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A 'late' Vanguard Group joins crowd selling ultra-short bond ETF --managed by humans -- after money markets refuse to rebound

In a zero-interest Covid-19 economy, the Malvern, Pa. giant is going out on risk curve a touch for an ETF and pocketing about 20% of the yield.

Thursday, March 18, 2021 – 3:27 AM by Oisin Breen
Jeffrey DeMaso: Vanguard is a little late to this game.

Brooke's Note: The amount of attention paid to how much an investor can earn risk-free, or relatively so, is mind boggling. Right now, you might make 50 basis points -- although not entirely without risk. The Nasdaq was up about 43% last year or about one lifetime's worth of 2021 risk-free cash returns. That said, the investments business is about meeting customer demand as much as guiding it. Given all that, Vanguard made a play that most firms of its ilk made in one shape or other. But Vanguard is Vanguard, so we're taking an extra-careful look. 

Reaching beyond its comfort zone to solve an uncomfortable dilemma, Vanguard Group is launching an actively managed ultra-short bond exchange traded fund (ETF) to fill a void created by cratering interest rates.

Daniel Wiener
Daniel Wiener: It sets the stage for Vanguard to put other active funds in the ETF wrapper.

The Malvern, Pa., giant's new ultra-short bond ETF was announced Jan. 19 and will launch this summer -- signaling a renewed push for marketshare in the ultra-short bond market. See: Vanguard's shuttering of municipal money market funds sends clarion call to RIAs to get ahead of COVID-19 squeeze, even if Schwab and Fidelity see fit to ride out the storm.

"Ultra-short bond funds are due a second golden age, The party is still getting started," says Peter Crane, president of Westborough, Mass., money-market fund tracker Crane Data.

Typically, the duration of bonds in these funds is between three-months and one-year, meaning that sharp interest rate moves have a relatively minimal effect on the underlying value of the securities.

The US central bank also said in its latest statement that it would keep rates steady near zero until it sees an uptick in inflation above 2%. It cut the Fed Funds rate to nearly zero in March a year ago when the COVID-19 pandemic slammed the economy.

Chasing returns

"[But] Vanguard is a little late to this game [and] the larger play is to launch more active bond ETFs ... The motivation for launching the [ultra-short] is in response to the lack of income coming from money market funds," says Jeffrey DeMaso, director of research for Newton, Mass.-based RIA Adviser Investments, in an email.

Ben Johnson
Ben Johnson: [ETFs are now Vanguard's] vehicle of choice for index and high-capacity active strategies.

Yet Vanguard rejects the idea that it's merely chasing a burgeoning trend for active ETFs.

"We don’t bring new products to market simply based on current market trends … [or] overly narrow or trendy mandates," says spokesman, Freddy Martino, via email.

That said, dwindling yields available through money market funds certainly left Vanguard with a gap it needed to fill, says Crane.

"Investors in the past have shown they don’t mind low yields, but zero they can’t tolerate. Once they hit zero the money leaves," he says.

The Vanguard Cash Reserves Federal Money Market Fund Admiral Shares (VMRXX), for instance, yields just one basis point, as of Mar. 15.

In January 2020, before the Covid-19 pandemic hit, Vanguard’s now defunct prime money market fund yielded 1.68% -- 167 basis points more than VMRXX, the fund investors were shifted into when the company closed its prime fund last August.

Filling a pot-hole

"The [new] ETF is intended to serve as a short-term liquidity solution for investors that have cash needs six to 18 months out, bridging the gap between money market funds and short-term bond funds," Martino explains.

Freddy Martino
Freddy Martino: [It] bridg[es] the gap between money market funds and short-term bond funds.

It does the job, but it's important to remember that Vanguard created the very pot-hole it's now filling, says Frank Bonanno, managing director of New York cash brokerage StoneCastle, via email.

"It was a void they created themselves [with fund closures]," he says.

Vanguard closed a number of money market funds in the past twelve months, particularly municipal bond funds. It also closed VMRXX to new investors. See: Vanguard's shuttering of municipal money market funds sends clarion call to RIAs to get ahead of COVID-19 squeeze.

Vanguard's first active bond ETF will invest in a mix of top rated and ‘medium-quality’ corporate and government bonds with an expected duration of one year.

The company has not launched an active ETF since 2018, but it expects its new ETF will attract investors by "bridging the gap" between low risk, low yield money market funds and higher risk, higher-yielding bonds, the firm states.

Moreover, if its new ultra-short bond ETF hits the ground running, fresh active ETF launches will swiftly follow as part of a bid to establish a dominant position as an active fixed-income ETF vendor, says Daniel Wiener, chairman of Adviser Investments, via email.

"It sets the stage for Vanguard to put other active funds in the ETF wrapper [and] I expect to see a Core Bond ETF in short order if this goes well," he says.

Price wars

The good news for Vanguard clients is that the ultra-short fund will yield about 49 basis points (bps) on an annualized basis. In contrast, Vanguard's six money market funds (three taxable; three tax exempt) return a one-year annualized average between 20- and 34-basis-points. 

The good news for Vanguard is that it can expect demand for its new product to justify its fee.

Vanguard has an immediate advantage over most of the existing field because the expense ratio of its new ETF is 10 bps, less than half the average of 22 bps for ultra-short ETFs, Morningstar reports.

The company is living up to its reputation for doing better than the market demands, says Ben Johnson, director of global ETF research at Chicago-based Morningstar, in an email.

"[It’s] a price point that we’ve come to expect from Vanguard."

That said, other fund giants are increasingly willing to enter into price wars on similar products against the $7.2 trillion AUM asset manager.

Pete Crane
Peter Crane: [Investors] don’t mind low yields, but zero they can’t tolerate. Once they hit zero the money leaves.

Vanguard's ETF will be joining 33 other similar ETFs on the market, according to Morningstar. 

The cheapest among them is the iShares® 0-3 Month Treasury Bond ETF (SGOV) at 3 bps and the iShares Ultra Short-Term Bond ETF (ICSH) at 8 bps. The Invesco Treasury Collateral ETF (CLTL) also comes in at 8 bps. 

Crane Data Principal Peter Crane says what ultra-short bond funds net out in revenues is harder to track because of the way they are traded.

"[With ultra-short bond funds] it’s easy to hide 20- or 30-basis-points just by changing your strategy a bit, and investors aren’t going to understand that’s going to entail more risk."

"But nobody cares about risk any more, because everything keeps going up," he adds. 

Competitive response

Vanguard’s decision to launch an ultra-short bond ETF also sparked a response from several asset managers with similar funds already available on public markets.

Sue Thompson
Sue Thompson: the ETF with the lowest expense ratio doesn’t always have the lowest cost of ownership.

Indeed, Sue Thompson, head of SPDR Americas Distribution for Boston-based State Street, which sells four ultra-short ETFs with expense ratios ranging from 13.5 bps to 20, says investors ought not be lulled by cheaper headline costs.

"State Street is committed to reducing fund costs where possible … [but] the ETF with the lowest expense ratio doesn’t always have the lowest cost of ownership," she explains.

State Street’s ultra-short ETFs took in $4 billion in 2020, 16 times the $247 million they brought in throughout 2019, and 15% of the $26 billion in net new asset flows that surged into ultra-short ETFs last year.

Not all ultra-short bond funds will manage to deal with increasing inflation sparked by the Biden government's impending fiscal stimulus either, says Ed Lopez, head of ETF product for New York-based VanEck.

"There is a growing recognition of the upward pressure on inflation that may come from stronger economic growth and expectations for more fiscal stimulus, and the potential impact on fixed income portfolios," he explains, via email.

Boston-based Fidelity Investments declined to comment specifically, but a company spokeswoman says that its costs are "competitive" and that when combined with the quality of its service, its ETF business line is "unmatched."

BlackRock did not respond to a request for comment.

Several robo-banks have also stepped up with higher yields than ultra-shorts can offer, and with less risk.

Palo Alto, Calif., robo-advisor Wealthfront, Goldman Sachs retail bank Marcus and New York RIA cash sifter MaxMyInterest pay yields of 35 bps, 50 bps and 60 bps, respectively, on FDIC-insured balances.

Established strategy

The new Vanguard ETF fits an established company strategy for periods of notably low interest yields.

Frank Bonanno
Frank Bonanno: It was a void [Vanguard] created themselves.

Vanguard launched its comparable ultra-short mutual funds in 2015, when rates hovered around 10 bps. Today, these funds manage a cumulative $17.5 billion.

It makes sense to press hard into ultra-short bonds during a rate depression, says Crane.

"Each time rates hit zero, and money market funds are further restricted, ultra-shorts get a boost," he explains.

Of Vanguard's two ultra-short mutual funds, its Investor Shares fund (VUBFX) carries an expense ratio of 20 bps, and its Admiral Shares fund (VUSFX) 10 bps.

By year-end 2020, the funds had returned 10.1% over five years, almost double the return produced by Vanguard's Federal Money Market fund (5.6%), according to Crane Data.

The new ETF will "be separate from, but have a similar strategy to the existing mutual fund[s]", according to a release. See: Into the PIMCO void, Vanguard re-applies itself to active fixed-income funds.

Ultra-short bond ETFs took in $26 billion in 2020, according to Morningstar. The ultra-short bond market grew 21% on average, as against 11.5% for the wider bond market, according to Crane Data.

Domestic investors hold $76 billion in ultra-short bond ETFs, according to Bloomberg.

The active ETF market overall remains in its infancy, with $193 billion in managed assets, as of January -- 3.5%* of the approximate $5.5 trillion held in ETFs, overall, according to Morningstar Data.

Yet today active ETFs account for $300 billion, an 55% increase in just two months.

Too many cooks

Beyond the firm's new ETF, Vanguard has also just abandoned its multi-year pursuit of a retail fund management (FMC) license in China, citing a "crowded" market. See: Vanguard shifts Asia focus to China's vast mom-pop retail market.

It continues to chop and change management of several of its large mutual funds, too.

On Mar. 2, Vanguard dumped San Francisco-based Jackson Square Partners from the management team for its US Growth fund.

Poor long-term performance and too many cooks in the fund's kitchen prompted the move, according to Wiener.

In late January, it narrowed the focus of five funds, including US Growth and Energy funds, then merged its $1.1 billion AUM US Value Fund into its $96.9 billion AUM Value Index Fund.

By folding the Value Fund into its smaller sibling, Vanguard also put the in-house quants who managed it on notice, says Wiener.

"Vanguard's quant funds have been sucking wind for a while now," he says, via email.

The company remains the largest global fixed-income asset manager with $2 trillion under its management.

Domestically it manages $1.5 trillion in fixed income funds, 2.3 times the $643 billion sum managed by BlackRock, and four times the $379 billion managed by Fidelity.

Some definitions of "active" ETFs include strategies like smart beta, and ESG, which, if included, brings the total percentage of the ETF market held in active funds to 30%, according to Bloomberg data.

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