This ETF Targets an Ultrasafe Segment of the Market

Investors aiming to protect their portfolio against inflation, the potential for loss of principal, and to reduce volatility would be wise to consider Vanguard Short-Term Treasury ETF VGSH. The strategy tracks a short-term Treasury bond index, resulting in a portfolio carrying very little interest-rate and credit risk. Risk and return are highly correlated in the fixed-income market, so this fund will not generate mouthwatering results, but it will deliver consistent returns and provide strong downside protection. Since its inception in November 2009, its standard deviation was over 2 percentage points less than the Bloomberg Barclays US Aggregate Bond Market index and nearly 12 percentage points less than the S&P 500.

Suitability Vanguard Short-Term Treasury is one of the cheapest short-term Treasury funds available, which makes it one of the best. It earns a Morningstar Analyst Rating of Silver.

The fund tracks the Bloomberg Barclays U.S. Treasury 1-3 Year Index, which includes U.S. Treasury bonds with between one and three years until maturity. Securities in the index are weighted by their market value (excluding amounts held by the Federal Reserve), which promotes low turnover cost by tilting the fund toward the most-liquid securities. This approach also harnesses the market’s collective wisdom about the relative value of each security. That said, it allows Treasury-issuing activity to determine the composition of the portfolio.

The Treasury market is highly efficient and liquid, reflecting the market’s inflation and interest-rate expectations. It is difficult for active managers to gain a durable edge and recoup their fees in this market, without also taking greater risk than this portfolio. Fees are particularly important in the short-term Treasury market, as these securities tend to have lower return potential than many other types of bonds. This fund ranks among the cheapest in its category, which should provide it with a solid edge over more-expensive alternatives.

This conservative portfolio has minimal credit risk, as Treasuries are backed by the full faith and credit of the U.S. government, and low interest-rate risk, as short-term Treasuries are less sensitive to interest-rate fluctuations than their longer-term counterparts. While the fund’s low risk profile does limit its potential return, it also limits potential losses. This portfolio provides strong downside protection because short-term Treasury securities can act as a safe-haven investment. For example, the fund outperformed its Morningstar Category average by over 100 basis points during the taper tantrum of 2013. It has also tended to be slightly less volatile than most of its peers.

The strategy’s performance has been solid but not spectacular. Its returns have lagged its category average by approximately 5 basis points during that time, ranking in the middle third of the short government funds category.

Fundamental View This is a very conservative portfolio that consists almost exclusively of U.S. Treasuries with less than three years until maturity. These securities have virtually no credit risk and minimal interest-rate risk, which should help this strategy offer a smooth ride during turbulent periods in the market. However, this limits the returns this portfolio can offer. Given its limited return potential, the strategy's low fee is especially important and should give it a durable edge.

This strategy carries less interest-rate and credit risk than the category average because it has a shorter average effective duration and it does not maintain positions in agency securities. As a result, it has tended to outperform the category average during periods of stress. For example, during the taper tantrum of 2013, the strategy beat its category average by over 100 basis points. And during the high-yield sell-off in the fourth quarter of 2018, the strategy beat its category average by 20 basis points.

It is common for other funds in the short government category to maintain positions in agency securities, which offer slightly higher returns than Treasury securities because they carry additional credit and pre-payment risk. This portfolio tends to take less interest-rate risk than most of its peers, which can also limit its return potential. However, this strategy has kept up well with its category peers since its inception, due to its low fee. The fund’s annual return during the period since its inception in November 2009 trailed the category average by 5 basis points.

Because it focuses on short-term U.S. Treasuries, the strategy must frequently buy and sell securities. Its turnover ratio is 67%, which ranks in the middle third of the short government category.

Portfolio Construction This strategy earns a Positive Process rating because it tracks a well-constructed market-value-weighted index that promotes low transaction costs by emphasizing the largest and most-liquid issues. In this market it is difficult for active managers to gain a durable edge without taking greater risk than this portfolio, as these bonds are highly liquid and expectations for inflation and interest rates are already baked in.

This portfolio employs representative sampling to track the performance of the Bloomberg Barclays U.S. Treasury 1-3 Year Index, which includes original term U.S. Treasury bonds with between one and three years until maturity. Qualifying bonds must have at least $300 million in outstanding face value. The index is rebalanced on the last calendar day of each month. This yields a conservative portfolio, which limits its return potential, but also cuts downside risk.

Prior to December 2017, the fund tracked the Bloomberg Barclays U.S. 1–3 Year Government Float Adjusted Index. That index included agency securities, which tend to offer slightly higher yields. However, Treasury securities accounted for more than 90% of the portfolio prior to the change. According to Vanguard, the change was made to reduce transaction costs as the Treasury market is more liquid than the agency market, resulting in tighter bid-ask spreads.

Fees The strategy has an expense ratio of 0.07% and is one of the lowest-cost options in its category, supporting a Positive Price Pillar Rating. The average expense ratio and median expense ratio of funds in the short government category were 0.62% and 0.58%, respectively. The strategy also has a strong index-tracking record. Over the trailing five years through July 2019, it lagged its benchmark by 1 basis point annually.

Alternatives Silver-rated Schwab Short-Term U.S. Treasury ETF SCHO (0.06% expense ratio) tracks the Bloomberg Barclays U.S. 1-3 Year Treasury Index and provides nearly identical exposure to VGSH, but is 1 basis point cheaper. Like VGSH, it targets Treasury securities with one to three years remaining until maturity and weights its holdings by market value.

Silver-rated Vanguard Short-Term Federal VSGBX (0.20% expense ratio) is a solid actively managed option. This fund has a slightly longer duration, holding bonds with maturities of one to five years, and includes agency securities.