Morningstar Magazine - October/November 2016 - 80

Investors Vanguard Core Bond Fund VCORX Category Intermediate-Term Bond Expense Ratio (%) 0.25 Morningstar Rating - 3-Month Return (%) 2.3 3-Month % Rank 43 Data as of 08/31/2016 our investors is that it's a defensive asset class for diversification," Davis says. For the Core Bond fund, low expenses are an integral part of what Vanguard executives believe will make the strategy work. The fund charges 25 basis points for the Investor share class and 15 basis points for its Admiral shares for larger investor accounts. Davis does the math on how this helps the fund: Core Bond has a longterm performance target of 60 basis points above the Barclays U.S. Aggregate Index, he says. Subtracting out the 15-basis-point expense ratio on the Admiral share version of the fund would return 45 basis points annually to investors over time. That kind of performance, Davis says, would be good enough for the fund to beat 90% of funds in the intermediate-term bond category. "Even if we come up slightly short, we should end up in the top quartile," he says. the various portfolios, which determine how aggressively or conservatively positioned the funds should be relative to their benchmarks. But the process isn't a one-way street. The sector-focused "satellite" teams provide the strategy group with their bottom-up outlooks on valuations and potential returns, which help shape overall calls and risk budgets. As of late summer, the Vanguard house view at the macroeconomic level was that it will be difficult for the Federal Reserve to raise interest rates too aggressively, WrightCasparius says. In part, that's because with economic growth still sluggish around the world, any significant U.S. interest-rate rise would likely lead to a higher dollar. That in turn would create a negative feedback loop for the U.S. economy of even tighter financial conditions, she says. Behind the Strategy Most of Vanguard's actively managed funds are sector-focused. Part of the idea behind launching the Core Bond fund was to make use of the resources from those narrower mandates-the firm has some 145 investment professionals in fixed income-and create a broad-based portfolio. At the center of the firm's "hub and satellite" approach is Vanguard's senior strategy group, composed of Davis and chief economist Joe Davis, along with the global heads of interest rates, credit, tax-exempt bonds, and risk management. This group develops the overall strategic outlook and investment policies for Vanguard's internally managed bond funds. Based on those outlooks, the strategy group then sets the "risk budgets" for 80 Morningstar October/November 2016 "We think rates are pretty much range-bound," Wright-Casparius says. Demand from non-U.S. investors for Treasurys should keep rates pressed lower, but without a sustained turn in inflation, rates also shouldn't head much higher, she says. As a result, the fund has underweighted its interest-rate bets relative to the benchmark. The portfolio had 30% of its assets in U.S. Treasuries as of July 31 compared to 40% in the Barclays Aggregate. However, Core Bond also had 6% in Treasury InflationProtected Securities, while there are no TIPS in the benchmark. On the credit side of the equation, the fund can turn to investment-grade teams in Europe and Australia, as well as the United States. It hedges all foreign currency risk on non-U.S. positions. But for now the fund has a bias toward U.S. corporate debt. "The U.S. environment looks very attractive," Nassour says. "There's a lot of foreign demand for U.S. corporates because of their higher yields. There is so much central bank stimulus that the hunt for yield will continue." As of July 31, the overall weight of the corporate debt stake in the fund was 26% compared to 28% in the Barclays Aggregate. However, the corporate bond position has a longer duration than that of the index, which has the effect of being modestly overweight. When it comes to residential agency mortgagebacked securities, Quigley says the group doesn't see much in the way of longer-term excess return opportunities, especially compared to other sectors. But with a large liquid market like agency MBS, the fund will make tactical trades when the team sees short-term dislocations. Commercial mortgage-backed debt, by contrast, was overweight by 4 percentage points with a 6% weighting in the fund. The fund was also overweight asset-backed securities, with an 8% position in the fund compared to less than 1% in the index. It all adds up to a "benchmark aware" strategy, the managers say, but one that isn't out to be a closet index fund. "There are some considerable differences versus the benchmark," Nassour says. "This is an actively managed fund." K Tom Lauricella is the editor of Morningstar Direct.

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016