Puzzling together exposure in the growing realm of index municipal ETFs

Picture this: You’re working on a puzzle. You’re looking for the missing pieces, matching them based on their color, shape, and size to complete the picture. The process is similar to the way municipal index funds are built. Fund managers must find bonds to match the complex characteristics needed to complete the “puzzle”— an index fund.

Because the bond universe is so vast, index bond funds are samples of the index they track rather than a full replication of the entire index. After all, it’s relatively difficult and expensive to build an index ETF from the S&P National AMT-Free Municipal Bond Index—a benchmark with more than 14,000 bonds, many of which do not trade regularly—compared to creating a fund based on the S&P 500 Index, a benchmark with only about 500 stocks that trade millions of shares per day.¹

By sampling the S&P Municipals Index, our fund managers can balance two crucial objectives: one, minimizing tracking error by matching the fund with key benchmark characteristics like duration and credit quality, just like matching puzzle pieces by their color, shape, and size; and two, reducing transaction costs.

But choosing the right bonds is only part of the challenge. The key is to match risk factors.

Matching risk in index municipal bond ETFs

Vanguard’s municipal bond team created a matrix of key risk factors to pinpoint the exact bonds needed to keep the fund in line with the benchmark—not unlike finding the right pieces to complete a puzzle.

While municipal bonds mature like any other bond, they’re also frequently callable, meaning they can be redeemed by the issuer prior to maturity. It’s like a few puzzle pieces getting mixed up again in the middle of putting the puzzle together. The callable feature adds a layer of complexity, making it more difficult to find the perfect bonds to match the characteristics of the benchmark.

Despite these added complexities, our proprietary “puzzle” method helps keep tracking error minimal and ensures that our municipal index products are performing in line with what investors expect. It’s one of the reasons Vanguard’s municipal index ETFs have tighter tracking errors than 80% of their peers over the past year.

Tracking error can be difficult to visualize. But excess returns, which are a reflection of tracking error, clearly demonstrate visually how returns can be affected. So it is that the tighter the tracking error, the more excess returns cluster around benchmark returns, as the chart demonstrates. In turn, tighter tracking error means it’s more likely that investors can avoid deviating from market performance.

ETF choices reach critical mass

ETF use has accelerated in recent years, opening an expanding universe of options to investors. The world of municipal bond ETFs is part of this and, with our work in the realm of municipal indexing, ETF options now include tools necessary to create institutional-caliber municipal exposure using low-cost index ETFs.

About two years ago, Vanguard had just one index municipal ETF that canvassed the full breadth of the national municipal yield curve. Now, we have six index municipal ETFs—four national strategies allocated across the municipal curve, and two state- specific strategies targeting California and New York.

These newer ETFs, VTES, VTEI, and our latest addition, VTEL, are the puzzle pieces for municipal investors that want more control over their interest-rate-risk exposure.

Tax-aware investors now have at their disposal low-cost ETFs to enter and exit positions, rebalance, and precisely manage duration risk with a convenience that simply did not exist previously.

For investors in high income tax states such as California and New York, which together make up just over 40% of all U.S. municipal bond issuance, Vanguard has the California-focused VTEC and, with the recent launch, now the New York State- focused MUNY.

Using these ETFs, residents of either state can enhance the tax advantages of their allocation to municipals because they can reap both federal and state tax breaks.

Takeaways

Municipal bond investors are no strangers to the puzzle that is constructing complex municipal portfolios.

And the growing options available in ETFs means that advisors can trust Vanguard’s bond experts to help complete the puzzles of bond portfolios, so that they can focus on the puzzle pieces that matter more to their clients. That’s what investors can get when you’re backed by institutional-quality bond managers.

1 The S&P 500 Index is actually composed of 504 different equities because some firms, such as Alphabet Inc., have more than one share class included in the S&P 500.

For more information about Vanguard funds or Vanguard ETF Shares, contact your financial advisor to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information 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 principal. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

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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.