Vanguard Municipal-Bond Funds Try to Up Their Game

Morningstar has long given Vanguard's municipal-bond funds high marks for their low fees and low credit risk. But is there more to these funds than low costs and high quality? 

No Pressure
Vanguard's muni managers aren't under pressure to reach for extra yield by piling into riskier securities. Instead, the typical Vanguard muni fund stuffs an above-average chunk of assets in the highest-rated securities, steers clear of interest-rate bets, and relies on its low-cost advantage to beat the competition. While that indexlike strategy has served investors well, several of Vanguard's muni funds look less impressive against the competition gross of fees, implying low costs explain more of their success than manager skill. Vanguard Intermediate-Term Tax-Exempt VWITX, for example, beat more than half of its peers over the 10-year period through March 31, 2011, but lagged almost 90% of them before deducting fees.

Low expenses and higher quality are still among Vanguard muni funds' biggest advantages, but managers over the past five years have shown a fresh determination to build on their low-cost advantage. Bob Auwaerter, Vanguard's head of fixed income, and Chris Alwine, the firm's head of munis, have hired managers and analysts, overhauled the team' structure, and built new quantitative tools.

Fresh Blood
The addition of several new members is the most obvious change to the muni team. In 2010, Matt Kiselak, former head of munis at Evergreen Investments, joined Vanguard, taking responsibility for Vanguard Long-Term Tax-Exempt VWLTX and Vanguard High-Yield Tax-Exempt VWAHX and bringing the firm's number of intermediate- and long-term muni managers to four. Kiselak also oversees that team's traders and managers. When portfolio manager John Carbone moved from Vanguard's California muni funds to its money market team in 2011, Alwine and Auwaerter replaced him with Jim D'Arcy from Columbia Management. Over the past five years, they've also doubled the number of credit analysts to 17, including 10 senior analysts and seven associates. The trading team backing the intermediate- and long-term strategies also doubled to six from three.

Both the muni- and taxable-bond sides of Vanguard's fixed-income operation also have benefited from a new hub-and-satellite structure introduced in 2009 to ensure the fixed-income team shares and implements ideas and strategies consistently across all portfolios. The hub includes Alwine, Auwaerter, chief economist Joe Davis, risk-management head John Hollyer, and taxable-bond head Ken Volpert. They set the general investment strategy for all the bond funds, including how much interest rate and credit risk to take, which sectors to emphasize, and how much exposure to allow for each maturity along the yield curve. Managers, analysts, and traders are divided into satellites, or sector-specialist teams that pick securities and place trades for the funds. Like their counterparts on the taxable side, the four intermediate- and long-term muni managers each manage a sector team and take responsibility for the tactical management of their funds, ensuring that trade ideas are shared. This structure is common for taxable-bond shops, but relatively new for munis, Alwine said.

New Tools
Finally, Alwine and Auwaerter built new proprietary software for the muni team with the assistance of John Hollyer's risk-management squad. Vanguard's muni managers now can monitor their portfolios' risks versus their benchmarks in real time on their desktops. Hollyer's team developed new models to help the managers incorporate into their decisions factors such as the effects of term structures on a fund's average maturity in different interest-rate environments or the likelihood that a specific bond will be pre-refunded.

While these changes don't signify a seismic shift in Vanguard's muni-investing philosophy, which retains its cautious streak, they're a welcome sign that the team is serious about competing as an active manager in the muni space and not just on costs.

The article originally ran in Morningstar's Vanguard Fund Family Report.