Vanguard Goes with the Float

In a sign of how dramatically government intervention has altered the fixed-income market, Vanguard's bond index funds will switch their benchmarks this year to bogies that don't include the trillions of dollars in mortgage-backed securities the Federal Reserve is buying as part of its quantitative easing program.

Vanguard said it will start using Barclays Capital float-adjusted benchmarks for its 12 existing and proposed bond index funds and ETFs. Float-adjusted benchmarks exclude securities that do not freely trade on public exchanges, such as those held by insiders or the government.

The family is making the switch because the investable market for taxable bonds has gotten smaller since the financial crisis. That's because the Federal Reserve has gone on a massive buying binge of mortgage-backed and government agency-issued securities to help the staggering housing market by keeping rates low. This quantitative easing policy has put more than 11% of the total $13.4 trillion investment-grade taxable-bond market in the hands of the Fed, according to Vanguard.

This situation can increase transaction costs and tracking error of funds trying to replicate bond indexes that don't adjust their constituents for those securities that have been essentially taken out of circulation. Furthermore, the Fed's buying program has driven up the valuations of MBS and bonds issued by government-backed agencies, such as  Fannie Mae (FNM) and  Freddie Mac (FRE), and when those bonds revert to their fair value, it could hurt performance. Vanguard funds have not seen significant increases in tracking error and trading costs yet, but could in the future if the funds don't switch benchmarks, said Ken Volpert, head of the family's fixed-income indexing group.

Bond indexes like the Barclays Capital U.S. Aggregate Bond have long float-adjusted the U.S. Treasury portions of their indexes. Recently, however, Barclays created versions of their fixed-income benchmarks that exclude mortgage-backed and agency bonds that the Fed buys and adds them back when the government sells them again.

The change could affect the sector allocations of Vanguard funds. For example,  Vanguard Total Bond Market Index's (VBMFX) mortgage stake could drop by 9% by the end of 2009 because of the switch, Volpert said. The funds' duration, yield, and overall risk profiles should not change, though.

Vanguard, which has used float-adjusted indexes for all of its stock funds for the last four years, prefers float-adjusted indexes because they offer a more realistic representation of investors' opportunity sets. "It's really best practices in indexing," Volpert said.

Vanguard wouldn't say specifically when it would make the switch but said it would be before the end of the year. The affected existing funds include Vanguard Total Bond Market, Vanguard Institutional Total Bond Market , Vanguard Total Bond Market II (VTBIX),  Vanguard Short-Term Bond Index (VBISX),  Vanguard Intermediate-Term Bond Index (VBIIX),  Vanguard Long-Term Bond Index ,  Vanguard Balanced Index (VBINX), and Vanguard Variable Insurance Fund-Total Bond Portfolio.

The four proposed bond index funds and ETFs--Vanguard Short-Term Government Index, Vanguard Intermediate-Term Government Index, Vanguard Long-Term Government Index, and Vanguard Mortgage-Backed Securities--will track float-adjusted indexes when they get SEC approval and launch.

In other news, Vanguard said it would merge $3.7 billion Vanguard Institutional Total Bond Market Index into $61.3 billion Vanguard Total Bond Market Index, which will issue new Institutional Plus shares to Institutional Total Bond Market Index shareholders, pending a Feb. 3, 2010, shareholder vote. The family also will combine $5 billion Vanguard Institutional Developed Markets Index  with $2.8 billion  Vanguard Developed Markets Index  in late January 2010. Developed Markets Index will issue new Institutional shares to Institutional Developed Markets shareholders. There should be no increase in expense ratios.