This month, BFI speaks with Vanguard Portfolio Manager Chris Wrazen, who runs Vanguard's Short-Term Bond Index Fund. He discusses a number of issues in the short-term bond and index fund marketplace, including supply, yields, flows, and the challenges in tracking bond indexes. Our Q&A follows. (Note: This "profile" is reprinted from the November issue of our Bond Fund Intelligence publication. Contact us if you'd like to see the full issue, or if you'd like to see our new Bond Fund Portfolio Holdings product. Also, let us know if you'd like to see the about-to-be-released preliminary agenda for our upcoming Bond Fund Symposium conference, which will be in Los Angeles, Calif., March 22-23, 2018.)

BFI: How long have you been running short-term bond and index funds? Wrazen: We launched Total Bond [Index] fund back in 1987, so we have about 30 years or so of experience with bond index funds. With respect to the front end, we launched Short Index in 1994, so about 23 years with the "maturity tranched" suite of funds out there.... I have been at Vanguard since 2004 and in fixed income since 2008.... The first five years or so, I was on the active side, focused on structured products. Then for the last five years, I have been on the index side.

BFI: Tell us about index funds in general. Wrazen: On the fixed income side, it's a little bit different than equities because you can't just go and buy a basket of securities to replicate the benchmark. The fixed income market is still primarily traded OTC, so a lot of it is still voice, over the phone. We do leverage some electronic trading platforms, but even so, the liquidity in the space is such that you couldn't just go out and buy the whole benchmark.

So anytime we have a subscription, we need to decide which securities we want to buy. Even though it's an index product, at the security level we are going to be putting on overweights and underweights. Granted they will be very small. But we do want to be very deliberate about those securities that we have small overweights and underweights in.

BFI: How's the fund been doing lately? Wrazen: Performance has been really strong, and tracking has been really tight. Year to date, we're within 2/10ths of a basis point of the benchmark for short index. We're outperforming the benchmark by a fraction of a basis point. But overall, the space has been doing pretty well.

Wrazen: Granted, rates have been very low. We've been averaging, over the past five years or so, one and a quarter percent 'ish', very much in line with the benchmark.... The slowly rising interest rate environment, I think, is the ideal environment for a short bond fund. You don't have a lot of duration, but you do want to see that incremental carry pickup over time as you're reinvesting coupons and maturities.... Flows have been really robust. Our Short-Term Bond Index Fund has grown to over $50 billion, and year-to-date we have seen about $4 billion.

BFI: Tell us about your other offerings. Wrazen: We have our Short-Term Bond Index, which is the one we have been talking about. But we also have a Short Corporate Index Fund as well. There's both a traditional share class and an ETF share class.... It is very similar to Short Term Bond Index, in that it is 1-5 year. But the difference is our Short-Term Bond Index is a government & credit fund; it is about 70% or so government or government-related securities and about 30% credit bonds. Our Short Term Corporate Bond is 100% credit.

Wrazen: If you just isolate that 30% or so in Short Term Bond Index that's corporate credit, and scale that up to the whole fund, that is pretty much what we get in the Short Term Corporate Fund. Because it's entirely corporate, it does have a higher yield.

BFI: What's your biggest challenge? Wrazen: The short-term funds are more challenging to manage because you do have that dynamic of legacy 10 year and 30 year bonds that are rolling down into the 5-year part of the curve. When that happens, sometimes you have these big chunky issues that [do not have] a whole lot of liquidity. But they are in the benchmark now, so it creates an underweight that we need to fill or find a way to proxy.... To the extent the liquidity is not there, we have to come up with proxies, or different ways that we can basically get a comparable risk exposure and continue to have the fund track.... The market has been supportive, with the new issue pipeline being so robust.

Wrazen: So we have been able to get a lot of risk on through the new issue market and haven't had a need to lean on secondary liquidity quite as much. That's been a little bit of a mitigating factor. If the new issue market were to shut down and we continued to have these kinds of flows, the secondary liquidity could be a bit of a challenge.

BFI: Tell us more about the strategies you use? Wrazen: Short Term Bond Index is a 'govt-credit' fund, so it invests in government and government related securities. It's Treasuries and also includes agencies as well. Between Treasuries and agencies, that makes up about 65%, about 60% 'govies' and about 5% agencies. The remaining 35% is investment grade credit, mostly corporate credit, which includes financials, industrials and utilities. But there is also an 8% slice of the fund that is 'non-corporate' credit as well.... It's a Bloomberg Barclays Index..... It's all investment grade, so it needs to have a composite rating of at least low triple-B. This specific product doesn't include mortgage-backed securities; it doesn't include ABS or CMBS.

BFI: Talk about the ETF version. Wrazen: It is actually a pretty sizeable ETF share class as well. I mentioned the fund has about $50 billion in assets. Around $20 billion or so of that is in the ETF share class.... To answer the question about how investors choose which one [fund or ETF], the ETF share class does have a lower expense ratio than the Investor shares of the traditional mutual fund. So if you are a long-term holder and you are just trying to get a lower cost, but you don't meet the criteria for the Admiral shares, you can look to the ETF share class. Some investors like the flexibility to be able to get in and out of the market throughout the day too. If you are going to invest in an ETF share class, I think you have to have a pretty good understanding of the premium-discount dynamic that is in play with ETFs.

BFI: Are you worried about big inflows? Wrazen: It has definitely been incredible, the amount of flows we have seen, and it really seems like it's not subsiding any time soon. It just continues month after month. To answer your question ... I'm less concerned about it. I don't think it's really performance chasing or anything like that. The market is relatively comfortable with the fact that even if interest rates go up, they're unlikely to go up drastically in a short amount of time.... I think it's more of a structural shift. You have this demographic, this aging population. There is always going to be demand for fixed income. If you are talking about a front-end product like the Short-Term Bond Index, I think it is always going to have demand as people use it as a cash proxy.

BFI: What kinds of investors are interested in this space? Wrazen: It's pretty much across the board. There is definitely retail demand and a big portion of Vanguard's investor base is retail. But we also have a very strong institutional presence. This includes anything from corporate treasury accounts to DB or DC assets. We just had an institution move over $1 billion dollars or so into short index within the past year... As they move their previous holdings from whatever institution they were with before, they are kind of 'mapping' them into our most similar offerings.

BFI: What about regulations? Wrazen: From a regulatory standpoint, I think most of the trends that we are seeing are very index friendly, [such as] all these rules coming out on transparency. You also have the 'fiduciary rule' still lingering out there. They are all regulations that are very supportive of index products. I think that is a major part of what is driving this structural shift toward indexing, just an overall alignment of the way money managers manage with the interests of investors, which again is a great trend for the market and a very supportive one for Vanguard and our index funds in particular.

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