Barclays Capital 2011 Portfolio Management Conference

Perspectives on Portfolio Management and Fed Policies

Ken Volpert, CFA Head of Taxable Bond Group, Vanguard

A Three Decade Perspective: Decade 1

Early 1980s

Monroe trader Stacks of research in the daily mail Maturity bucketing. Portfolio average maturity Long callable utility bonds Dollar value of an .01 Inside the Yield Book Immunized and cash matched portfolios v liabilities Barra risk model Start of option adjusted durations and spreads Event risk (RJR), LBOs, rapid growth of the high yield market Multi factor risk models (ex ante tracking) Institutional bond indexing Growth of the mortgage market Start of move from DB to DC assets under management

Late 1980s

>2

A Three Decade Perspective: Decade 2

1990s

New tools for managers (PC Product , Yield Book, Wilshire, etc) Bloomberg widely used in the market (becomes a standard for analysis and messaging from sell-side to buy-side) Key rate durations catch on Improved option adjusted measures of risk Scenario analysis Better, broader, and cleaner index data Growth of the securitization market Growth of bond indexing (retail mutual funds) Improved risk models (POINT in the late 1990s) Rapid growth of DC assets under management

>3

A Three Decade Perspective: Decade 3

2000 to 2010

TRACE (bond price transparency) Electronic bond trading (TradeWeb, MarketAxess, Bloomberg, etc) Growth in TIPS issuance and TIPS bond funds gain popularity Greater awareness of idiosyncratic risks (2002 credit cycle Enron, Worldcom, etc) DTS (duration times spread) risk measure Research delivered over the internet, improved real-time data Increased use of derivatives to target risk factors Separation of alpha and beta Hedge fund growth accelerates Ongoing bond index growth Bond ETFs introduced and grow to $150+ billion Global bond funds, EM bond funds The great recession fallout

Reaching for yield performance hits (non agcy MBS) Security lending investment risks

Consolidation of dealers (2008 mergers) Consolidation of managers (Blackrock + BGI) and the move to more global reach by the largest managers LDI (liability driven investing) comes back again

>4

Fixed Income: Looking Forward

2011-2020

Less dealer liquidity (heavy regulation and buy-side too big for sell-side) leading to more agency trading (rewarding those with best distribution networks) Global regulatory convergence Continued growth in bond indexing in US and globally Central clearing, standardization, and risk management needs will lead to increased CDS and other derivatives trading Possible separation of credit and funding in corporate bonds (credit component trading separate from the libor based funding piece) US agency market becomes an orphan market post GSE reform GSE reform and new legislation leads to rapid growth of the covered bond market to support housing. Continued move toward global benchmarks (reduced single developed market dependence) Ongoing sovereign risk management challenges, especially in the major developed markets However, ongoing move toward local currency EM bond markets especially in the largest EM markets Continued buy-side mergers/consolidations to facilitate globalization and scale Bond ETF 3-5x greater growth rate than conventional funds but with fewer ETF offerings than exist today and more sophisticated tools to evaluate total cost Risk of policy of inflating the way out of the debt problems leading to weak bond returns relative to equities.

>5

TIPS Influence on Fed Policy

Provides more clear inflations expectations 5 Year 5 year forward BEI is a good policy tool

>6

Inflation dynamics
Inflation expectations (wages, BEI, Fed credibility) key to stable trend inflation

Source: Vanguard Investment Strategy Group

>7

Trend inflation is low, but upside risks rising

Wage inflation (year-over-year percentage) Commodity price shocks

Wage growth low, but rising

Output gap

M2/monetary base

Output below trend, but improving

Low velocity of money: Hyperinflation fears unwarranted

Source: Vanguard Investment Strategy Group. For additional information, see Vanguard white paper, Recent policy actions and outlook for U.S. inflation, (Davis and Cleborne, 2009).

>8

Asymmetric future CPI inflation risk

Market inflation expectations ~2.5%

IMPORTANT: The projections or other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from Vanguard Capital Markets Model (VCMM), derived from 10,000 simulations for U.S. equity returns and fixed income returns. Simulations as of December 31, 2010. Results from the model may vary with each use and over time. For more information, please see the disclosures slide. Source: Vanguard Investment Strategy Group. For details, see Vanguards Economic and Capital Markets Outlook (Davis et al., 2010).

>9

A positive long-run outlook for the U.S. stock market

Trailing P/Es and 10year forward returns

Forward P/E

Cyclically adjusted P/E

Sources: Shiller, Standard & Poors, and Vanguard Investment Strategy Group. For details, see Vanguards white paper What does the crisis of 2008 imply for 2009 and beyond?, 2009. Note: Trailing P/E ratio reflects the so-called Graham P/E ratio as used by Professor Shiller, calculated as the ratio of the previous years price/ten year average earnings.

> 10

Q&A

> 11