-sensitive investors might maximize tax-exempt income. McFee and his team oversee six of Vanguard’s seventeen muni mutual fund and ETF portfolios, including Vanguard Short-Term Tax-Exempt Bond ETF (VTES), which launched on March 7, 2023. The team is responsible for almost $42 billion in assets as of April 30, 2023.
Note: This interview was edited for length and clarity.
Can you walk us through your background? For instance, how did you come to the Vanguard Fixed Income Group, and what roles have you held during your career?
Absolutely. I am a Vanguard lifer. I grew up in this area and I came to work at Vanguard 18 years ago, right after I finished college. I started in a client-facing role, which is where I got familiar with the people Vanguard serves, their needs, and how Vanguard helps meet those needs. After two years, I had the good fortune to move to the muni desk as a trader, where I was later promoted to assistant portfolio manager. In 2018 I was promoted to senior portfolio manager.
I have always had a passion for managing money, which made this role a natural fit for me. I feel particularly fortunate to be at Vanguard in general and on this muni team in particular. I love that I can wake up in the morning knowing that I’m working for a company and with a group that makes a difference in the lives of the people we serve.
Vanguard Short-Term Tax-Exempt Bond ETF (VTES) launched on March 9, 2023. How does this ETF align with the rest of the Vanguard muni lineup? What differentiates it?
Vanguard has a mature lineup of state and national tax-exempt bond funds, although the majority of our portfolios are actively managed mutual funds. VTES is the second passively managed fund in our muni lineup, and it’s available as an exchange-traded fund (ETF). The other is Vanguard Tax-Exempt Bond ETF (VTEB), which is our core passive muni offering.
Our newest ETF (VTES) is effectively a short-term sub-slice of VTEB, investing in investment-grade munis with between zero and seven years to maturity.
Some investors have a perception that all index funds are the same. What is it that makes Vanguard municipal index funds unique?
Three factors set our index funds apart: Our people, our process, and our chosen benchmarks.
We have a well-staffed, diverse team of experts whose skills include trading and execution, portfolio management, and fundamental credit analysis. Investors often hear that there is nothing “passive” about indexed fixed income funds, and this is accentuated in a municipal market with tens of thousands of unique issuers. So even for a passive portfolio, that knowledge and expertise is crucial for closely replicating index returns. We’re all located here at our Malvern headquarters, which gives us the unique ability to gain efficiencies, be more productive, and respond to unusual situations as they unexpectedly arise. All of these advantages have translated to exceptionally low tracking error.
Our team is solely focused on tracking the benchmark as closely as possible. There are no surprises or style drift. We do what we say we’re going to do. We believe this approach ultimately enhances the client experience.
Finally, before we launched VTES, we put a considerable amount of effort into selecting the most appropriate benchmark. Our goal with this portfolio is to optimize the trade-off between interest rate sensitivity and our ability to maximize the investor’s tax-exempt income. Ultimately, we were looking for the ideal duration and yield when compared to the central tendencies of existing passive short-term munis. Months of research and testing went into our benchmark selection; we wanted to provide an optimal experience for the shareholder looking for exposure to the front end of the yield curve.
Can you tell us a bit about the state of the municipal market? How are valuations, and are balance sheets healthy?
Volatility is high in the financial markets, but municipals are well positioned to have a strong year. 2022 was challenging, but that was primarily because of technical influences such as restrictive central bank policies, which led to lower asset prices, higher yields, and wider credit spreads across the bond universe.
Despite that movement, muni fundamentals stayed strong. The uptick in real estate prices led to increased state and local tax revenues over the past several years, and many municipalities bolstered rainy-day funds with COVID-era stimulus funds. Despite current market movement, many municipalities are in healthy fiscal shape. That all makes this an attractive asset class for investors looking to maximize tax-exempt income while maintaining a certain level of portfolio stability.
Why did Vanguard decide to launch a short-term tax-exempt ETF?
The ETF market has expanded dramatically in the past few decades; we think inflows during the past few years in particular point to a continued trend of expansion. We had launched our most recent ETF—Vanguard Tax-Exempt Bond ETF, which we talked about earlier—a full seven years ago. Enough time has passed since then for us to properly assess the ETF market, including the success of and demand for these types of investments.
Vanguard clients have expressed interest in additional tax-exempt ETF portfolios. It’s important that we listen to and aim to meet client needs. We saw this demand as an opportunity to create more depth in our current lineup by focusing on a highly sought slice of the universe. It’s also worth noting that rising interest rates, in concert with the inverted yield curve we experienced this year, set an attractive stage for the launch of a shorter-duration portfolio. But in general, the shorter end of the curve is an attractive place to be for an investor who prefers lower volatility and who has greater sensitivity to interest rate changes.
Finally, ETFs, by the nature of their structure, are generally tax-efficient portfolios that can be managed at a very low average cost. One of Vanguard’s primary principles for successful investing is to minimize costs—through management fees, trading costs, and tax efficiency. Vanguard research shows that lower-cost investments tend to outperform higher-cost alternatives.1
1 Wallick, Daniel W., Brian R. Wimmer, and James J. Balsamo, 2015. Shopping for Alpha: You Get What You Don’t Pay For. Valley Forge, Pa.: The Vanguard Group.
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