Vanguard’s Cheapest Short-Term Bond ETF Costs Just $3 a Year on $10,000. Hardly Anyone Mentions It.

One of the things that really grinds my gears is when investors looking for a cash management vehicle simply default to whatever money market fund their brokerage platform happens to highlight first.That can be less than ideal because a lot of these are older legacy products that still charge fairly high expense ratios. And when your fund is only earning something around the risk-free rate to begin with, even a few extra basis points in fees can materially reduce your yield over time. That is before we even start talking about taxes.

The good news is that you can get performance fairly similar to a money market fund, but with greater liquidity and lower fees, through ETFs. While the net asset value (NAV) per share is not fixed at $1 the way a money market mutual fund is, the actual risk of principal loss for many short-term bond ETFs still remains low enough to satisfy a lot of investors’ risk tolerances.

There is quite a bit of variation in this area, though. If you opt for a 100% Treasury solution, you generally benefit from exemption from state and local taxes along with higher credit quality, but your yields are usually lower. If you are willing to take on a modest amount of credit risk and tax inefficiency in exchange for higher yield, especially inside a tax-sheltered account like a Roth IRA, one option that may deserve a closer look is the Vanguard Short-Term Corporate Bond ETF (NASDAQ: VCSH). Here are a few reasons why I think this ETF is underrated.

What Is VCSH?

For those unfamiliar, VCSH is a passive ETF that tracks the Bloomberg U.S. 1-5 Year Corporate Bond Index. This benchmark currently consists of 2,965 bonds with an average duration of 2.7 years. Duration is a measure of interest rate sensitivity. A duration this short means rising rates generally will not hurt VCSH’s net asset value very much, but falling rates will not provide much upside either. That makes it more suitable for investors who are not comfortable taking substantial duration risk.

Credit quality remains firmly investment grade. Roughly 90% of the portfolio is split fairly evenly between BBB and A-rated bonds, which represent the two lowest tiers of investment-grade debt. And lowest here is not necessarily a bad thing. There simply are not many corporations in the world with AA or AAA ratings comparable to sovereign governments. Still though, the income potential from VCSH remains fairly attractive. On a 30-day SEC yield basis, the ETF currently pays 4.52% as of May 15.

Why VCSH Stands Out

A big reason why I think VCSH is one of the better short-term bond ETFs comes down to fees. Remember, the 30-day SEC yield is quoted after fees and expenses are deducted. VCSH is extremely cheap here with a 0.03% expense ratio. To put that into perspective, if you invested $10,000 into VCSH, your annual fee drag would only amount to about $3 per year. Importantly, this is not a fee you pay upfront. It is gradually deducted from returns over time.

Those low costs have also helped VCSH maintain an exceptionally low tracking error relative to its benchmark. Over the trailing three-year period, VCSH delivered a 5.32% annualized return on a net asset value basis, while the underlying benchmark returned 5.33%. A tracking error of just 0.01% is excellent and shows the ETF is doing exactly what it is supposed to do.

That said, investors absolutely need to pay attention to tax efficiency here. Interest from corporate bonds is taxed as ordinary income at both the federal and state levels. According to Vanguard, while VCSH generated a 5.36% annualized net asset value return over the last three years, that figure would have dropped to just 3.69% annualized after taxes on distributions. That tax drag is one major reason why VCSH generally makes more sense inside a tax-sheltered account like a Roth IRA rather than a taxable brokerage account.