Building tax-efficient portfolios: Q&A with Justin Schwartz

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Building tax-efficient portfolios: Q&A with Justin Schwartz

Expert Perspective


March 7, 2024

Justin Schwartz is head of municipal index and money markets and senior portfolio manager for Vanguard’s municipal money market funds and tax-exempt bond index ETFs. In this conversation, he chats about the recent growth of municipal exchange-traded funds (ETFs), his team’s active edge as muni indexers, and what higher interest rates mean for investors who seek tax-efficient yields. Schwartz and his team manage seven portfolios and $58.7 billion in assets.1

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 (FIG) and what roles have you held during your career?

I came to Vanguard right after graduating from the University of Richmond. I started in our participant services group as a client relationship associate, servicing our 401(k) clients. A year later, I moved to FIG, where I’ve been for the past 19 years. I started as a trader for active long-term municipals and moved after a few years to our short-term municipal desk, trading for our municipal money market funds and active short-term tax-exempt fund. From there, I became a portfolio manager for a few of our state municipal money market funds.

I was given the opportunity to become head of the short-term municipal desk in 2015, with portfolio management and oversight responsibilities for our municipal money market product lineup and active short-term tax-exempt fund. Then this past October, due to the growth of our municipal index product, FIG split our active and index muni trading teams and I became the head of the newly created municipal index and money market desk. I also manage five investment products, two of them being new tax-exempt bond ETFs that just launched in January.

Sounds like there have been several recent changes—regarding both your team’s organizational structure and the Vanguard municipal product lineup. What inspired these developments, and what can investors expect from the shifts?

There has been substantial demand for municipal ETFs in recent years. We’ve seen similar shifts toward ETFs in the equity and taxable bond markets. Now, munis are following suit. The separation of our active and index portfolio management teams allows for proper resourcing among both, while also positioning us to meet demand in an accelerating muni ETF market.

Part of this demand shift can likely be explained by an evolution of the municipal investor base. It was once primarily composed of buy-and-hold retail investors. As advice has grown as a service, municipals have become a more dominant part of model portfolios. Further, advisors have become more tactical with asset allocation shifts as well as capitalizing on tax-loss harvesting opportunities. That means there is now a greater base of investors who can benefit from the liquid ETF vehicle to build municipal portfolios that are also low cost and broadly diversified. Access to the bond market, in general, and to municipals, in particular, has been democratized. We’re diversifying our product offerings to meet that demand.

Growth of ETFs by asset class since 1997

A line chart shows the growth of the ETF share of ’40 Act funds from January 1997 through December 2023. Equity ETFs led the growth trajectory, followed by taxable bond ETFs and then municipal bond ETFs. The percentage of municipal bond ETFs began to grow around 2008 and this trajectory has been steepening in recent years.

Source: Vanguard calculations based on Morningstar data from January 1997 through December 2023.

You mentioned the two new municipal bond ETFs that launched last month. Those are Vanguard Intermediate-Term Tax-Exempt Bond ETF (VTEI) and Vanguard California Tax-Exempt Bond ETF (VTEC). How do these new offerings fit within the rest of the Vanguard muni lineup? And why the focus on ETFs as an investment vehicle?

These two new portfolios enhance our offerings across the yield curve, giving advisors and investors the ability to target exposures they want represented within their portfolios. Intermediate-duration bonds are particularly attractive to some investors because they generally capture a good portion of yield opportunities while mitigating some of the interest rate sensitivity seen with longer-dated issues.

For residents within the Golden State, the new California ETF provides additional exemption from state taxes (beyond those at the federal level). For earners in the highest tax bracket, this means an additional 13.3% of tax exemption. And despite the ETF being focused on a single state, California offers ample latitude for proper diversification. Representing roughly one-fifth of the total municipal market,2 California is practically a world economy. The state is extremely well diversified across many different municipal debt sectors like schools and universities, water, sewer, airports, toll roads, and transportation.

These new ETFs also offer access to more of a beta pure-play to the municipal market. We believe active management can add value in the municipal space. That said, different investors have varying objectives and investment horizons that dictate different approaches to management style. These high-quality indexed muni portfolios should serve as a complement to our existing lineup for those who prefer such exposures. Both can help investors reach their goals.

And why the ETF structure? In general, it offers a greater level of tax efficiency for the end investor, allows for intraday trading, and provides access to consistent exposure. For advisors and intermediaries, ETFs often experience fewer platform frictions, which means a greater number of their underlying investors can access the product. Finally, the structure allows access to the underlying municipal securities at a much lower transaction cost than if individual bonds were purchased outright.

Some investors have a perception that all index funds are the same. What is it that makes the Vanguard fixed income index approach unique or more effective?

There are three key facets that differentiate Vanguard index funds. The first is our product design. We go through a careful and thorough benchmark selection process to make sure we’re designing products that have strong tax efficiency, healthy yield maximization, and good liquidity to ensure efficient ETF trading conditions.

The second is our deep access to credit analysis and research through our broader fixed income team. On the municipal side alone, we have more than 20 analysts who carefully cover the entire market. The municipal market is much more vast than other bond sectors. There are close to 50,000 municipal issuers and nearly 1 million active CUSIPs within the space. As a result, every position a muni indexer takes is really an active position. But our unique expertise enables our team to more accurately replicate beta exposures at the top-portfolio level. In short, the deep investment knowledge we have on our desk helps us manage risk while tracking closely to our benchmarks.

Third is our access to technology. On the index side, our quantitative analysts have developed advanced optimization techniques that allow us to track our benchmarks more tightly. Our tools also allow us to set specific parameters for risk exposures across different aspects of the funds, like maturities, call risks, and credit sectors, and to quickly analyze a large swath of the bond market against those specifications.

Let’s turn toward current market conditions. Higher interest rates are here to stay. Even after monetary policy rates recede from current highs, we expect rates will settle at a higher level than we’ve grown accustomed to. What are the short-term implications for the municipal market? And longer term?

The primary reason people invest in munis is for tax-free income. Higher interest rates over longer periods of time will offer a great opportunity for investors to achieve that goal. The inverted yield curve we’ve seen over the past year is a relatively rare condition that doesn’t typically continue for extended periods. As the Fed eventually adjusts policy rates lower, that will likely provide a tailwind to municipal returns. Rates overall will adjust lower, likely leading to some tightening of the market’s risk premium as well.

How do you feel about municipals relative to other fixed income sectors?

Overall, municipal valuations are attractive. At full-index levels, tax-equivalent yields are higher than what Treasuries, mortgage-backed securities, and even corporate bonds are offering. But valuations are not universally attractive in this market. Compared to Treasuries, AAA rated municipal values are stretched relative to historical levels, but the bulk of investment grade municipals exist in lower than AAA rated credits. The additional spread that you get in that part of the market makes those bonds very attractive relative to other asset classes like Treasuries or even corporates in some cases.

From a macro perspective, municipal issuers are generally in a good position. Many have spent the past few years filling their reserves with a combination of funds from pandemic aid and strong tax receipts. Those flush rainy-day funds lead us to expect they’ll be able to weather a potential economic dip.

This is also true in California, whose bolstered reserves have put the state in a historically strong position. It has more volatile revenues than other states, given its higher income tax and reliance on capital gains tax income, which means it experiences a financial ebb and flow as market conditions shift. But those higher state income taxes are also what make a municipal bond investment an appealing option for California residents.

Nationwide, municipal yield levels remain attractive from a long-term perspective. Fundamentals look good, credit quality is high, and we maintain a positive view of issuers, in general. This is an attractive market for investors, particularly those in higher tax brackets.


Related links:

Vanguard launches two tax-exempt bond ETFs (press release, issued January 2024)

Active Fixed Income Perspectives Q1 2024: Yield mountain (economic update, issued January 2024)

Vanguard expands lineup as ETF market grows (portfolio manager Q&A, issued May 2023)


1 As of January 31, 2024.

2 Bloomberg as of December 31, 2023.

For more information about Vanguard funds or Vanguard ETFs, visit or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you carefully review the terms of the consent and consult a tax advisor before taking action.

Vanguard Intermediate-Term Tax-Exempt Bond ETF and Vanguard California Tax-Exempt Bond ETF are not to be confused with the similarly named Vanguard Intermediate-Term Tax-Exempt Fund and Vanguard California Intermediate-Term Tax-Exempt Fund. These products are independent of one another. Differences in scale, certain investment processes, and underlying holdings are expected to produce different investment returns by the products.


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