john,
This is an excellent question and our Investment Committee has just reviewed this fund so I can share some of our findings.
Data source Bloomberg June 2001 to Feb 2011
The annualized average return was 4.41%pa compared to One Month Libor in Euros which was 2.67%pa.
So, on the face of it, this seems like a good strategy....
However, the worst one year return for the fund was -2.44% for the period 11/07 to 10/08.
Remember that risk and return are related. If you want a higher expected return, you have to be willing to bear more risk. Risk in this sense means risk of loss.
So, a "traditional" saver looking to get out of a bank account because of the risk, could be jumping out of the frying pan and into the fire.
Bonds have a role within a balanced and diversifed portfolio to reduce risk and provide liquidity but they are not an alternative to a bank deposit.
Two factors explain the majority of returns from a fixed interest portfolio as follows:
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Credit Risk - The quality factor describes how low-grade obligations have higher expected returns than high-grade obligations.
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[FONT="]Duration risk - The term factor describes how long-term bonds have higher expected returns than short-term bonds.
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[FONT="]We believe, however, that these risk premiums have not been large enough historically to reward the additional risk. Therefore, we believe fixed interest is best kept short in maturity and high in credit quality. [/FONT]
The Vanguard fund scores well on the credit risk with an average rating of Aa3 (Moody judges obligations rated Aa to be high quality, with "very low credit risk")
When looking at the term structure, although 57% of the bonds have maturities of 5 years or under, the fund is exposed to some longer-term bonds and therefore if and when interest rates go up, this fund will suffer. Maybe not as much as some other funds but we would recommend not exceeding terms of 5 years in a bond fund.
Finally, additional diversification can be obtained by buying non-euro area bonds and hedging the currency risk back to Euros.
So, although this is a good fund, we would recommend the
Dimensional Global Short-Fixed Interest fund in preference.