Vanguard municipal bond fund tracking error

Tracking error is one means of measuring active manager performance against an appropriate market index. Vanguard's national Municipal bond funds are actively managed, defined asset class funds. The funds include four municipal bond funds  structured across four bond maturity levels: short, limited, intermediate, and long term bonds. In addition to these four portfolios, Vanguard manages state specific municipal bond funds and a high yield municipal bond fund. The municipal bond market is a very large market, with many illiquid securities. The following table shows the number of securities held by the funds and by municipal bond benchmark indices. The comparative indices include the Barclays Capital 1 Year Municipal Bond Index; the Barclays Capital 1-5 Year Municipal Bond Index;  the Barclays Capital 1-15 Year Municipal Bond Index; the broad market is represented by the Barclays Capital Municipal Bond Index.

Tracking error
The table below provides long term average tracking errors for Vanguard's Municipal bond funds. Admiral share class data covers the period from 2002 (the first full year of operations of the share class) to the present. In 2012 Vanguard changed the funds' benchmark indexes and retrofitted the time series for each fund's relative performance.

The relative performance of investor and admiral share classes can be best illustrated by viewing performance over a common holding period. The following table examines the average tracking error performance of each fund over the period beginning with the first full year of admiral share performance to the present. The lower expense admiral shares provide for lower tracking errors to benchmark performance.

Tracking error has been volatile and considerably high over the 2007-2010 financial crisis period (tracking errors: Short term fund -1.54%; Limited term -0.84%; Intermediate term -1.56%; and Long term -1.62%). The 2008 financial crisis was marked by the following disruptions in municipal market fundamentals:
 * 1) In 2008, first a freezing up of funding in the auction-rate securities market; later in the year investors saw the downgrading to junk status of most municipal bond insurers, with a coincident downward repricing of insured municipal bonds. On December 12, 2008, in response to the virtual disappearance of bond insurance, Vanguard merged it's insured long term municipal bond fund into its long term municipal bond fund.
 * 2) Late in 2008, large sales imbalances in the marketplace due to institutional selling of municipal securities to meet obligations backed by defaulted mortgage securities;
 * 3) In 2010 a surge in supply of new municipal securities due to the impending termination of the Build America Bond program.

Vanguard municipal funds vs. municipal bond etfs
The advent of the exchange traded fund gives investors access to indexed municipal bond portfolios. The following table provides a comparison of Vanguard actively managed defined asset class municipal bond funds with comparable indexed ETF funds from iShares&reg; and  SPDR&reg;s.

Key points:
 * 1) The Vanguard municipal funds are benchmarked to Barclays Capital municipal bond indices. IShares&reg; ETFs are benchmarked to S&P national AMT free municipal bond indices.  SPDR&reg; ETFs are benchmarked to Barclays Capital Managed Money Municipal indices.  The indices, while measuring similar segments of the municipal market, will provide different returns to investors. This is measured by index return dispersion, which can be considerable. In this instance, much of the return dispersion is due to the fact that the benchmark indices have different average modified durations.


 * 1) A fund's expected tracking error is the net return after costs. The Vanguard funds have average expense ratios of 0.20% (lower cost admiral shares available for $50,000 minimum investment). SPDR&reg;s have average expense ratios of 0.23%  plus potential transaction costs (commissions, spreads, discount/premium) borne by the individual investor.  IShares&reg; ETFs have average expense ratios of 0.25%, plus potential transaction costs (commissions, spreads, discount/premium) borne by the individual investor.
 * 2) The iShares&reg; market returns (see second tab in Table 5.) have been  lower than the net asset value return. The market returns for  SPDR&reg;s have been higher than net asset returns for the short term fund and lower for the long term fund (see the fourth tab in Table 5.)
 * 3) The Vanguard funds' active management should result in higher variability in tracking error.
 * 4) IShares&reg;, SPDR&reg;s, and Vanguard municipal funds all hold more bond issues than do most other available municipal bond ETFs.
 * 5) Both IShares&reg; and SPDR&reg;s ETFs track benchmarks which exclude private activity bonds subject to the alternative minimum tax (AMT). Vanguard's funds are allowed to invest up to 20% of net assets in private activity bonds subject to the AMT.