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Bond Indexing Efforts

My team manages Vanguard Total Bond Market Index Funds. If you’re imagining that we let computers do the work, think again. While technology is an important tool, the bond index team is powered by the collective talent and experience of 16 people doing business the old-fashioned way—often by telephone.

That’s why it was a little strange that a Wall Street Journal headline¹ recently asked whether the new “bond king” is a machine. While it’s true that I am hard at work on my very own Iron Man suit, for the time being I am, in fact, human. Occasionally, I even make jokes.

Powered by people

More seriously, as managers of the world’s largest bond fund, we work in one of the more people-intensive areas of the financial markets.

I’m not really sure how the misconception that running a bond index fund is as simple as turning on a computer got started. Perhaps it’s just easy to think that a computer program could replicate an index of 500 stocks with predetermined weights traded with transparent pricing on exchanges.

But humans play a huge role in our stock index funds, and bonds, in many ways, are more complicated than equities. There are no central exchanges for bonds and minimal transparency into their prices. To buy and sell bonds, we often have to call the individual traders and firms that own those specific securities and negotiate prices with less-than-perfect information. It requires that Vanguard analysts and traders are constantly up-to-date on company (or country) fundamentals and trading levels so we get the best execution for our clients.

The bond market is also much bigger than the stock market. Our broad bond market index funds track the performance of the Barclays U.S. Aggregate Float Adjusted Index, which had 8,958 bonds, compared with just 502 stocks for the S&P 500 Index, both as of October 31, 2014. It would be unwieldy for our broad bond market index funds to own that many securities, so we sample the index, meaning we hold a range of securities that together capture the key risk factors of the index, with the goal of realizing indexlike performance.

One company, many issues

Even when we’re talking about the bonds of a single company, our choices are complex. A large company may have 40 unique issues in the index, with different maturities, credit ratings, and other attributes. For example, the same company may issue debt at the holding-company or the operating-company level. The bond index team consists of specialists in various industry sectors who are experts on those issues and understand how they fit in our portfolios.

We hold government, mortgage-backed, and credit securities in just about every industry, so we are constantly striving to match the different categories of index risk in the most efficient way.

We also fight every day for best price execution so we can deliver as much of the market return as possible to our clients, closely tracking the Barclays index. We must constantly balance how much we are willing to pay for or accept on a sale against what the funds need to track the index. Fortunately, we’ve been doing this since 1986, so we have managed these funds through up and down markets, always hewing closely to our index. Clients have been choosing us because few in the industry can rival our long-term record of success.

So robotic, machinelike, computer-driven? Hardly. This is a very human endeavor, driven by some of the brightest people in fixed income.

Now, how about a nice game of chess?

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Notes:

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

All investing is subject to risk, including possible loss of principal.

© 2014 The Vanguard Group, Inc.  All rights reserved.  Used with permission.

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