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Evaluating Vanguard’s New Core Bond Fund

A reader writes in, asking:

“Apparently Vanguard’s new Core Bond Fund is going to be similar to the Total Bond Market Index Fund, but actively managed with an eye as to upcoming interest rate hikes and cuts.

Am interested if you think this fund is worth looking at to complement the Total Bond Market Index Fund in a way to attempt to ‘time’ interest rates. Would it be a bit easier to ‘time’ interest rates than the market? There are some long term trends I think we all can agree on. For example, sooner or later interest rates will once again rise. Of course knowing when and how much rise there will be is the rub. I would also be interested if you knew what the proposed duration of this fund was, as I did not notice while doing my preliminary research.”

For those who haven’t yet heard about the new Vanguard Core Bond Fund, you can read Vanguard’s announcement here or see the fund info page here.

Here are a few of the details:

  • The plan is for the new fund to be an actively managed counterpart to the Vanguard Total Bond Market Index Fund — investing in similar securities, but trying to outperform via “security selection, sector allocation, and, to a lesser extent, duration decisions.”
  • The fund will have an expense ratio of 0.25% (0.15% for Admiral shares).
  • The fund is supposed to have a duration ranging from “0.5 years above or below the fund’s benchmark, the Barclays U.S. Aggregate Float Adjusted Index,” which would give it an average duration roughly in the 5-6 years range.

As I’ve said before I do not necessarily have any opposition to using actively managed funds. The problem is simply that most actively managed funds cost quite a bit more than their passively managed counterparts. And lots of research (a few cases of which are mentioned here) has shown that lower-cost funds tend to outperform higher-cost funds.

And on that note, the good news is that this new fund is pretty darned cheap for an actively managed fund. It is, however, still somewhat more expensive than the Vanguard Total Bond Market Index Fund, which has an expense ratio of 0.20% (0.07% for Admiral or ETF shares).

With regard to the question of whether it’s easier to predict interest rate movements than stock market movements, I am not aware of any evidence showing that to be the case. Perhaps ironically, one of the more compelling arguments I’ve seen against trying to predict interest rates comes from a 2011 Vanguard research paper.

On pages 6-7 of the paper the authors discuss how well the market (as a whole) does at predicting both the federal funds target rate and the yield on 10-year Treasuries. In short, the predictions are terrible. (Figure 7 is particularly noteworthy. In the figure, each of the little hairs extending away from the dark line shows the market’s prediction at a given time. As you can see, it’s pretty rare for the predictions to line up with what actually occurred going forward.)

The authors also note that shortening the duration of one’s bond holdings due to an anticipated rise in interest rates means forgoing the higher yields that could have been earned on longer-duration bonds while waiting for rates to rise. In the authors’ words:

“Finally, in addition to interest rates’ unpredictability, it’s important to consider that even if a manager makes a correct call on the direction of rates, the timing and magnitude of any change are crucial, as a short-duration strategy is a “negative carry” position. In an environment characterized by a steep yield curve, this negative carry can mean a significant return forfeiture if yields do not rise as anticipated. Even then, a manager who correctly predicts a rise in interest rates could likely suffer a performance penalty if rates rise less than forecast or if the timing of the change is either too early or too late.”

So, frankly, I would be surprised if the fund is able to reliably add value by predicting interest rate movements.

In other words, if I were to buy the fund, it would be as a low-cost way to bet on the managers’ ability to exclude specific bonds that will underperform (e.g., due to credit troubles) rather than as a way to bet on somebody’s ability to predict interest rates. But personally, I’d prefer to just stick with my index funds rather than make any such bets.

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