A Cheap, Diversified, Mortgage-Backed-Securities ETF

This fund delivers a higher yield than most of its peers that invest in agency MBS because of its relatively larger investments in Fannie Mae- and Freddie Mac-issued mortgage bonds. Unlike Treasury bonds, these bonds are not explicitly guaranteed by the U.S. government, and they offer higher yields than Treasuries with a comparable term. The fund's investments in Fannie Mae- and Freddie Mac securities represented roughly 70% of the portfolio as of March 2017. The rest of the portfolio is invested in Ginnie Mae securities, which are guaranteed by the U.S. government. The fund focuses on residential mortgage bonds even though it is part of the intermediate-government category, which encompasses funds investing in all sorts of government-related debt.

Despite the fund's sizable investments in non-government-guaranteed bonds, it takes minimal credit risk. The portfolio is entirely invested in AAA rated securities, the highest possible credit rating. Also, the fund's 4.4-year duration is on par with its peers that focus on agency MBS.

Vanguard's index group has kept the fund's performance close to its benchmark. From its November 2009 inception to March 2017, the fund produced an annualized return of 2.81%, lagging its benchmark by 0.04% on an annualized basis. This gap is less than its 0.07% management fee, which is among the lowest in the category. Over the same period, the fund's absolute and risk-adjusted performance was in line with its average agency-mortgage fund peers.

Fundamental View An agency MBS is a pool of residential mortgages assembled by government agencies Fannie Mae, Freddie Mac, and Ginnie Mae. These entities were created to facilitate mortgage lending and promote home ownership. The agency-mortgage market had grown to more than $5 trillion at the end of 2016, and it is a major component of the taxable-bond universe. This segment currently accounts for roughly 30% of the Bloomberg Barclays U.S. Aggregate Bond Index.

Unlike a corporate or Treasury bond, an agency MBS carries prepayment risk. There is uncertainty surrounding the timing of the principal payment because the borrower can prepay the mortgage at any time without a penalty. This prepayment risk is difficult to analyze because borrowers prepay their mortgages not only for economic reasons such as low interest rates but also for personal reasons such as moving for a job or marriage. Also, Fannie Mae- and Freddie Mac-issued bonds carry higher credit risk than Treasuries and, as such, offer slightly higher yields. This is because they do not carry the legal backing of the U.S. government. However, investors price them under the assumption that the government will step in if necessary to bail out these privately owned government-sponsored enterprises.

The fund's investments in Fannie Mae- and Freddie Mac-issued mortgage bonds mean it tends to have a higher yield than its mortgage-bond fund peers that focus on government-backed Ginnie Mae securities. As of March 2017, Fannie Mae and Freddie Mac securities took up approximately 70% of the fund. These securities offer slightly higher coupons than Ginnie Mae bonds to compensate for default risk as they are not explicitly guaranteed by the U.S. government. As of March 2017, this fund had an SEC yield of 2.2%, about 10 basis points higher than its mortgage-fund peers.

This fund's credit and interest-rate risk profile is comparable to its peers that focus on mortgage bonds. As of March 2017, the fund's duration was four years, similar to its average peers.

Since the fund's November 2009 inception, its index-tracking record has been solid. From November 2009 through March 2017, the fund trailed its index by 0.04% on an annualized basis, net of its 0.07% fee. Its three- and five-year annualized returns of 2.5% and 1.9% were on par with its index peers. However, the fund's return lagged the average actively managed mortgage fund by 19 basis points and 14 basis points over the trailing three- and five-year periods, respectively. Its risk-adjusted performance, measured by its Sharpe ratio, was in line with mortgage-bond fund peers over the same periods.

Portfolio Construction The fund earns a Positive Process rating because it accurately captures the agency MBS market and weights its holdings by market capitalization. This weighting approach tilts the portfolio toward the most-liquid issues, which helps mitigate transaction costs.

The fund employs a sampling approach designed to track the performance of the Bloomberg Barclays U.S. MBS Float Adjusted Index. This Index covers U.S. agency mortgage-backed pass-through securities issued by the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). To be included in the Index, each security must have at least $250 million currently outstanding and a weighted average maturity of at least one year. This fund maintains a dollar-weighted average maturity consistent with that of the Index, which was 5.8 years as of Aug. 31, 2016.

Fees The fund has an expense ratio of 0.07%, which is among the lowest in the intermediate-government category, supporting the Positive Price Pillar rating. This fund is cheaper than 97% of its category peers, and its fee is much lower than the 0.65% category average. This fee is on par with other mortgage-bond index funds and exchange-traded funds and lower than actively managed mortgage funds that typically charge more than 40 basis points. Thanks to this cost advantage and effective portfolio management, this fund has tightly tracked its underlying index. The fund lagged its bogy by 0.04% on an annualized basis since its inception.

Alternatives

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.