The disabled list: It can be the bane of a professional athlete’s career. And because there are so many injuries in professional sports, players who play in every game tend to stand out and be applauded for their efforts and commitment by coaches, fans, the media, and their peers.

In some ways, the bond index traders in Vanguard’s Fixed Income Group (FIG) are like the “iron men” (and women) of professional sports. When it comes to managing our bond index funds, our traders are very diligent and highly committed to the task at hand. They continuously seek to tightly track our benchmark indexes—and, where possible, add value incrementally to offset some of the costs of managing index funds.

Our approach to bond trading in our index funds

The Vanguard Fixed Income Group (FIG) manages our bond index funds using sophisticated “sampling” techniques to match the fundamental investment characteristics and performance of their benchmarks. (It’s not just impractical—in most cases, it’s impossible to buy and sell all of the bonds in the diversified indexes we track.) Like ballplayers who scour video seeking even the slightest opportunity to improve or gain an advantage, in FIG we’re always looking to refine our sampling approach so we can better match key characteristics of our benchmark indexes.

In addition to careful sampling, a key part of our disciplined, risk-controlled process is our use of float-adjusted indexes. Since a “float-adjusted” index excludes bonds that don’t trade on the open market, it reflects actual, investable markets—rather than theoretical ones.

And to help ensure that FIG is a team of experts, we use a specialist model—as opposed to a generalist model—that allows our traders and portfolio managers to dig deep into narrow slices of the market. (For example, breaking up corporates into communications, energy, etc.). This specialist approach is not unlike any great sports team where every player knows his or her role and executes it flawlessly; in FIG’s case, it means we use the indexing expertise, discipline, and experience of our traders to tightly track each small piece of the bond market—while keeping the cost of index fund management to an absolute minimum.

There are a number of other strategies our traders use to stay on top of their game:

  • By not subtracting value. Trading very efficiently is a basic indexing tenet. Smartly managing cash inflows and outflows, and minimizing unnecessary trading, are just a couple examples of avoiding unnecessary costs in the indexing process
  • Proceeding with caution. In seeking to offset some of the costs of fund management, the team focuses on value-added trades that we believe have a high probability to pay-off – in other words we are looking to hit a lot of singles. Performance attribution tools, in combination with a rigorous focus on risk control, help us determine which trades make sense, and  won’t compromise our ability to tightly track our benchmarks.
  • Investing in new issues, which are similar to equity IPOs. There tends to be an opportunity to add positive performance by purchasing bonds in the new issue market. Under the right conditions these bonds can outperform the broader market from when a new issue hits the market and when it enters the benchmark.
  • Using Vanguard’s size and diversity to our advantage—because our scale tends to present us with opportunities to trade at favorable prices.

Vanguard FIG: We’ve changed—yet stayed the same

I’ve been at Vanguard for close to 20 years, and I’ve seen our fixed income trading evolve over the years. Electronic trading is more prevalent than ever before, and it’s almost certain to continue to expand. Another big change is globalization. Between London, Australia, and our home base in the United States, FIG has become a worldwide operation—with indexing mandates for each of the three sites, and each site trading in its particular time zone and currencies.

Ultimately, I’m glad to say these developments haven’t changed the way we think about our business: We still strongly believe in delivering competitive returns without undue risk and in keeping costs low.

The FIG philosophy aligns with Vanguard’s ownership structure.* Having the freedom to be completely aligned as a fiduciary with our clients is part of what differentiates FIG from other mutual fund companies. Like professional athletes who help their team win by giving maximum effort in every single game, our bond traders are passionate about positioning the funds to deliver the return of the market—and they’re working to incrementally add value beyond the index for the fixed income investors whom we serve.

*Vanguard is client-owned. As a client owner, you own the funds that own Vanguard.

I’d like to thank Wayne Moser for his much-appreciated contributions to this piece.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • Past performance is no guarantee of future returns.