Young & Invested: Investors are flocking to this ETF. But are they making the right choice?
Higher yields and an increasingly concentrated share market are pushing investors back towards fixed income. The question is whether they’re taking the correct approach.
Mentioned: Vanguard Australian Fixed Interest ETF (VAF)
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Edition 82
There is a reason most investment conversations don’t begin with a discussion on bonds.
For most of the past decade, bonds have struggled to compete for investor attention. Low yields offered little income while equities continued to reward those who took additional risk.
But today’s environment is changing. The pandemic introduced a surge in inflation, which was followed by central banks responding with one of the most aggressive tightening cycles we’ve seen in recent years.
At the same time, governments around the world showed little sign of developing a lasting aversion to spending money. Larger fiscal deficits have increased the supply of bonds available to investors. Normally, rising supply isn’t something investors celebrate. Yet higher interest rates have changed the landscape. Investors are now being paid a meaningful yield. But this alone doesn’t explain the renewed interest.
Global equity market returns have become concentrated around a select group of companies that are tied directly or indirectly to artificial intelligence. Whether the enthusiasm is justified remains to be seen, but it is clear that investors are progressively more exposed to a narrow set of outcomes.
The result is that two things appear to be happening at once. The case for owning bonds has become more compelling on a standalone basis and the importance of diversification is becoming harder to ignore.
As questions continue to emerge around valuations, concentration and the sustainability of AI-driven spending, some might be willing to sacrifice a little excitement in exchange for resilience. Against this backdrop, it is not difficult to see why investors are flocking to bond ETFs. One of the largest beneficiaries has been Vanguard’s Australian Fixed Interest Index ETF VAF.
A quick rundown on fixed interest ETFs
The main attraction of bond ETFs is their simplicity. Rather than having to research individual bonds, monitor credit quality and manage maturity schedules, ETF investors gain exposure to a basket of bonds through a single investment. This can range anywhere from government debt to domestic and international company debt.
Most bond ETFs are also relatively inexpensive, accessible and liquid. They typically charge low management fees, don’t require high minimum investments and can be bought or sold on the ASX throughout the trading day.
But a bond ETF isn’t the same as owning an individual bond. An individual bond has a maturity date and will generally return its face value at maturity (if the issuer doesn’t default). Meanwhile, a bond ETF does not have a maturity date. Its value rises and falls with the market value of the underlying bonds, meaning investors can receive more or less than their original investment when they sell.
Vanguard Australian Fixed Interest Index ETF VAF
- Total Cost Ratio: 0.10%
- Assets under management: 3.9 billion (AUD)
- Morningstar Medalist Rating: Bronze
- Benchmark: Bloomberg AusBond Composite 0+Y TR AUD
- Morningstar Category: Australia Fund Bonds
VAF is among the largest fixed-interest ETFs available on the ASX. The fund tracks the Bloomberg AusBond Composite Index and provides exposure to investment-grade Australian bonds.
Composition
The Australian bond market is dominated by Treasury and government-related bonds, which make up around 90% of VAF’s total exposure. The remaining 10% is allocated to corporate bonds. The portfolio is skewed towards high-quality issuers, with AAA-rated securities accounting for roughly two-thirds of the benchmark. Banks and other financial firms issue most of the credit in the index, followed by industrials.
VAF is considered a fairly conservative option, as its credit risk broadly remains lower than that of the category average. Though the fund’s peer-relative returns have had heightened sensitivity to interest rate changes owing to an underweight duration position among many active peers.
That said, interest-rate sensitivity has fallen in recent years. Duration has declined from around 6.2 years in late 2020 to 4.9 years, which is moderately below the category average. This leaves VAF somewhat less exposed to rising rates than it was during the low rate pandemic era.
Yet the more relevant consideration is arguably risk. The fund isn’t designed to maximise returns, through credit risk, as its exposure remains lower than the category average. Its composition could interest investors who are seeking a stabiliser when risk assets come under pressure.
Performance and fees
As one would expect from an index fund, VAF has delivered benchmark-like returns over time. The fund has historically benefited during periods when government bonds performed well. This includes much of the 2010s and the market turmoil of early 2020.
However, that same conservatism became a headwind when rising yields and tighter credit spreads created opportunities for active managers to add value. We saw this in 2021 and 2022 when a sharp increase in bond yields weighed on returns.
VAF requires investors to accept a trade-off. The fund is unlikely to be the best-performing option in every market environment because by design, it can’t react to changing conditions. Yet one could argue that this same limitation also represents a strength.
Index funds do not require investors to make a judgement on the future of interest rates, credit spreads or the skill of a particular portfolio manager. At a time when a growing number of investors are looking for defensive exposure, that could be an appealing proposition. Especially because the alternative is often making another active bet.
Notably, VAF’s total cost ratio is 0.10% p.a., which places it in the cheapest quintile of funds within the category where the median fee is 0.37% per year.
Active or passive?
For years, the active vs passive debate has been increasingly one-sided. In most categories, the evidence has favoured low-cost passive funds because active managers have struggled to consistently outperform after fees. However, bonds are one of the few asset classes where the discussion is more nuanced.
Our 2026 Active/Passive Barometer report found that active managers in the Australian bonds category continue to hold an advantage across longer time periods. One of the primary reasons for this is flexibility. A passive fund is constrained by the composition of its benchmark. Meanwhile, active managers have a wider set of tools at their disposal.
Managers can alter exposure as rate expectations change and be more selective with the credit market. During periods of market volatility, this flexibility can have a meaningful impact on returns.
Australian bonds remain one of the few areas where active managers can still present a reasonably convincing argument for their existence. But as investors, the challenge is that we don’t get to simply buy active management as a concept. We also have to pick a specific manager.
Though active bond managers have generally enjoyed an advantage, the past year has seen several funds disappear through closures and mergers. This creates a two-part risk where it isn’t just underperformance that is a concern, but also the possibility that the fund may not even survive over the long-term.
Passive bond funds such as VAF solve that problem by opting out altogether and accepting benchmark returns. Our research suggests that active managers generally have more scope to add value in this category, however that does add another layer of decision-making for an investor.
Concluding thoughts
We often discuss the active passive debate as though the objective is to squeeze every possible basis point from a fund. In reality, our portfolios are built to achieve something.
Ultimately, I think the question is less about whether an active manager can outperform and more about what role fixed interest is expected to play in a portfolio. Most investors don’t allocate to bonds because they’re seeking to maximise returns at all costs. They likely require a degree of stability, diversification or income alongside their growth assets. From that perspective, outperforming other bond funds may not be the most important objective.
The case for active management becomes stronger if investors believe their bond allocation should do more than simply provide defensive exposure. However, accessing that potential outperformance requires investors to decide whether the pursuit of additional returns is worth introducing an additional variable into the equation. As always, successful investing is about understanding what you’re trying to achieve and the trade-offs you’re willing to accept to get there.
