What ETF Index Funds are offered by Vanguard and How to Choose Funds?

The Vanguard UK platform sprang onto the scene a few years ago as a low cost online broker with a solid reputation. Their SIPP offering gained a lot of exposure in the financial press as they were one of, if not the lowest cost SIPP platform om the market. In this article we will get to grips with their ETF Index funds, their risks and how they combine together in a portfolio. This guide should help you get familiar with the relationships between funds and familiarity with the contents of each fund.

Here are the eighteen Exchange Traded Funds available in the Vanguard Direct account arranged as a tree on its side with the trunk on the left and the leaves on the right. Each fund has a four-letter codename called its ticker and these tickers and short descriptions of each fund are on the branch labels. I’ve cut the tree into five groups based on how often their prices move up and down together. ETFs whose prices behave similarly are grouped closely together in the tree.

PLEASE NOTE: All of the Information below about these Vanguard funds may be somewhat out of date as far as exact amounts for volatility etc but they will still be fairly accurate in terms of comparing risk and the descriptions of the funds themselves.

Legend:-

• Green: Lower risk/volatility (< 8%)

• Blue: Low risk (< 9%)

• Amber: Medium risk (< 10.5%)

• Pink: Med/Higher risk (< 11.5%)

• Red: Higher risk (< 13.5%)

Dollar Bonds

This branch is associated with safety and capital preservation. That’s because it contains bonds that trade in US dollars which is linked to the World’s largest and safest economy. Two of these funds are closely related because they contain two types of US domestic bonds. These are VUTY which contains US Treasury bonds which are ultra-safe loans to the US government, and VUCP a fund of US dollar-denominated corporate bonds which are loans to large and financially strong US companies. The riskier wildcard in the group is VEMT which contains loans to Emerging Market governments issued in dollars.

Euro Bonds

Relatively low-risk investments as for the other bond branches in the tree. It’s split into two funds that contain loans to European governments (VETY) and large and relatively safe European companies (VECP).

Shares outside the UK

Compared to the bond funds this branch contains share funds. Shares are risky but provide the largest returns over the long term. Notice that the structure of this branch is geographic. The US has by far the largest stock market so “All World” funds tend to track the US quite closely and are grouped together. Developed Europe with (VEUR) and without the UK (VERX) and the FTSE 100 (VUKE) are on a separate branch from the All-World (VEVE, VWRL, VHYL), US (VUSA), North America (VNRT), Japan (VJPN), Asia Pacific excluding Japan (VAPX) and Emerging Market (VFEM) stock funds.

UK Mid-Cap Shares

Just one fund on this branch VMID which contains UK mid-cap shares. The FTSE 100 contains the largest stocks listed on the London Stock Exchange which are multinationals that generate most of their earnings outside the UK. The FTSE 250 are the next largest 250 companies and these are more domestically oriented and linked more strongly to the strength of the UK economy.

UK Government Bonds

The safest branch for UK investors contains just one fund, VGOV, which contains UK government bonds. These are loans to the UK government denominated in sterling. The UK government has never defaulted in centuries, so these are seen as ultra-safe. They are doubly safe for UK investors because they have no currency risk: if Sterling strengthens all the non-UK bonds will fall in value (such as VUTY the dollar-denominated US government bond fund). Not so VGOV. Although it won’t generate huge returns the risk of losing money on VGOV is very limited so this adds a safety cushion to your portfolio.

Diversification of Risk

If you are building a portfolio the idea is to keep a lid on risk by choosing a mix of funds that have the potential to move in opposite directions during a downturn. If you add too much money to just one branch, say the ex-UK share branch, this will have the effect of increasing the risk of your portfolio. That’s because spreading your money across different branches diversifies your portfolio.

For example, if you split your money between VWRL the FTSE All-World fund and VHYL the FTSE All-World High Dividend Yield fund you are just doubling up your risk as the two move up and down together almost all the time. If instead, you combine VWRL with VGOV the UK Government bond fund you will reduce your risk. This is because the prices of VWRL and VGOV don’t move up and down in tandem so they dampen the overall price fluctuations of your portfolio. This is risk-based diversification.

There is a separate but necessary exercise you can do to figure out your risk profile. This is in production at the time of writing but you can sign up on the homepage of this blog and we will let you know when you can try it out. It really is important to figuring out where and what you would be happy to invest in.

The Vanguard Funds

Here are the Exchange Traded Funds offered by Vanguard sorted by the typical daily percentage price movements, or volatility. This is a measure of risk, and we rank the funds from safest, with the lowest volatility, to riskiest with the highest volatility. The images below show the fund ‘ticker’ (code) and where it sits in the risk/reward performance in comparison to the other funds. (The fund in focus will be more prominent in the image.) The higher up the better the recent return, but the further to the right the riskier it is.

The safest fund is the UK Government bond fund VGOV with a volatility of 6.4%, which means that the typical annual move in the price of VGOV is just 6.4%. At the other end of the risk spectrum is the Emerging Markets fund VFEM with a typical annual move of 13.2%. The funds in between these the max/min volatile funds form a fairly straight line from 13% to 6% and the volatility % id given for each…

The funds are listed here in order from riskiest to safest (but remember, risk here means ‘volatility’ in price. It doesn’t necessarily reflect on the returns achieved)

VFEM: FTSE Emerging Markets (Volatility 13.2%)

Asset Type: Equity / Index Tracked: FTSE Emerging Index / Fee Per Year as % of Amount Invested: 0.25%

Inception Date: 22 May 2012 / Total Assets: $1.6 Billion / Income Dividend paid: quarterly

This fund buys stocks in Emerging Markets, and a look at the geographic breakdown of the FTSE Emerging Index shows that it is most heavily invested in China (29%) and Taiwan (14%), with the next three largest exposures lagging far behind: India (12%), Brazil (9%) and South Africa (8%). This dominance is driven purely by the size of the Chinese stock market which is the second largest in the World behind that of the USA. If we break down the index by industry it is dominated by financial companies (30% in companies such as banks and insurance companies) and Technology companies (15%).

Emerging Market is a rather outdated label as it applies to a very diverse group of countries ranging from a superpower to small, technologically underdeveloped countries. EM is considered risky because:

* Some EM countries are politically unstable and this creates instability in share markets.

* Emerging Markets are very strongly linked to global growth. If global growth fades EM markets are often hit harder than Developed Markets.

* Crises such as debt crises, epidemics, wars, currency instability, and bouts of high inflation tend to occur most often in EM.

China expert George Magnus had some interesting, and unsettling, comments about Chinese stock indices which you should be aware of:-

Politics is becoming a bit of a headwind now because of the growing role of the party and of political interference and political intervention over the course of the economy and of what companies do, and can do and are allowed to do. So this is another reason why investors need to be a little bit wary about what they are getting exposed to because of the political intrusion of the regulatory intrusion not just from outside the company, which is something that we all are accustomed to, in the UK, US and Europe and so on, but regulatory intrusion from inside the company as a consequence of the growth of the influence of the party.

George also expressed concern that openness and liberalisation has taken a step backwards recently:

So we have a sort of a strange situation in China where the market does exist but it is a sort of caged phenomenon within a kind of a state directed system which if anything the current leadership under Xi Jinping is actually moving further away from openness and liberalisation and more towards emphasis of state and party control.

Optimists would note that China is becoming the mainstay of global growth, contributing about a third of the total global economic growth at the moment. China’s growth of between 6% and 7% does not translate directly to share price growth of 6% to 7%, but if you think over the very long term this higher rate of growth in China specifically and EM more generally means it is worth considering if you can stomach the risk.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. Its value will also depend on the strength of its various EM currencies versus the dollar.

VAPX: FTSE Asia Pacific excluding Japan (Volatility 12%)

Asset Type: Equity / Index Tracked: FTSE Developed Asia Pacific ex Japan / Index Fee Per Year as % of Amount

Invested: 0.22% / Inception Date: 21 May 2013 / Total Assets $310.5 Million / Income Dividend: paid quarterly

The FTSE Asia Pacific (excluding Japan) index is split between five countries: Australia (40%), South Korea (30%), Hong Kong (22%), Singapore (7%), New Zealand (1%). The region is often abbreviated as APAC, pronounced “A-Pack”.

Breaking down the exports of any of these countries will show that they are hugely dependent on China. For example 35% of Australian exports in 2016 went to China and 60% of those exports were iron ore to feed Chinese steel mills. A quarter of South Korea’s exports in 2016 went to China composed of integrated circuits (17%) and LCDs (10%).

One way to think of this index, then, is as a Developed Market wrapper around Chinese growth. Bear in mind that if China stumbles these economies will be dragged down heavily. But if Chinese growth holds up companies in APAC will

prosper. If you look at the risk-return graph you will see that the risk of VAPX is lower (further to the left) than the emerging market fund VFEM but so is the return (lower down).

The base currency of this fund is US dollars, and the stocks in the fund will be in a variety of currencies, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar but it will also be

affected by the strength of the US dollar versus the Australian dollar, the Korean won, Hong Kong dollar, Singapore dollar and New Zealand dollar.

VERX: FTSE Developed Europe excluding UK (Volatility 11.5%)

Asset Type: Equity / Index Tracked: FTSE Developed Europe ex UK Index / Fee Per Year as % of Amount Invested 0.12% / Inception Date: 30 Sep 2014 / Total Assets: €869.0 Million / Income Dividend: paid quarterly

The FTSE Developed Europe (excluding UK) index is dominated by stocks of three countries that make up two-thirds of the index: France (22%), Germany (21%) and Switzerland (18%). Most of the countries in the index are in the eurozone which depends heavily on internal free trade which carries no tariffs or currency risk. Europe was impacted by the growth fallout of the Global Financial Crisis in 2008/9. Then it was struck again by the European Sovereign debt crisis in 2011/12 which was a result of southern European countries such as Greece, Portugal and Spain borrowing too much.

Europe is finally emerging from this double-blow and financial indicators such as growth, Purchasing Manager Indices and the German Ifo index are looking very positive. After Brexit, there was a concern that other European countries would also consider leaving the European Union and that the single currency, the euro, was under threat. Instead, it seems that the desire to remain in the EU and eurozone remains, but that separatist movements, such as Catalonia in Spain, may still pose a threat. Almost every country has one or more regions that have separatist movements. However, the EU itself opposes such movements, as we saw in the case of Catalonia, and Europe continues to grow for now.

European equities reflect this strong growth and sentiment as can be seen in the risk-return graph below. This is based on data since VERX was created in 2014 and shows an annual return of 8% and volatility of 16% over this period.

Remember that this fund buys shares denominated in euros so its value will increase as sterling weakens versus the euro and decrease as sterling strengthens versus the euro.

VUSA: S&P 500 (Volatility 11.3%)

Asset Type: Equity / Index Tracked: S&P 500 Index / Fee Per Year as % of Amount Invested: 0.07% /

Inception Date 22 May 2012 / Total Assets: $19.3 Billion / Income Dividend: paid quarterly

The S&P 500 is an index of the 500 largest stocks in the US. A sector breakdown (sectors are industries) shows that technology makes up a quarter of the index which is reflected in the top four stock weightings which are Apple (3.9%), Microsoft Corporation (2.9%), Amazon (2.0%) and Facebook (2%). There is a high concentration of capital, almost two thirds, focussed in the top four sectors of Information Technology (25%), Financials (15%), Health Care (14%) and Consumer Discretionary (12%). Consumer Discretionary goods are desirable but non-essential goods such as fancy clothes, entertainment and sports cars and include stocks such as Amazon, Home Depot (a bit like B&Q in the UK) and Walt Disney.

The risk-return graph shows that since inception in 2012 the VUSA fund has returned 11.4% on average each year with a middling risk, or volatility, of about 14%. This is a blistering rally and not typical of the long-term history of the index which would be about half this return. This has been fuelled by ultracheap lending and a bounce following the Global Financial Crisis in 2008/9. Valuations are now very high in the US.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar.

VNRT: FTSE North America (Volatility 11.2%)

Asset Type: Equity / Index Tracked: FTSE North America Index / Fee Per Year as % of Amount Invested: 0.10% / Inception Date: 30 Sep 2014 / Total Assets: $109.0 Million / Income Dividend: paid quarterly

The VNRT FTSE North America fund is very similar to the VUSA US S&P 500 fund. The correlation between the two is extremely high, such that in 2017 the two funds moved in the same direction each day 97% of the time.

The geographical split of the index is 95% US stocks and 5% Canadian stocks, but the addition of a tiny bit of the Canadian stock market to the mix adds little to either risk or return, as you can see in the plot below. Note how close to one another VNRT and VUSA lie. They are also close together in the relationship tree, which reflects the fact that by buying both you would essentially be buying more of the same thing and not adding any diversification to your portfolio.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. The stocks in which the fund invests are denominated in Japanese yen, so this is a currency hodge-podge.

VJPN: FTSE Japan (Volatility 11.1%)

Asset Type: Equity / Index Tracked: FTSE Japan Index / Fee Per Year as % of Amount Invested: 0.19% / Inception Date: 21 May 2013 / Total Assets: $1.5 Billion / Income Dividend: paid quarterly

The VJPN FTSE Japan fund contains about five hundred of the largest Japanese stocks. It is dominated by car manufacturers, and this is not surprising given the importance of the car industry to Japan. The two primary export destinations for Japan are the US and China which in 2016 were running neck and neck (US 22% and China 19% with South Korea a distant third at 8%).

Japan has been suffering from bouts of deflation and low growth for a very long time. Prime Minister Shinzo Abe came up with three “arrows” in 2013 to turn around Japan’s economy and although people were cynical it now seems to be paying off, although this might be due to a pickup in the global ecnonomy. The arrows were:

1. Monetary Policy: The Bank of Japan sets the interest rate and it has had an extremely aggressive Qualitative and Quantitative Easing programme (QQE). Unlike other central banks it has bought not only Japanese government bonds but also Exchange Traded Funds linked to the Japanese stock market. The volume of ETF purchases is staggering: the annual purchase target at the end of 2016 was set at ¥6tn which is about £40 billion.

2. Fiscal Policy: This is the Keynesian idea that in a recession the government should pour money into the economy to stimulate growth. Abe’s government increased funding for public works, help for small businesses and higher defence spending.

3. Structural Reform: Of the three arrows this is the most important but takes the longest. For example women in Japan have low presence in the workplace compared to, say, the US and this reduces the number of economically productive people in society. Japan has strict immigration laws so that Japanese mothers can’t get inexpensive nannies from abroad to look after their children while they work so childcare is an issue which these reforms addressed by making it more widely available. Another action was cutting corporate taxes to make companies more profitable and able to invest more to grow their future profits. Trade reform came in the form of the Trans Pacific Partnership, but this arrow also included loosening laws intended to protect domestic industries from foreign competition, particularly in agriculture.

Remarkably for a politician who has pushed through so much reform Abe has been re-elected for a fourth term and markets reacted positively to the news. Japanese equity has finally gained some upward momentum, but as the graph below shows it lags far behind the US at the moment while having the highest volatility since inception amongst all the ETF funds offered by Vanguard.

Remember that this fund buys shares denominated in Japanese yen so its value will increase as sterling weakens versus the yen and decrease as sterling strengthens versus the yen.

VEUR: FTSE Developed Europe (Volatility 10.7%)

Asset Type: Equity / Index Tracked: FTSE Developed Europe Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 21 May 2013 / Total Assets: €1.3 Billion / Income Dividend: paid quarterly

This fund is obviously strongly similar to Developed Europe excluding the UK as you can see in the relationship tree. If you want to diversify your portfolio that means you have to make a choice between these two. Over the period since inception in 2013, this fund which includes the UK has returned 4% per year whereas the version that excludes the UK (VERX) has returned 7.6% since its inception in 2014. With the possibility of the imposition of trade tariffs with Europe which constitutes 50% of UK trade, low productivity compared to Europe and a government in disarray it seems unlikely that the UK can turn its growth story around any time soon.

A country breakdown of VEUR shows that its allocation to the UK is large (28%) because the UK has a relatively large stock market. The UK weight is almost twice that of the next two largest countries France (16%) and Germany (15%).

One consideration in distinguishing VEUR from VERX is currency. The base currency of the fund is the euro because most of the stocks are traded on European stock exchanges. However, the large UK allocation means that the sensitivity to the strength of sterling versus the euro is decreased. The fund will gain in value if sterling weakens versus the euro and lose value if sterling strengthens versus the euro but the currency driven price changes will be smaller than that of VERX.

VWRL: FTSE All-World (Volatility 10.3%)

Asset Type: Equity / Index Tracked: FTSE All World Index / Fee Per Year as % of Amount Invested: 0.25% / Inception Date: 22 May 2012 / Total Assets: $1.5 Billion / Income Dividend: paid quarterly

If you can’t decide which country’s shares to buy or how to split your money between countries then this fund solves your problem by deciding for you. As with almost all share indices the countries are capitalisation weighted, so the biggest markets dominate. This means that by buying this index you will get a very large exposure to North America (54%) and Europe (22%) with only 15% in the “Pacific” region and 10% in Emerging Markets. A country breakdown shows that the US (51%), Japan (9%) and UK (6%) alone make up two thirds of the index.

The relationship tree shows that VWRL forms a tight little cluster with VEVE (Developed World Equity) and VHYL (All-World High Dividend Yield), and a slightly looser cluster with VUSA (US S&P 500) and VNRT (North America) because of the high weighting of US stocks. This means that if you want to diversify your portfolio you shouldn’t allocate too much money in this group of strongly related funds.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. Its value will also depend on the strength of its many and various currencies versus the dollar.

VEVE: FTSE Developed World (Volatility 10.2%)

Asset Type: Equity / Index Tracked: FTSE Developed Index / Fee Per Year as % of Amount Invested: 0.18% / Inception Date: 30 Sep 2014 / Total Assets: $137.1 Million / Income Dividend: paid quarterly

VEVE is extremely similar in behaviour and country exposure to VWRL the AllWorld fund. As you can see if we compare the regional weights the difference is the exclusion of Emerging Markets, but this only constitutes 10% of the world fund, and this difference has not made much difference either in return or in risk.

In theory excluding emerging markets should make the risk and return of VEVE lower than VWRL over the very long term. However, VEVE has only existed since 2014 and VWRL since 2012 and this is not long enough for a fair comparison.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. Its value will also depend on the strength of its many and various currencies versus the dollar.

VHYL: FTSE All-World High Dividend Yield (Volatility 9.7%)

Asset Type: Equity / Index Tracked: FTSE All-World High Dividend Yield Index / Fee Per Year as % of Amount Invested: 0.29% / Inception Date: 21 May 2013 / Total Assets: $595.0 Million / Income Dividend: paid quarterly

If you buy shares you may profit from capital gain if the share price rises above your buying price, and from dividend income as you receive a proportion of the profit generated by the company whose shares you own. VHYL boosts dividend income over capital gains by putting more money into stocks that generate a higher dividend than average.

The price of VHYL moves in tandem with VWRL All-World and VEVE Developed World as you can see in the relationship tree. In contrast if you look at the graph of risk and return below VHYL has a much lower return since fund inception in 2013 of 4% when compared to the All-World fund which returned 9.3% on average since its inception in 2012.

If you’re investing for income you can use a handy measure called dividend yield.

Dividend Yield = Fund Dividend Payment / Fund Price

For example the most recent four dividend payments per share spanning the last year were $0.413, $0.63861, $0.34836 and $0.2947, a total of $1.69, and the price of VHYL is $56.26 then the dividend yield is: –

Dividend Yield = 1.69 / 56.26 = 3.0%

The larger the dividend yield the better because it’s the ratio of income (in pounds) over what you pay for that income (in pounds). This measure of income lets you compare different funds and shares to see which might give you the best income. As we saw there’s no guarantee that dividend won’t be cut to zero tomorrow, so past dividend is only a guide to future dividend.

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. Its value will also depend on the strength of its many and various currencies versus the dollar.

VETY: EUR Eurozone Government Bond (Volatility 9.5%)

Asset Type: Government Bond / Index Tracked: Bloomberg Barclays Euro Aggregate: Treasury Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 24 Feb 2016 / Total Assets: €5.0 Million / Income Dividend: paid monthly.

Eurozone government bonds have a low yield relative to, say, US government bonds at the moment, and consequently, they are not particularly attractive with a dividend yield of about half a percent. The risks of this fund are two-fold: –

Interest Rate Movements: if interest rates rise the value of the bonds within the fund fall, as does that of the fund and if interest rates fall the bond prices and fund price rises. Currency Movements: this fund buys assets that are European government bonds and they are denominated in euros. Sterling investors will gain if sterling weakens versus the euro and lose if sterling strengthens versus the euro.

Annoyingly Vanguard does not give the single most important risk measure for a bond fund: its duration. This is a multiplier that tells investors how much the price of the fund changes if interest rates change. For example, if the duration is one year and rates increase by 1% then the price of the fund will fall by 1 times 1% or 1%. If the duration is five years that same 1% rate rise will push down the fund price by 5 times 1% or 5%.

It turns out that the fund has a duration of 7 years, so it is very sensitive to rate rises and falls. If you think rates are about to rise this is a problem and vice versa if you think rates are about to fall. With wafer thin yields a fall has a lot less leeway than a rise providing a lot of downside for this fund.

On the risk-return plot, you will see that since inception in February 2016 the average annual return has been 5% and volatility has been around 12%. This will have been dominated by the volatility of the currency fluctuations between the euro and sterling which swamp the usually low volatility of the bonds owned by the fund. This fund is not just an investment in European government bonds, it is an investment in the euro.

VUKE: FTSE 100 (Volatility 9.1%)

Asset Type: Equity / Index Tracked: S&P 500 Index / Fee Per Year as % of Amount Invested: 0.07% /

Inception Date 22 May 2012 / Total Assets: $19.3 Billion / Income Dividend: paid quarterly

Most people have heard of the FTSE 100 stock index, as its value is usually quoted in the news. It consists of the 100 largest stocks traded on the London Stock Exchange. That does not mean the companies are domestic UK stocks, far from it. About 70% of the revenues of FTSE 100 companies come from outside the UK as it contains many multinational companies such as HSBC Bank, British American Tobacco, Royal Dutch Shell and BP (global oil companies) and GlaxoSmithKline (a global pharmaceutical company). In order to be such large companies, they must service a global market.

A myth is that the FTSE 100 benefits from the weakening of sterling. The correlation between the FTSE 100 and currency movements such as sterling versus the US dollar shows no relationship at all. A very strong relationship exists with the German DAX index: the DAX and FTSE 100 have risen and fallen together each day three-quarters of the time since 1984. This is because the UK and German economies are driven by common factors as are the earnings of companies in the FTSE 100 and the DAX.

The top five sectors for the FTSE 100 show that it is very heavily skewed towards financial companies (23%), consumer goods (18%) and oil & gas companies (15%). These three sectors make up over half the index.

The FTSE 100 is therefore driven by global growth, but it has the benefit of being denominated in sterling which removes currency risk from consideration for sterling investors. Since inception in 2012, its return has been very poor in comparison with the US S&P 500 fund VUSA while the risk has been comparable with VUSA. Risk-adjusted return is the return (above the risk-free rate) divided by the volatility of the fund. So the return, and, in particular, the risk-adjusted return, of the FTSE 100 has been far lower than the US historically.

VEMT: USD EM Government Bond (Volatility 8.7%)

Asset Type: Government Bond / Index Tracked: Bloomberg Barclays EM USD Sovereign + Quasi-Sov Index / Fee Per Year as % of Amount Invested: 0.25% / Inception Date: 06 Dec 2016 / Total Assets: $160.4 Million / Income Dividend: paid monthly

The primary reason for buying this bond fund is that it has a high income. At the time or writing is approx 4.5%. This is not an earth-shattering income, and it comes with some risks.

Buying the government debt of emerging countries is more risky than the debt of developed countries because the risk of default, or non-payment is higher. This is why the income is higher, to compensate investors for taking the higher credit risk. Emerging Markets are accident-prone: they have frequent currency crises, debt crises, political instability and outright wars. While times are good, as they are now, these crises are less frequent, but they also hit without much warning giving investors little time to sell. So just because we’re enjoying the good times now don’t assume this will always be the case: the music will stop at some point.

The country breakdown of the fund shows a sizeable allocation to Latam with Mexico and Argentina coming top of the list. One of the difficulties of bond funds is that by weighting allocations by the amount of debt issued they naturally lean towards more indebted countries, which may not become problematic in a debt crisis: –

Country Weight

Mexico 7.4%

Argentina 5.6%

Indonesia 5.1%

China 4.8%

Hong Kong 4.6%

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. The bonds held by the fund include several emerging market currencies, so if these weaken versus the US dollar the fund lose value, and if they strengthen versus the US dollar the fund value will rise.

Note that the volatility of this fund is very low, which suggests that its risk is low. This is typical of bond funds that have low volatility particularly if their duration is low. However, the high income should warn you that there are risks, and these include both credit risk and currency risk.

VUTY: USD Treasury Bond (Volatility 8.7%)

Asset Type: Government Bond / Index Tracked: Bloomberg Barclays Global Aggregate US Treasury Float Adjusted Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 24 Feb 2016 / Total Assets: $17.2 Million / Income Dividend: paid monthly

The US Government bond (US Treasury) market is the largest and safest in the World. When there is a crisis the two things that investors flock to are US Treasuries and gold. This is the ultimate safe haven asset.

Because US Treasuries are safe, with top-notch credit ratings of AAA from the credit rating agencies, they provide a low income. They also provide diversification from shares as US Government bond prices tend to move in the opposite direction to US and global shares. While shares fall into the “risk-on” group of assets that investors buy when they are feeling confident, Treasuries fall squarely into the “risk-off” group.

The price of bonds falls as rates rise, and the multiplier is called duration. A 1% rate increase will create a duration times 1% fall in the price of a bond, or a bond fund. The duration of this fund is 6 years so: –

Percentage Fund Price Movement = -6 x Interest Rate Increase

US interest rates are in the process of rising. This means that while you may suffer a fall in the price of the fund, the income you are receiving will steadily increase. The reason for buying Treasuries is to offer this small, but very slowly rising, income while diversifying the equity component of your portfolio.

VUCP: USD Corporate Bond (Volatility 8.6%)

Asset Type: Corporate Bond / Index Tracked: Bloomberg Barclays Global Aggregate Corporate United States Dollar Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 24 Feb 2016 / Total Assets: $84.8 Million / Income Dividend: paid monthly

This is a global credit fund that buys corporate bonds from all over the world. However, because the US corporate bond market is so large it dominates this index. According to Blackrock the size of the various corporate bond markets in 2016 were US $11.4 trillion, Europe $7.9 trillion, China $3.1 trillion, UK $1.2 trillion and Japan $1 trillion. Consequently, the allocation to US bonds is 79% with a long tail of smaller single-country markets such as the UK (4%),

Netherlands (3%), Canada (3%) and Australia (2%).

The duration of VUCP is 7 years which means it has a slightly higher rate sensitivity than the US Government bond fund VUTY (6 years). The return on the fund has averaged 4.5% since inception in February 2016. Its volatility is high in sterling because of the currency risk as sterling fluctuates versus the dollar.

The average credit quality of the fund is A- so it contains investment grade i.e. creditworthy company bonds. The proportion of different credit ratings shows that about half is on the lowest notch above junk, boosting the return of the fund while remaining investment grade: –

Credit Rating VUCP Allocation

AAA 2.1%

AA 9.3%

A 37.6%

BBB 50.8%

The base currency of this fund is US dollars, so its value will increase as sterling weakens versus the dollar and decrease as sterling strengthens versus the dollar. Its value will also depend on the strength of its various currencies versus the dollar.

VECP: EUR Corporate Bond (Volatility 8.5%)

Asset Type: Corporate Bond / Index Tracked: Bloomberg Barclays Euro Aggregate: Corporates Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 24 Feb 2016 / Total Assets: €21.0 Million / Income Dividend: paid monthly

VECP is a European corporate bond fund, and corporate bonds are tradeable loans to companies. The US has the largest corporate bond market in the world, but Europe is slowly closing the gap.

Some companies have very safe income and lots of cash so they are almost certain to be able to repay their debts. Other companies live hand to mouth with large amounts of debt and unstable income. The safe companies can borrow cheaply which means investors make relatively small income from these investment grade companies. Bonds issued by the companies with low credit quality are called junk bonds or high yield bonds.

This fund buys investment grade corporate bonds with an average credit rating of single A- (on a credit rating scale of AAA, AA, A, BBB then we get into junk bonds). Its yield, which is roughly your income from the fund, will be higher than the Treasury fund because of this slightly higher credit risk.

VECP, like the US Government Bond fund VUTY, has interest rate risk. The duration of this fund is 5.3 years, which is lower than the duration of VUTY which is 6 years. Consequently VECP is a bit less sensitive to interest rate changes than VUTY. A 1% increase in rates will drive the price of VUTY down 6% and VECP down by 5%.

Since inception in February 2016 the risk-adjusted return of the fund has been very good, with a 7% return and just 10.7% volatility.

VMID: FTSE 250 (Volatility 7.9%)

Asset Type: Equity / Index Tracked: FTSE 250 Index / Fee Per Year as % of Amount Invested: 0.10% / Inception Date: 30 Sep 2014 / Total Assets: £586.9 Million / Income Dividend: paid quarterly

FTSE splits the UK share market by size. The top 100 by market capitalisation (share price times number of shares issued) are in the FTSE 100. The next largest 250 are in the FTSE 250 and the smallest are in the FTSE SmallCap index. The FTSE 350 is a combination of the FTSE 100 and FTSE 250 and the FTSE AllShare is all the categories combined.

Compared to the FTSE 100 the FTSE 250 index that the VMID fund tracks is more oriented towards UK domestic stocks. This means buying this index will give you greater exposure to UK-specific growth than global growth. If you believe the UK will punch above its weight and domestic companies will reap the benefit then this might be the index to express that view.

From a currency perspective, VMID has no currency risk for sterling investors because all the stocks are traded in sterling on the London Stock Exchange.

VGOV: UK Government Bond (Volatility 5.4%)

Asset Type: Government Bond / Index Tracked: Bloomberg Barclays Sterling Gilt Float Adjusted Index / Fee Per Year as % of Amount Invested: 0.12% / Inception Date: 22 May 2012 / Total Assets: £104.4 Million / Income Dividend: paid monthly

Being boring is often a strength, and the VGOV fund is certainly boring. It has the lowest volatility of all the Vanguard ETFs. For UK investors this fund offers diversification for their equity holdings because it is not correlated to the stock market. In fact if you take a look at the relationship tree you will see that it sits all alone on its own branch which means it has a low correlation to all the other Vanguard ETF funds.

Bonds have low volatility so currency risk is more important as a risk factor than it is for equity funds. This is because developed market currency volatility is usually around 10% to 12% which is often higher than bond volatility. This also affects diversification because correlation for bonds is drowned out by foreign exchange correlation. Fortunately for this fund sterling investors do not have to worry about currency because it’s buying sterling denominated UK government bonds.

The return on UK government bonds is low because they are safe. Since the 1680s the UK has never defaulted on its debt. Well, not officially. In the 1930s there were some technical defaults, but the UK’s credit record is generally clean. Brexit did lead Moody’s to downgrade the UK from Aa1 to Aa2 in September 2017, but few expect a default is even remotely likely. For investors, lower credit risk means lower yield, and the return on this fund is therefore low at just 1.5% per year on average since inception in 2012.

ALL FUNDS RISK/RETURN INCLUDING THE LIFE STRATEGY FUNDS