Gus Sauter is a former member of Vanguard CEO's senior staff. Gus is known as the inventor of Vanguard's ETF share class structure and is Vanguard's first chief investment officer, overseeing USD 1.7 trillion upon retirement in 2012. He participated on CFA Institute Best Execution Task Force, is a former member of NYSE Institutional Traders Advisory Committee, the Nasdaq Quality of Markets Committee and the Investment Company Institute Trading Committee.
He consulted with members of the US Senate and House of Representatives and provided a testimony to the US Congress on two occasions. He also presented at several US Securities and Exchange Commissioners' hearings and is currently a member of 6 investment committees, including US FINRA, an Australian Superannuation fund, and PGA of America.
The indexing revolution is something that underpins all of our work here at the Rational Reminder and is a subject we reference in different ways in almost all of our episodes. Today we have a special exploration of this history, as we welcome Gus Sauter, the former long-time CIO of Vanguard, to talk about his incredible history at the firm, the role he played in the rise of the company, and its huge role in reforming the investing landscape. We also hear from our guest about his experience of working on numerous investing committees since he retired about a decade ago. One of the most notable things about this conversation is Gus' ability to weigh both sides of the arguments about active management, and he does a great job of balancing what he sees as the potential positives of this way of doing things. This is all strengthen by the way he presents these ideas as a powerful mix of stories, evidence, and the research he himself has conducted. To all our listeners, be sure to listen right to the end of the episode, as after the official conversation ends, Gus shared a few more thoughts on Jack Bogle and ETFs as a bonus.
Key Points From This Episode:
(0:03:49) Looking back at the part that indexing played at Vanguard when Gus started at the company.
(0:04:20) The rise of indexing in the subsequent years and the pivotal moments in this process.
(0:06:28) Initial ways that indexing was denigrated by Vanguard's competition.
(0:08:36) How the narrative changed around indexing when its utility became undeniable.
(0:09:10) The role of the University of Chicago in the growth of indexing early on.
(0:11:11) Changes in the active management space over the last few decades.
(0:12:04) Considering the role of an active manager in today's climate.
(0:14:43) Gus' opinion on balancing the strengths of indexing and active management.
(0:20:48) Differences between traditional active management and factor investing, and Gus' preferences.
(0:29:09) A look at Vanguard's recent forays into factor-based funds.
(0:31:00) Recounting Jack Bogle's thoughts on active management at different points.
(0:32:27) Evaluating active managers; weighing the processes and their maintenance.
(0:35:09) Vanguard's relative low fees and how this impacted their success.
(0:36:35) How Vanguard went about selecting investment managers.
(0:38:44) Gus talks about the structure of Vanguard; what it meant to be a truly mutual company.
(0:41:19) Thoughts on home country bias and global diversification in light of countries like Canada.
(0:45:07) Approaches to private equity; Gus' recommendations for the average investor.
(0:48:30) Access to private markets and the prohibitive effect of high fees.
(0:51:25) Accounting for the recent large flows towards private equity and the current institutional philosophy around it.
(0:54:10) Gus talks about the important questions he asks when joining a new investment committee.
(0:56:30) Comments on hedge funds and liquid assets, and their decreased returns.
(0:59:50) The psychological benefits of holding a single fund.
(1:02:44) Gus comments on how direct indexing might figure into the future.
(1:09:20) The education of investors; Gus talks about where he believes Vanguard's biggest success lies.
(1:11:48) Reflection on the impact of introducing the implementation of ETFs at Vanguard.
(1:12:56) Areas that still excite Gus about investing; the good and bad sides of increased opportunity.
(1:14:48) Gus' definition of success and his gratitude for finding a home at Vanguard.
(1:17:07) Bonus content: Gus talks about Jack Bogle's relationships with ETFs.
Read the Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: And this week is episode 216 Ben, and what a guest we welcomed. I would argue legendary former CIO of Vanguard, Gus Sauter, and what an amazing role he has played in an incredible company that really has changed the landscape of investing around the world. And we talked about so many great perspectives he has on, of course, being Vanguard cost matter. We talked about the history of Vanguard, the indexing revolution that happened. And then it was also really interesting, I found, at the end, talking to him about his experience on investment committees, from someone who has the experience running a company like Vanguard, then joining investment committees. So interesting. We could have asked him questions all day long.
Ben Felix: He gave us an amazing mix of stories from his time at Vanguard and on investment committees, evidence, or theory and evidence, like speaking to things just like efficient markets and portfolio theory and stuff like that, but also primary research that he did at his time at Vanguard. So you combine those three things together in answering the breadth of questions that we gave him. I think it was a pretty cool conversation.
Cameron Passmore: Pretty cool conversation or pretty cool guy, and he's been retired. I was amazed. He's been retired from Vanguard for a decade now. And he tells a story of when he joined and he was asked to head up the quantitative equity group and get indexing going. And they were managing a billion dollars in index funds then. And then he joined just before the crash in '87 and he said the index assets went down to $700 million, which you can't even imagine now. And he talked about how the goal was to hopefully get, this is Jack Bogle's vision, to get to 10 billion, which he said is probably a couple weeks of incoming cash flow these days.
Ben Felix: Yeah.
Cameron Passmore: It's truly unreal story, and to have been at the epicenter of that for 25 years is pretty incredible.
Ben Felix: Yep. And we also talked about, people will be happy to know, we talked about a lot of arguments against factor investing. As listeners know, we like to try and think outside of our own bubble. We often talk about why factor investing can be an interesting opportunity. Gus gave us some solid reasons for why it may not be something that investors should be pursuing. And he gave us some pretty interesting arguments in favor of traditional alpha seeking active management.
Cameron Passmore: So he currently sits on six investment committees, which is really interesting. He's a past member of the University of Chicago Booth school of Business Council for the Dean. He got his bachelor's degree from Dartmouth College and his MBA from the University of Chicago. And I want to make sure to remember for everyone to listen past the end of the episode, where we ask our typical last question, there's a really interesting six-minute conversation. And we just started the conversation after we finished our original conversation. So listen to the bonus clip at the end.
Ben Felix: Yeah. He did a great job telling a very interesting story about the relationship between Vanguard, ETFs and Jack Bogle.
Cameron Passmore: Yep. And to hear from the guy who was the center of that conversation is pretty cool.
Ben Felix: Very cool.
Cameron Passmore: Very cool. Anything else you want to add, Ben?
Ben Felix: No, no. I was excited to have this conversation and it was better than I could have imagined. It's worth a listen.
Excellent. So here's our conversation with Gus Sauter. So Gus Sauter, it's so great to welcome you to the Rational Reminder Podcast.
Well, thank you. It's great to be with you both.
Let's kick it off right away. So how important, really curious for this question, how important was indexing to Vanguard's business when you started there back in 1987?
Well, it was still a fledgling operation at that point. We had about a billion dollars the day I started, which happened to be two weeks before the crash of '87. So we had about 700 million a couple of weeks later, and it was about 3% of our assets. So it was a small part of the operation, a tiny part of the operation at that point in time.
What do you think the tailwinds have been behind index investing's massive growth since then?
There were a number of things, I think. I'd say the first one was really when some of our competitors got into the game. For many years, Fidelity and Dreyfus and other large fund families at the time, really poopooed indexing. They were all about active management. And I think it was maybe about 1992, I want to say, that both Fidelity and Dreyfus jumped into the indexing game. And interestingly, they spent a lot of money advertising indexing after really denigrating previously. And interestingly enough, while they were spending a lot of money advertising, Vanguard really didn't spend much money advertising, but we got all the assets. So it was to our benefit that they jumped in the game, and I think that was really the big impetus behind indexing.
I think another tailwind happened in the latter part of the 90s. You recall the last three years of the 90s were really pretty much straight up after Alan Greenspan's comments about irrational exuberance, that's when the market really started taking off. And it was really the large cap stocks that outperformed during that time period. Primarily in the United States, it was the S&P 500 just going through the roof, and outperforming more than 90% of the active funds. And a lot of people were focusing on that and the success of the S&P 500 relative to the investment universe. And so they started thinking, "Oh. Well, that's what indexing does." That was really not quite fair because it was a large cap market at that point in time and active managers invariably have a little bit of a small cap bias relative to the S&P 500. And so they were operating in a disadvantage, an unfair disadvantage, but really, the headlines people were reading was just that the S&P was trouncing active management.
And then I'd say the other driver behind indexing was just active performance over long periods of time. Looking at the last 20, 30 years, the total market portfolio has tended to outperform vast majority of active managers. So all of those have been tremendous tailwinds for the concept of indexing.
I want to follow up on one of the things that you said there. What kind of stuff were competitors like Dreyfus and Fidelity saying to denigrate indexing before they flipped their script?
Oh, it's all about indexing is accepting mediocrity. You're guaranteeing you can't beat the market because indexing has some fees, although small, but it's going to guarantee that it under performs the market by those small fees, and active management gives you the opportunity to add value. And in fact, in the late 70s, when Vanguard started the first index mutual fund, a competitor, The Leuthold Group, took out an ad in, I think it was The Institutional Investor, and it was Uncle Sam with a rubber stamp on a piece of paper that said indexing, and it said unAmerican. And Jack Bogle actually gave me a copy of that, a framed copy of that I had in my office for the rest of my career. So their concept was it's all about active management, not being mediocre.
So why did Vanguard start winning the battle then? What was going on?
Well, indexing itself just proved itself. The concept of indexing should outperform. Vanguard, in particular, won the battle because we were the starters in the mutual fund industry and we were the promoters of it. One year in the 1990s, I remember traveling to 27 different road shows. Back at that point in time, various cities would have a weekend conference full of retail investors, and they'd have maybe 50 different presentations. And I was always the guy they got for the indexing and I was always debating somebody else who had great performance. Bill Miller, I've debated Bill Miller five times, I think, because he was the hottest money manager around.
Yeah. I remember those days.
Yeah. Yeah. But we were promoting the concept since 1976. And so I think that's why ... And we believed in the concept, whereas even when Fidelity started offering indexing, Ned Johnson said, "I still don't believe that indexing is the way to go. I still think active management is way to go." So they were offering it, but not supporting. And we obviously believed very strongly in it.
You also mentioned that they started campaigning for index funds. What kind of stuff were they saying in favor of indexing after they had changed their minds on it?
It was really having their hand in the game and saying, I think trying to literally quote Ned Johnson, and I'm drawing a little bit from the memory banks, but it was, "Well, we offer indexing if you want an index portfolio, but we still think you should be in active management." So it was saying we've got it here if you've got to have it, but we still think you should be in active management. So it was a backhanded way of supporting indexing.
From a big picture standpoint, what role did University of Chicago play in this revolution?
Well, it all started in academia. The concept started in academia back in the 1960s, and it pretty much developed at the University of Chicago. Some of the big, big names in finance, Eugene Fama, Fischer Black, Myron Scholes, Jim Laurie, a lot of people were right there at the University of Chicago and they were known as the Chicago gang, I think. And they developed the concept in the late 60s and actually implemented it. I think it was an assistant professor's father was the CEO of Samsonite luggage. The assistant professor at the University of Chicago, his father was the CEO of Samsonite and their pension fund had been underperforming for many years. And so he convinced his father, "Why don't you just invest it in an index fund?" And so that was the very first index portfolio was Samsonite luggage. And again, it was the assistant professor at UChicago who said, "There's been a lot of great work, a lot of thought going into this. Why don't you give it a try?" And from there, it took off.
Was there a distinct point that Vanguard realized that indexing was going to be huge?
I do remember about 1992 or '93, our indexing, as I mentioned, started at about a billion then went down to 700 million with the crash of '87 by about 1993, '92 or '93. I think we were maybe up to two or three billion. So it was growing, but growing slowly. And I remember Jack Bogle showing up in my office door saying, "Gus, you wait and see. Indexing is going to be a big thing. We're going to get $10 billion someday." And I remember thinking, "Wow, $10 billion. That'd be amazing." And of course, nowadays that's about two weeks cash flow for Vanguard alone. But that was the first time I heard Jack express that, that it would be big thing. And I thought, "Oh, $10 billion. That's just unbelievable."
Wow. How has the playing field for active management changed since the 80s?
I think active management has become more difficult. I was actually hired by Vanguard to not only develop the index portfolios, but also to develop Vanguard's active equity program. And so I was actually managing a couple of active portfolios when I first started out before I got out of the portfolio management business all together, but I think it's become more difficult. The problem with active management is it's a very Darwinian process in that there are always bright people coming into the industry and making it more and more difficult. I think the market is much more efficient today than it was back in the late 70s, early 80s. I think it's just more difficult to outperform now. One advantage is that costs have come down, but still, active management is at a disadvantage because it is higher cost.
What role do you think active management should play, if any, I guess, in the typical retail investors portfolio?
I think it depends on the capability level of capability of the typical investor. I would say most typical investors don't spend a whole lot of time thinking about investing. They may have committed to invest in a retirement program and save money on the side as well, save and invest, but they're not spending a lot of time doing research and figuring out exactly where their money should be placed.
For an investor like that, quite honestly, they're probably best off being 100% indexed. If an investor spends a lot of time and can identify other money managers that really do have skill, tremendous skill, they might be well served by putting some money in with those active managers. But I think still every investor is well served by having a foundation of their portfolio in indexing. I actually did a study. This is maybe 20 years ago, and I used real data to try and come up with a percentage amount that you should have invested in indexing. And what I came up with was that if you don't have skill at selecting managers or investing in individual stocks yourself, you should have 100% indexed. If you have tremendous skill and you invest only managers that will outperform, you should still have about two-thirds of your money in indexing. So even with great skill, having a foundation in indexing is beneficial because it's typically lower risk, lower volatility.
Interesting. How did you measure skill in that study?
I literally took the 50% of managers that outperformed the median money manager and called them skillful and then said the other half were not skillful. In fact, some of those skillful managers themselves were underperforming the market because the majority of managers in any given year, or maybe 60% of active managers in five years, maybe 75% of managers underperform. So I was looking at, I think, three year performance. And so maybe about 70% were underperforming. So in that top half, still two-fifths of that top half were underperforming.
That's super interesting. So if you can identify X anti-skilled managers, even in that case, you still want to have the majority of your portfolio indexed?
Yes. Yeah.
That's unreal.
I went into the study thinking there would be a fairly big number that you should have indexed. I didn't know what it would be, but it even surprised me. Yeah.
Yeah. No, that's interesting. Has the perception that indexing is good and active management is bad gone too far?
Yeah, I think it probably has. I myself believe that there can be a role for active management for, again, people that are highly skilled and people who can identify managers that are highly skilled. The concept of indexing, initially, it was based on the idea of efficient markets, the hypothesis that stocks are all priced fairly. And if that's the case, it doesn't make any sense to try to outperform the market if everything's already priced the way it should be priced. I think a lot of people have put that aside and said, "Well, there are some inefficiencies in the marketplace," and that's my personal thinking, that the marketplace is quite efficient, but not perfectly so. And I do believe it's become more efficient over time, but yet, the argument for indexing that doesn't require any sort of assumptions would be just the cost argument. And that's the simple realization that before any costs, in aggregate, investors are going to get the market rate of return.
So somebody can outperform in that environment, but it necessarily means if somebody outperforms then somebody has to underperform because on average, you're going to get the market rate of return. When you overlay costs into that, then the average performer before cost becomes an under performer after cost. So without any assumptions whatsoever about market efficiency or any other concept, the cost of investing will require that a majority of active managers will underperform, but it doesn't mean that all active managers will underperform. It does mean that some active managers could outperform, but they will have to do it at the expense of other active managers, to the extent one manager outperforms, somebody else has to underperform. So I do believe there are some managers, not a tremendous percentage of managers, but some managers that really do have the magic. They have the skill. They got enough skill to overcome the cost disadvantage that they have. That's the handicap of active management, is cost. There's nothing else, no other magic to index, and low cost, and just getting the market rate of return.
So I do think that the concept of, well, everything should just be indexed and forget about active management isn't really quite fair. I think that the pursuit of the best managers is still a lofty goal. And I think can be solved by investors that really want to spend some time doing some research, and not just looking at portfolio managers that have outperformed in the past. Unfortunately, that's the way too many investors do invest. They say, "Oh. This investor or this fund outperformed over the last five years," and they start throwing money at it. That's not a very successful strategy in the long run.
How do you square that with stuff like the evidence of, or lack of evidence of persistence in active managers and diminishing returns to scale with increasing scale in active funds?
Yeah. Well, the lack of persistence is a statistical phenomenon. There's a distribution of performance. It's the best managers and the worst managers, and some distribution in between somewhat of a normal distribution. Over time, statistically, that distribution will narrow down and hone in on the median and the cost will still be the same, so that the out performers, over a shorter time period, they get closer and closer to the cost disadvantage. So it is difficult to persistently outperform over time, but I do think the highly skillful managers can do it. Sorry, Ben. The last part of your question was?
The negative relationship between scale and skill where the best managers attract assets and yeah.
Yeah. There is no question about that. Size kills when it comes to investing, basically because costs become higher and higher. Your transaction costs go up and if you've got a $100 million portfolio, you can move around the marketplace pretty easily without having much impact in the market, without having any impact quite honestly. But if you've got a $20 billion fund and you want to move a big slug of money, all of a sudden, your costs are going to be significant. And I think the average investor really underestimates the amount of transaction costs that they incur. Back 15 years ago, I did a calculation and the average fund incurred at least 1% in transaction costs. When you consider that the stock market historically returns, let's say, nine or 10%, to give away one percentage point right off the bat, then you're giving away 10% of the potential return in the form of transaction costs. And so I think a lot of people underestimate that.
Now transaction costs have come down. There have been a lot of changes in market microstructure that have been very beneficial for investors. So they've come down. Maybe an active fund that does a good job of controlling their transaction costs may get it down to 35 to 50 basis points, a third of a percent or half a percent, but that's still significant. And over time, over that long haul, as the narrowing of the normal distribution happens over time, even 50 basis points can be a significant detriment to outperformance.
And those are implicit transaction costs? Those aren't going to show up in any reports anywhere?
Most of them are. So we measure brokerage commissions and most people say, "Oh, well. My brokerage commissions are penny a share," or whatever they might be nowadays. You can find brokers that'll do brokerage commissions for free. And people think, "Well, that's transaction costs." That's always been a very minor part of transaction costs. More important would be the spread between the bid and the offer, and that has narrowed. So market structure today is much better than it was 20 years ago, 30 years ago, and so spreads have narrowed, but you can still have market impact.
So historically, the lowest component of transaction costs where brokerage commissions and then spreads would probably be second and market impact would be third. Those relative distances are still the same, although they have come down. But that market impact is what really kills you when you're a big portfolio manager. If you've got 20 billion or $50 billion, it's the market impact that'll kill you.
Yeah. Super interesting, and I agree. That often gets missed when investors are looking at costs.
Yeah.
How do you explain the difference between alpha seeking traditional fundamental active management and factor investing?
Yeah. So factor investing is investing in something like a style, like size or maybe value or growth. So it could be investing in large cap stocks or small cap stocks or value stocks or growth stocks. And what you see in factors is a sine wave that runs through it, through the performance. And if you go back and you look at value investing as an example, and the compliment of value investing is growth investing is if value investing outperforms for a period of time, and it tends to for extended periods of time, three, four, four years, obviously not on a month by month basis, but generally outperforming, it doesn't work that way for forever. So we know Fama and French went back and did the study going back to 1926 and they showed that value investing outperformed, but it outperformed significantly over certain periods of time and underperformed significantly over other periods of time and some relatively long periods of time. Look how long growth has outperformed over the past decade. And so all of a sudden, people think, "Well, value's dead."
Same thing happened in the latter part of the 90s. And I remember one of our quants saying, "I think value's dead," and I'm thinking, "I'm glad he said that. Now I know that value's going to come back." And literally he said that in the end of 1999, which was about three months before growth peaked. So the point is that you see this sine wave going through factor investing. You'll have periods of great outperformance and you think you're on top of the world, and then you go through underperforming periods.
Alpha seeking is different. In alpha seeking, you try to consistently outperform by some margin as opposed to riding that wave of performance, the wave up and wave down of factor investing, you try to add a similar amount of value period after period. So let's say a phenomenal investor would be adding a half a percent a year on a relatively consistent basis above and beyond the market rate of return, or their segment of the market, but there's going to be noise in that. So we know nobody's going to do half a percent or a percent year after year after year. They'll do it with noise around it. But what you tend to see with pure alpha is yes, random noise, but the median, the tendency of that is still a positive number and it doesn't have the sine wave going through it.
From a practical standpoint, most active managers practice both of those. So managers will have a certain investment style, might be larger cap stocks. It might be growth stocks or value stocks, and then they try to add alpha above and beyond that style. So if I look at a manager, who's a value manager, I want to see that they're not just getting the style performance, but they're getting that alpha as well, the incremental return above and beyond the style.
That's super interesting. If I understood correctly, if we take the cap and alpha, which a factor style would be adding alpha in that case, and we're comparing a style factor index to an active manager that may have a style tilt, I think what you're saying is the alpha on the active side is going to be more consistent than just the factor index. Does that make sense?
The alpha should be more consistent than the factor itself, yes.
Interesting.
Or you don't have alpha. Alpha unfortunately doesn't have to be positive. There are lots of managers that have a very consistent negative alpha, driven down by costs for the most part, but also lack of skill. It's important that you recognize where the return is coming from with the active manager. Is it coming from skill or is it just their investment style? Because you can index an investment style.
Right. Yeah. You could end up paying active manager fees to get a style when you could have it at an index fee.
Exactly. Yeah.
What's your personal preference in active management style between alpha seeking and factor investing?
I'm not a big fan of factor investing. The problem with factor investing is it's a relatively binary approach. Let's say we split the world into value and growth and it's that raw. It's just value and there's growth. So one of them is going to outperform, the other's going to underperform because in aggregate, they equal the marketplace. So factor investing means that you get that right, when the switch is on and when it's off. I think that's incredibly difficult to know when to get out of value and get into growth. You only have two choices and if it's flipping a coin, which it usually is, it's tough to win at that. It's tough to flip heads 60% of the time and tails 40% of the time. And you only have a limited number of flips, and you might have 10 flips in your life.
And on the other hand, alpha investing, which we typically think of as security selection or stock picking, if you will, that's actually what I was doing in the active quant work that I was doing at Vanguard, was trying to manage portfolio neutral relative to a factor style, but add value through picking individual stocks. And the advantage there is that you've got a lot more bets than just on off. You've got thousands and thousands of stocks you can choose from. Let's say you've got a tremendous amount of skill and you outperformed 53% of the time. 53% of your bets outperformed, 47% underperformed. And actually, that is a very skillful manager. That sounds like, "Well, anybody can do that." Well, that was like Peter Lynch capability if you recall the 80s and Peter Lynch. But if you have that level of skill, imagine if you only got to flip a coin 10 times and 53% of the time, you'd win. The odds of actually outperforming being right 60% of the time are not much better than 50-50. Actually, they're less than 50-50.
But if you have 10,000 bets, the odds of being right 53% of the time starts to happen. Again, from a statistical standpoint, you get the statistical averages that you don't get when you get 10 coin flips. So 53% of the time when you're stock picking, you might outperform. And so I personally believe that you'll have a better chance of outperforming if you try to add value through security selection than if you try to time different factor bets.
What if you don't time them? What if you just hold the factor style consistently?
You had better have the right one because you're pretty much guaranteed that you'll be going through good periods and bad periods. And so we do know that over very long periods of time, that value was outperformed. But in the latter part of the 90s, as I mentioned, growth outperformed significant. In 1999, the US marketplace was up about 30%. And at the same time, the value portion of the market was up 5%. So I remember investors thinking ... we had one fund that was a very popular fund, Windsor II, which was a large cap value fund, and it was up 5% or 7% or something like that. It was actually doing fine relative to what value stocks were doing, but people were saying, "Well, the market's up 30%. This fund is out of touch with reality." So what we experienced in '99 and the latter part of '98 and the beginning of 2000, investors were getting out of that fund and they were going into growth funds just in time for growth to underperform.
So when you pursue a factor approach, it seems great when the tide is in your favor, but invariably, when you're swimming against the tide, you give up after a period of time. And usually, when you give up, it's about time for the tide to turn. And that's the real difficult thing about staying with a factor approach, and I just don't have any confidence. And People can say, "Oh, well, now's the time that value is going to start outperforming," predict that. People have been predicting value outperforming since probably 2014. For about five years, they were dead wrong.
Yeah, yeah. It finally came back recently. We just talked about this in a recent podcast episode, that they were outflows from value funds up until 2020. And then since April 2020, value's outperformed by a pretty wide margin. But the outflows happened before the outperformance, which is exactly what you're saying.
Yeah. Yeah.
Yeah. That's a tricky one. What do you think about Vanguard quantitative equity groups more recent venture into factor-based funds?
Well, there's the reason we didn't do it when I was there. Quite honestly, I think the lineup that we had previously pretty much covered that space already anyways. There are some fine tuning factors you can introduce, but if you look at the nine morning star style boxes, large, medium, small, value, blend and growth, those nine boxes cover most of the factors. You can pretty well mimic the factors that many investment firms are producing nowadays.
And again, I come back to the problem of how do you invest in those things? Do you think you can move around and move from one factor to another successfully? Or do you think that that factor is going to outperform over your lifetime? And will you be able to survive the downturns? Momentum is one factor. Momentum has gone through long periods of outperformance and then got slaughtered in 2009. 2010, you would have given up everything that you've gained. So I think factor investing is really, really difficult to do successfully. Number one, get the right factor. Number two, stick with the right factor. And number three, I just have no confidence anybody can time factors.
Interesting. You mentioned momentum. I was thinking about momentum when you were talking about transaction costs earlier because it's a high turnover strategy. Yeah.
It's very high turnover. So in some of our active point work, we played around with momentum a lot and we generated some good portfolios, but it was 40% turnover a month and you're not going to outperform when you're doing that.
Wow. What did Jack Bogle think about active management?
Well, when I first got there in 1987, he was obviously a supporter of the concept of indexing, but active management was 97% of our portfolios. So we didn't not believe in active management, but we also saw that there was a significant role for indexing. I would say as Jack got older, and by the time he retired from Vanguard, I remember him saying to me towards the end of his initial career, he went on to do research later, but end of his time working for Vanguard him saying to me, "I don't know why we have any active funds. We should just have index funds." And I was thinking at the time about 40% of our assets were indexed. And I thought, "Well, we might be able to use that other 60% of our assets. So we might not want to get out of active management just now." So Jack became more and more skeptical over time. And literally as he got older, he said, "We should just be indexing."
Yeah. That's very interesting because you hear stories about Jack liking active management. That's interesting to hear the trajectory over time though.
Yeah. Yeah. It definitely changed. And I think subsequent to that, I think Jack eased up a little bit, but not much. Jack's son has been a very successful active manager, and Jack actually coaxed him into getting into active management, quantum investing. And so John Bogle Jr. has been very successful.
Huh? Yeah, that's very interesting. We've talked a few times about the benefits of a skilled active manager, and we talked about your study, where you just picked the ones that you knew to be the best. How do you, without having perfect foresight, evaluate an alpha seeking active manager?
Yeah. So I'll start with a little bit of background of what we were doing in our active quant work. We always started with a hypothesis before we ever tested anything, but in the quant world, you go back and you do back tests. But I was very strict in saying that we will specify everything in advance. And once we run through the data, we get one shot at running through the data and if it doesn't work, it doesn't work. And we abandon it because it's very, very easy to tweak what you thought was originally right and you can fine tune it to the point where you memorize the data and then you can predict it perfectly.
So we actually started with behavioral finance and said, "Okay. Why would there be a pocket of irrationality in the marketplace?" And we always brought it back to, well, because people are irrational. And so we looked for concepts would basically take advantage of that, look at one aspect of people's investing that's irrational and say, "Okay. How could we recognize that in the marketplace?" And so we'd come up with a theory in advance, and as they say, run through it and see if it worked.
Vanguard uses a lot of active managers. We had, I think, 35 or 40 when I finally retired. We would always look at number one, do they have a process? So in my case, I was also being observed by our investment committee. I was on the investment committee, but also being graded by the investment community on the active portfolios we were running in my group. And so did we have a process? And I said, our process was really starting with behavioral finance, but does the manager have a valid process that makes sense? And then do they maintain it? It's very difficult to maintain your value proposition in 1999, but if you give it up, then if you don't have confidence in it, we don't have confidence in you. So do they maintain it? Are the costs appropriate? We had a huge bias that if you've got high costs to some degree, you're just not going to be able to add enough value. And so are the costs under control? And then finally, does it actually work? Does it add value?
In the quant world, we did it by going back and doing back testing, which you have to be very careful about. But in the real world, we would look at managers that had real-time performance and would take a look at that and make sure that it made sense as well, but that was the last step. Too frequently, that's where investors start. A retail investor might say, "Well, who did well? And that's where they start their research. We went the other way around and said, "if everything else is in place, did it actually work?"
So one of the things you often hear from proponents of active management is that, "Well, Vanguard does active management." How much of the advantage that you had was because you were, relatively speaking, a low fee shop on the active side?
Yeah. Well that certainly was an advantage relative to the active universe, no question about it. It was a little bit of a disadvantage relative to the market return itself. Obviously, any cost is a disadvantage, but we felt it was very important to keep that cost down, keep basically, the handicap that the manager was facing, keep that to a minimum. We had the advantage of using external managers in our equity business and we didn't do traditional active equity internally. We only did active quant internally, but I think that gave us the opportunity to scour the world and find great managers. As I said, I do think that there are some managers that have the magic. They have enough skill to take advantage of other investors and outperform, buy something that somebody's selling too cheaply.
But we didn't always get that right. We'd have some managers we'd have to move on from. But at the same time, we had managers that worked for a company that Vanguard hired for 20 years, 30 years. So we have had some successful investors over very a long period of time, but yeah. You've got to keep the handicap that they face down, and you've got to be able to search the world for the best managers.
Can you talk about that dynamic, Gus, of selecting external managers? When you show up as a potential provider to them of lots of client assets potentially, is the dynamic such that you're able to get a discount on pricing, kind of the Costco model?
Yeah, definitely. We had tremendous negotiating power with the managers because we took the ugly part of the business off their plate, but money managers want to manage money. They don't want to do the back office work. They don't want to have to do all the record keeping and the distribution of making sure that they're getting cash flow into the funds. And so we take that ugly part off their plate and let them just manage money. That's all they really had to worry about. So number one, their costs were less because they didn't have to worry about all the accounting and marketing and everything else, and they could pass that on to us. And then since we had such a big business and could bring them a nice amount of investment assets, they gave us a break for that. So we could get a money manager far less than anyone else because of the size of our assets that we commit to them.
Well, was there ever a concern either on your side or on the managers side that you were just, like what we talked about earlier, that you would swamp their skill with assets?
Absolutely. No question about it. And Vanguard closes down funds from time to time when they get too large. Two ways that happens, either Vanguard identifies it internally and says, "We think it's getting too big and we should shut this down." Or we always relied on the managers as well to say. "No mas. We think we're at a point where our performance is going to start to falter." So it works both ways, and Vanguard would always honor that and respect a manager who comes and says, "We're comfortable where we are, but we don't want to go anymore."
But then I recall back in the year 2000, or roughly, maybe it was 2003, we shut down the High Yield Bond Fund because it was just attracting too many assets. And we just internally felt now, we've got to slow this thing down. So you do have to absolutely watch out for that. On the other hand, indexing can grow as big as it can grow, and you're not going to have to worry about that.
The other unique thing that Vanguard has is the overall structure as a true mutual company. Can you describe that? Because I assume when you're bring on an external manager, you're not looking to pick up margin like a traditional mutual fund company. Am I correct?
Yeah, that's absolutely correct, and that was the secret behind Vanguard. That was Jack Bogle's greatest invention. So he invented the index mutual fund, but the greatest invention was Vanguard itself. And that concept is unique in the mutual fund world, that Vanguard is literally owned by its mutual funds. So if you invest in a Vanguard fund, you're an indirect owner of Vanguard. Every other fund company has an external set of owners. They may trade on the stock exchange, but there are owners that want to be paid for owning the stock and see the stock perform well.
We didn't have a stock. Jack Bogle didn't own any stock in Vanguard. None of senior management can possibly own direct ownership in Vanguard. We all owned Vanguard through our investments in Vanguard funds, but so we didn't have a layer of profit that we had to generate to provide to the third party investors. We certainly had investors. We had our funds and we returned the profit to the funds in the form of a lower expense ratio. So that was really the magic of Vanguard. The reason we were the low cost was simply because of the ownership structure and that's the magic. Indexing wouldn't work if we were a high cost money management firm, but clearly, Jack's best invention was Vanguard itself.
Gus, you think there's a risk of investors focusing too much on fees when they're building their portfolio?
There probably is a slight risk of that. Certainly, fees are extremely important. When it comes down to the last basis poin, I don't think you get too hysterical about one 100th of a percent or two 100ths of a percent. But the difference between 80 basis points and 50 basis points is significant. And there, I think you need to be focused on it, but at the same time, if you're finding great active managers, you need to also recognize that they're going to be paid a premium amount. So a great active manager at a 25 basis point fee can be justified. I think a great active manager at a 100 basis point fee can't be justified. So there's probably a little bit too much focus, but it's hard to say. You can over focus on it, but just recognize that if you want some active performance, you're going to have to pay a little bit more for it.
As you know Gus, Canada's three to 4% of the world stock market value, but most Canadians hold much more than that so that's home country bias. What do you think are the best arguments for home country bias?
Well, first of all, I think it is appropriate. And I think the reason why it's like an immunization strategy. It is kind of an immunization strategy. If you're managing a pension fund and let's say it's in a wind down phase, you know that you can predict, "Well, my employees will be quitting or retiring at certain points in time," and so you can pretty well estimate what your pension payments will be over time, and you can immunize that. You can invest in bonds so that the bonds throw off enough interest and they mature at just the right time so that you don't have to worry about the management of the fund. And I view that similar to someone that has a home country bias.
For the most part, assuming you're going to retire in Canada or your home country, you're going to be spending most of your retirement money and also pre-retirement money in your home country. So therefore, you want to make sure that your investments are performing in line with your home country. And if your home country just happens to be on a roll and goes through a much stronger period than the rest of the world, you'd hate to be invested, let's say, 4% in Canada. And if Canada goes through a decade of tremendous outperformance economically, likely, it's market will as well and you want to make sure that your investments perform with that.
So I think it's a way of immunizing and recognizing that most of your expenditures are going to be in your home country. So your investments, which are going to enable you to afford those expenditures should likely be overinvested in your home country.
That's interesting. So is that like a hedge against the local price level if the economy takes off?
Yeah, exactly. Exactly.
And what about on the fixed income side? How important do you think is global diversification there?
Well interestingly, fixed income is by definition fixed. You're going get a that certain payment. There can be some credit risk. But for the most part, it doesn't really matter if you're investing in German fixed income, German boons, or Japanese fixed income or US or Canadian fixed income. You're basically getting a fixed payment for your investment. So it turns out that global fixed income investing tends to be more of a currency play than a fixed income play. And so I don't think it's as important to have as much global diversification in fixed income as it is in equities, because invariably, you're ending up basically taking on a lot of foreign currency exposure, which can give you some diversification. So it's not all bad news, but at the same time, I don't think the same benefits accrue to global fixed income investing as to global equity investing.
Definitely agree in an unhatched portfolio. What do you think about global diversification and fixed income with local currency hedging?
Well with local currency hedging, then you're basically getting a more diversified investment. And modern portfolio theory would tell us that more diversification is better than less diversification. From that standpoint, you should have a more global portfolio. However, the question becomes the cost of hedging, and it just depends on relative interest rates of whether or not the cost of hedging works in your favor or against you. And if the cost of hedging is working against you, it can be fairly significant. And so you want to make sure that you don't engage in that where the cost of hedging offsets the benefit of diversification.
Yeah, that makes sense. I want to ask about private equity, which is something that we are surprised, frankly, to see Vanguard get into more recently. How do you think the retail investors, the average investor, I guess, should approach private equity?
So again, the argument for investing modern portfolio theory would be that broad diversification is appropriate. And it turns out that most of the investment world is private. The public markets are large, but there's a lot, there's more in the private markets than there is in the public markets. So to the extent that you should get broader diversification, you should have investments in private markets.
Now having said that, your question was really should retail investors be investing in private markets? And then again, you need to try to figure out the costs of investing in private markets versus the benefit of that diversification that you're going to get. And it turns out that the cost of a retail investor investing in private markets are tremendous. You have fees on fees. Typically, a retail investor would invest in a fund of funds. So you pay a fee to the fund of funds, and then there's another fee that the underlying fund gets. So you've got high fees on high fees, and I'm not talking about 1%, I'm talking about two and 20 or three and 30, which means 2% of assets and 20% of performance. And so for the retail investor, you're at a tremendous disadvantage.
And there seems to be this notion that private equity outperforms public equity. Well, that's what we hear about. You don't hear about the unsuccessful private equity managers. And in fact, if you look at it, certainly after costs, the average private equity fund has underperformed the public markets because of costs. And so just like in active investing in the public markets, if you're going to go into the private markets, you better get the best active managers, and that's another problem that retail investors are going to face. It's one of having access. The best private managers, the institutional money managers, are going to be all over them.
We had a client at Vanguard 20 years ago asking me how they should find private managers, the best private manager. And I said, "Well, look for the ones that are closed. Those will be the best ones. You won't have any access, but you'll find the best ones." And that doesn't help you a whole lot when you're a retail investor. And so I think the average retail investor should be very cautious about getting into private markets because the costs will outweigh the benefit of diversification and the hope of outperformance. We just don't hear about the under performance in the other side of the tail. So I talked earlier about the performance distribution of active managers, the out performers and the under performers. Same thing is true with private investing, except that the distribution is far wider. It's not like this. It's like this. So the best private managers do well, do very well, but the worse ones do really poorly. And again, there's the cost. So retail investors should be very cautious going into private investing.
Yeah. We've seen estimates between six and 8% for total fees that you pay, or all the different fees and private equity. It's pretty crazy, but it's also interesting because of the pre-fee performance, before fees, private equity managers in a lot of cases, are generating alpha because there may be at parody or a bit below public markets after fees, which means if you weren't paying their fees, you'd be doing great. Who can access private markets without paying those crazy fees?
Well, institutional investors can, to some extent. Large institutional investors, they can do what's known as co-investing. And so they can invest alongside a fund and pay lesser fees. They can do direct investments, where they find the private investments themselves and avoid the fees that way. So institutional investors that are devoting a lot of money to it, Ontario Teachers is an example of success of that, but they've kept fees down to a minimum and it's quite clear that's how they've been successful, is keeping fees extremely low. You're not going to have that opportunity as a retail investor. And there's also a misconception about private investing, that it doesn't have the same degree of volatility that the public markets have. It's simply because they don't mark to market. The public market's marked to market. The private market's marked to value. So in other words, you can't trade the private market. So they just say, "Well, what's the value of this?" And the value doesn't decline as much as the market does.
The US market was off 20% through June. Do you actually think that the US economy was down 20%? The market didn't reflect true value. It reflects, again, these behavioral finance components of a little bit of hysteria playing in. But if you tried to sell a private investment, which does happen in the secondary market, occasionally, not much, but if you try to sell a private investment in a distressed environment, you're going to find out what volatility's all about. It'll be at least as much as what you find in the public markets.
Yeah. I love that point. We talked to Antti Ilman in a while ago and he called that smoothing as a service, which is one of the things that you get with private equity.
Yeah, exactly.
Yeah, no. That's really interesting. So we talked about institutions, maybe they can negotiate on fees or do co-investments or direct investments. Is the same true for ultra high net worth individual investors?
A really ultra high net worth investor could have some opportunities, but you're probably talking about somebody that's willing to devote at least a couple billion dollars to private investments. It's not a family fund that has 500 million. They're not going to have that kind of leverage, unless there's some reason that the private companies want to allow them in. If they have a super huge name, maybe they could get in and get access that way. I actually am on an investment committee that does benefit from that, but you'd have to be a well known brand.
Very interesting. So you have to have an in or a huge amount of capital for it to make sense?
Yeah.
Huh. Super interesting. So given what we just talked about, why do you think the flows into private equity have been so huge in recent years?
Well, partly because of access to the marketplace. For years, you had to be an accredited investor, so there were very few people that could actually qualify to invest in private investments. And that's been loosened up quite a bit, and so there are more and more opportunities now. The fact that there's more capital available or are able to go into that marketplace. And then I think it's probably what Dr. Johnson, the lexicographer said. It's a triumph of hope over reason. He was talking about his second marriage, but I think the same applies in investing. People hear these great stories about performance in private equity. And so they want in, but it's like hedge funds in the 1990s.
Okay. So you sit on some investment committees, which sounds like a very, very cool retirement project, if I can call it that. I listened to you on another podcast talking about it. It sounds amazing. Based on that experience, how are institutional investors looking at private equity? How are they thinking about it?
They're all thinking about it. No question about it. If there of any size at all, they're trying to participate. Every committee I'm on ... I was on seven. I'm on six now, and winding it down a little bit. Everybody's involved in private equity and again, it's hope springs eternal. I've seen some great success with some of the investment committees I'm on. I've also seen some under performance as well. The ones that do well tend to be the investment committees that have a brand name and therefore, have the access to the great managers, but everybody wants into the private world based on Ontario Teachers, based on Yale, based on Harvard. Everybody wants in.
So they're looking at it on the basis of expecting higher than public equity returns? Is that-
Invariably. Yeah. I've mentioned the argument for broader diversification. There is nobody investing in private equity because of broader diversification, even though they should be. Everybody expects higher returns.
How do they respond to you being a skunk at a garden party saying, "Maybe you shouldn't be expecting that"?
Well, we have the best managers, so we will outperform.
Right.
And that's what active management is all about. Active management is as much about selling as it is performing. Every active manager I've ever talked to is going to outperform in the future despite the fact they never have in the past. But again, hope springs eternal, and I think that we believe, in the committees I'm on that, we do have access, for various reasons, to the best managers. And to be quite honest, we don't always get it right. At Vanguard, we didn't always get it right with active managers, but we actually have won a lot more than we've lost.
So I'm curious, Gus. When you join a new investment committee, what is the very first thing that you do?
Well, personally, I have always asked people in the committee, "How do you measure yourself? Do you have any benchmarks that are just a simple index benchmark like 65% equities, 35% bonds, or 70% equities, 30% bonds?" Invariably, I have never joined an investment committee that actually had that simple benchmark. And I think it's really important because we could all do that. In minutes, we can set up that portfolio and it doesn't require a whole lot of monitoring and invariably, it's a very difficult portfolio to beat. And so after the fact, after my suggestion, every one of the investment committees I'm on have added that as a benchmark. They have other benchmarks they measure against, but I always say, "Well, what about the simplest one?" And we don't want to have an engineered benchmark that's easy to beat. Not that they always are, but I find that having that simple benchmark is a really good guideline. And if we can beat that in these investment committees, we're doing pretty well. And so we have had some success.
And how do those investment committees view low cost index investing?
So the people on the investment committee are really savvy investors. There aren't people who aren't professionals in the field of investing on the committee. So in the investment world, there is a lot of respect for indexing. So I would say that in all of the investment committees I'm on, there's a lot of respect for indexing. And in fact, every investment committee I'm on has some degree of commitment to index investing, some assets in index investing. It's interesting and I mentioned that I managed quantitative equities. Indexing is passive quant. I also managed active quant, but commons thread. There are a lot of commonalities between indexing and active quant. And I'm in a group called the Chicago Quantitative Alliance, and these are all active quant managers across the country and even across the world. What I find is virtually every single one of them has investments with Vanguard index funds. So there are tons and tons of active managers that can be managing their own portfolios, but have investments in index funds as well. So there is a lot of respect for indexing, certainly among the most sophisticated investors.
Amazing. Good to hear. What role do you see in portfolios for other alternatives like hedge funds or liquid alternatives?
Hedge funds were really a product of the 80s and 90s. And as I mentioned earlier, I think that there were greater marketing efficiencies back then than there are now. And so we heard of returns back in that era. Hedge funds routinely returned 15%, 20% a year. There were just opportunities around. There was less capital chasing it, so the opportunities were greater. And I think that there's still this perception that that's what hedge funds will perform, that they're going to give you these super-sized returns. Well, over the last 20 years, the markets have become more efficient. It's much more difficult to find great opportunities. There's a lot more capital, a lot more capital chasing hedge funds nowadays so that's going to drive market efficiencies. And so now, hedge funds returns are modest. If you look back over the last 10 years, a good hedge funds returned, let's say 4% a year, and then hedge funds are high costs.
So I've got to admit that I'm not a huge fan of hedge funds in particular. There can be some that have outperformed. They typically aren't a true hedge fund. They're not frequently looking for a long position in an offsetting short position. They typically have some sort of market exposure as well, which wasn't always the case. So they're taking some active factor bets as well as really looking for long and short positions. So there are some decent ones, but I think if you go in there expecting 10 or 12% returns out of a hedge fund, you're probably going to be disappointed. If you think, "Well, this is going to be a risky cash investment," you can be rewarded. And that's the the way I think of hedge funds nowadays is more of a risky cash investment.
Other alternatives, so when I think of other alternatives, I'm thinking of investing in real estate or maybe infrastructure, those can have a real return to them. Infrastructure can be somewhat bond-like, but maybe some equity kicker. If you're talking about, let's say a toll road, that'd be infrastructure that's sold off to the investing public. You think, "Well, people are going to pay the fees on the toll road," and that seems like a bond investment. But if traffic picks up over time and populations grow, that maybe there is a growth component to that as well. So if it's priced appropriately, you can get a reasonable return in infrastructure. I would not expect equity-like returns out of infrastructure.
Real estate goes through boom and bust periods. I actually was a commercial real estate developer back in 1980 to '82. You can do well in real estate, but I think people tend to get a little overly enthusiastic about real estate at times. And so it goes through boom and bust cycles, and we may be in a bust one now certainly for commercial real estate and probably retail real estate as well. But all of these, it's important to keep costs down. So infrastructure would be another type of private investment, and again, difficult to access as a retail investor. Real estate, lots of opportunities there, but not all real estate is the same. There's residential, there's commercial, there's industrial. You want to know what you're investing in there.
We're talking about a lot of different asset classes. How important do you think the psychological benefits are of holding one single fund, like a target-date fund, for example, as an asset allocation tool?
I think the big benefit of something like that is that you can't measure investments within your portfolio. So if you're not pursuing that type of approach, if instead you're picking five different equity funds and three different bond funds and maybe some other smatterings of things thrown in there, let's say you've got some real estate investment, well, there's a tendency for people to look at the performance of those investments. It may be actually a reasonable portfolio that they've laid out, but there's a tendency to take a look at each one of the investments and say, "Oh. Well, that's done well over the last three years," or, "That's done poorly over the last three years." And then investors have a strong propensity to throw the ones that have been under performing overboard. That's the advantage of not being able to see inside. Typically, the best investors are the ones that establish an appropriate asset allocation to begin with and then stick with it and don't tinker around too much.
By definition, if you've got a handful of equity investments, there will be some under performing. There's going to be some out performing the others. And just to assume that the under performers are bad over a certain time period, over, let's say a two year period or a three year period, may be wrong, but there's a strong desire to get rid of those at just the wrong time. So I think the huge psychological advantage of a target-date fund is just saying, you don't have that opportunity to say, "Well, get me out of this portion of the portfolio."
The one thing a lot of people are concerned about would be well, I've got all of my money with one fund and then they think, "Well, I should diversify." Well, the fund itself is providing you with that diversification. And there's sometimes some worry, well, should I have it all with one fund company? Should I put it all with, I'll use Vanguard because I'm familiar with Vanguard, or should I be concerned about that? It's important to understand that the fund itself is a separate company. So it is separate from the fund management company and it has its own assets. It directly owns those assets. So it's going to rely on the performance of the assets, not the performance of the fund company. If the fund company were to go out of business, and now I won't use Vanguard as an example, let's call it Acme fund company, they were to go out of business, it wouldn't matter to the portfolio. The portfolio has its own board of directors. The board of directors would just have to find another fund company to manage the assets, but the assets would be fully intact.
I'm so glad you brought that up. Yep. Those are all excellent points, and we hear that a lot.
That's great.
How impactful do you think direct indexing will be to the future of portfolio management?
Everything gets a little overdone in the world of investing, and every year, it gets a little bit more overdone. I think there's probably a role for direct indexing for a certain segment of investors, not a huge segment of investors, but a certain segment. It could be that if you're CEO of a major company, it could be that you've got a vast amount of your wealth tied up in that company, and therefore, in the industry that company is in. And you may not want to put any more money into that company or industry. And so there, a direct index approach may be a good compliment to what you already have. Let's say 50% of your assets are in your company. You could take the other 50% and exit if you will. Own everything else other than your company and the industry your company is in. And so that would be perhaps an appropriate approach for someone who has that exposure.
And another one might be someone who has a very specialized philosophy around social investing. And for some reason, they don't want one investment and all of the social investment funds out there that they might have an interest in, might just have that particular stock or bond. And there you could work around it and not have it in your portfolio. Again, I think these are niche situations and may apply to a small group of people trying to either get better diversification or express some sort of social interest. But for the most part, most investors are still going to be well served by the traditional index approach.
The social screen customization makes sense. We tried to think through the closely held stock scenario, but in a globally diversified portfolio, even if you own the largest company in the world, it's a pretty small portion of the portfolio. And if you end up paying 40 basis points for a direct index, instead of five, I don't know.
It could be, but let's say it's in the energy industry. So you also have broader exposure to the energy industry and you may not want to double down on that.
Yeah. That makes sense. Strip out the industry. What do you think the effect has been or will be of big asset managers like Vanguard, but also BlackRock and other competitors, what do you think the effect of their growth will be on corporate governance?
I'd love to answer that after I finish off with the former question that escaped me at the time. I'll come back to that, but when it comes down to this private indexing, you also have to be concerned about cash flow into your investment portfolio. Because if you don't have constant cash flow into your portfolio, you're going to end up with a lot of unrealized capital gains over time. It may not impact you in the first two, three, four, five years, but after 10 years, most of the assets in your portfolio will be at a gain. And then any adjustments you have to make to that portfolio, all of a sudden going forward, it becomes a very, very tax inefficient portfolio, realizing capital gains and paying taxes all the time on those capital gains. So you have to be cognizant of that.
If you're 30 years old and you've got constant cash flow going in, let's say into your retirement portfolio, so you got 30 years of cash flow going in, maybe it can make some sense, but then again, remember when you're 70 years old and 10 years into retirement, all of a sudden, you've got a really bad tax situation going forward.
Right.
So regarding the big indexers owning a large portion of the marketplace between say the big three indexers, Vanguard, BlackRock and State Street, SSGA, they own probably a quarter of the US market or more than a quarter of the US market and a very, very significant portion of the world portfolio as well. A lot of people worry that that has a negative impact on corporate governance. I personally think it has a positive impact on corporate governance. There's a lot of money spent by these three companies, doing a lot of analysis on corporate actions and voting proxies, much more analysis than the average investor would do or a small fund company might do.
And so when it comes down to voting on proxies, I think there's a lot of thought going into creating the best value that they can because indexers are lifelong holders of stocks. And active managers, we always felt active managers rent stocks. They own them for a year. That's the average holding period of an active holding, and then they move on. So they're really not going to have much of an impact from a corporate governance standpoint. Whereas an index portfolio, you're owning it for forever, and you're making decisions about how the governance of the company is responding in other aspects of the company. And so it's very important that you take actions to maximize the performance of that company over time.
I haven't gone out on BlackRock's website or on SSGA, but you can go out on Vanguards and they show an example of, I think, maybe 100 different proxies that they have voted and they talk about why they voted one way or another. They voted for a shareholder proposal or against a shareholder proposal. And I think a lot of times, people say, "Well, if you're not voting for shareholder proposals, you've got some negative ulterior motive." And I don't think that's right. There are a lot of times when shareholder proposal just isn't appropriate. We felt, when I was at Vanguard, and I think the feeling is still the same that micromanaging the company is not the purview of investors. That it doesn't seem like we should assume that as an investor, we know more about management of the company than the management does. So there can be instances where there's a shareholder proposal where they're proposing something that management is much better capable of addressing than we as investors would know. So as an investor, we would vote against that and defer to corporate management.
But there are other times, that you'll see, that Vanguard does endorse a shareholder proposal. And again, you can go out on Vanguard's website and just see 100 different examples of ones they voted for or against. And so I think there's a lot of thought that goes into it, and I think corporate governance has improved because of those managers activities.
That's really interesting. So as you look back, what do you consider to be the greatest success of Vanguard during your time there?
I guess I'd say it was educating investors. I go back to 70s and 80s, investors really weren't very well educated. They didn't have a whole lot of information back then. The internet didn't exist or wasn't available to anybody outside of a few people. We didn't have the flow of information that we have today. And there's no question investors are much more educated today than they were 40 years ago. I'm very proud of the role that Vanguard has played in that. Vanguard certainly has been in the lead of investing with low cost, preaching the value of low cost investing. Vanguard has always also been in the lead of saying, "Stay the course." To select an investment strategy and don't flop around and move in and out, that you're much more likely to have superior performance if you set your strategy and stick with your strategy.
So we had a big effort of educating investors. I would say, quite honestly, that I think that Vanguard has some of the most educated investors in the world. And one of the reasons I would say that is I think you have to be somewhat of an educated investor to actually invest in an index fund. And somewhat counterintuitive, we would just naturally assume an active manager gets paid a lot of money, they should add value. So the fact that Vanguard has attracted so many people into index funds, to me, says, well, these people are thinking outside of the box. They are getting the fact that active management's not going to always out perform.
And so I think Vanguard investors are highly educated. They are very, very sticky. Vanguard's turnover rate, when I was, there was 10% per year of the investors compared to the industry average of 27%. So you can imagine if we had ... I said, turnover rate. I should have said redemption rate. If we had 27% of our assets being redeemed or if Vanguard did today ... Vanguard has roughly $8 trillion, that would be $2 trillion of assets redeemed every year. Vanguard can't possibly sell $2 trillion worth of new investments to replace two trillion walking out the door. So we had investors that had far longer time horizons. And again, I think that was the education of stay with your investment strategy and don't try to time markets and move here and there and everywhere.
How big a deal in contributing to the success at Vanguard was the decision to implement ETFs?
Well, I'd like to say it was very important because I invented it. I invented Vanguard's ETF structure and promoted Vanguard's ETFs. I think it enabled us to address a different marketplace. A lot of people think ETFs are a different investment. Back in 2000, people were saying, "This is a new novel investment." And I kept saying, "It's not a new investment. It's a new way to distribute an old investment." It's an index investment for the most part, and it's just distributed over the marketplace. So over the markets, as opposed to directly distributed by the mutual fund company.
So you used to, with a traditional investment, you have to go to the mutual fund company. With an ETF, you can buy it through your broker on an exchange. And so it's just appealing to a different marketplace, and that opened up a whole new market for Vanguard. The advisor space really grew dramatically at Vanguard because of that. So I think it has been important to Vanguard's success over time. It was slow going to begin with.
Looking ahead from where you sit, you're doing the investment committees, but you're out of working at Vanguard so you're somewhat of an observer. What about investment management excites you most today?
Excites me in a good way or a bad way?
Oh, I'll take both answers.
Yeah. Well I guess there are two sides to the same coin that the good news is there are lots of opportunities for investors. The bad news is there are lots of opportunities for investors. There, quite honestly, are just simply too many things. One of the early ETFs was a wound care ETF, and I'm thinking who could that possibly be appropriate for? I'm thinking what's in this portfolio? It's band aids and stitches. So thankfully, that ETF did go under as it should have. And there are just too many things out there where it's spaghetti thrown against the wall and it's just a question of how long it sticks on a wall before it falls off. So that, I get excited in a bad way about seeing the massive proliferation of things out there to the point where it really starts to confuse investors.
And Vanguard's done a lot of work on that, that investors end up with gridlock when they have too many choices. And it's not only true in investing, but it's true in many aspects of our lives. And so we bombard investors with thousands of choices, and how are they supposed to know what to do? And so you look at IRA plans and 401k plans in the US and I apologize. I'm not entirely familiar with your retirement plans up there, but frequently, the plan sponsor will limit the number of options because there's been a ton of work showing that if you have too many options, people just go into gridlock. They end up in a money market fund because they just don't know what else to do. So that worries me a little bit about the industry.
Final question, Gus. How do you define success in your life?
I was very fortunate to find a home at Vanguard. I worked at five other companies before I ended up at Vanguard, and the first week I was at Vanguard, I realized that was the company I wanted to work for for the rest of my career. I absolutely love the culture of the company. It had a really strong corporate culture. Most of the companies that I had worked for didn't really have a corporate culture I could put my finger on, but Vanguard really was unique in that. We talked about the ownership structure, and it made us very much focused on the investors in the funds. We only had one master to serve. We didn't have external investors that wanted us to generate a profit for Vanguard. We only had investors in our funds, and so we were fully devoted to making sure those investors in the funds were treated fairly and succeeded. And I recognize that the first week I was at Vanguard and I love that aspect of Vanguard.
And to me, I feel that was psychological payment for me, to know that we were doing really good things for investors. And we had a program that we called our Swiss army that cropped up in 1987 when the markets were in turmoil. We called it our Swiss army and we would answer the phones from all different parts of the company. So I would answer the retail phones when people would call up nervous and out of control. And I was sitting there next to Jack Bogle one time. Jack was answering the phones. And so you really got to see the fear of investors and the good news about investors as well, and really feeling that and feeling how we were impacting investors. I can't tell you how many investors would say, "I'm just so thankful for what you're doing for me." And to me, that is really what has been valuable in my life.
Incredible. Well, Gus, this has been an incredible time. You've been a major part of such an incredible organization, and I'm so happy you could join us today. Thanks so much.
Oh. Thank you so much for having me. I've enjoyed it.
BONUS:
…So Jack Bogle hated the concept of ETFs. Nate Most was the guy who really invented the concept back in the 80s and actually went in and met with Jack Bogle and wanted Jack to turn our S&P 500 fund into an ETF. And Jack virtually kicked Nate out of his office. So then about 1993, Nate came back and tried again and said, "Jack, I'd like to start this ETF," and I don't know what he was calling at the time, not an ETF, but whatever. And Jack, again, kicked him out of his office. And so then Nate ended up going to SSGA State Street and they started The Spider. That was the very first ETF, but Jack was adamant against ETFs. He felt that since they could be traded, they would be traded and they just turned people into market timers. And Jack really, really did not like ETFs.
Well, Jack retired, but he stayed around Vanguard. He had office space at Vanguard doing his research, the Bogle Research Center, and Vanguard has several large campuses. And the main campus has a cafeteria and basically 75% of the people eat in the cafeteria every day. So Jack always went to Lake Placid for a month, the month of August every year. And he had had a house there. So he was away when it came out that we were actually working on ETFs. We had started working on it two years earlier, but we kept it very, very quiet. Nobody in the world knew about it. Even Jack didn't know about it. And it came out and then appeared in the Wall Street Journal that Vanguard was going to be coming out with ETFs. So Jack, first time he heard about it was reading it about it in the Wall Street Journal in Lake Placid.
So he came back from Lake Placid, and the way our cafeteria was set up, you could go in on the ground level, it was two levels. So you could enter the top level or the ground level. And I was coming across from across the courtyard at the ground level. And I went in there and the cafeteria was actually on the ground level, but there's a big, big foyer there. And then you'd enter the other side, and Jack came in from the other side at just the same time. And there are always, at noon, there are 50 people at a minimum in the foyer itself going into the cafeteria. And Jack's at the top of the stairs, and I don't know if you've ever heard Jack speak, but he had an extraordinarily deep voice. He was a double bass, and he was at the top of the stairs and he saw me at the bottom.
And all of a sudden, I just heard this. "Gus, What the hell is going on around here?" And so I said, "Oh. Hey, Jack, welcome back." And so Jack didn't like ETFs too well, but-
Wow. He softened up though with time, right?
Well, yeah, kind of. Maybe his last three or four years, I think he did, but he was also invited to speak at something that Jim Wyatt put together. Jim Wyatt put together a group on ETFs and it was an advisory group to begin with. And I was on the advisory group and he thought, "Well, for the inaugural meeting, we'll have Jack Bogle speak." And I'm thinking, "Jim, I don't think you know what Jack's view on ETFs is. Jack spoke at this and they're probably 12 or 15 people in the group, and Jack just beat the hell out of ETFs. And Jim Wyatt was, he was in a coma thinking like, "Wow, I didn't see that coming." I said, "Jim, I could have told you this was what would have happened."
That's too funny.
But yeah, he didn't ... For the first 10 years or so that we were in ETFs, 10 or 15, he was not a fan, but I think in his final years. His last three or four years of life, he acquiesced a little bit.
Super interesting. Do you think that, because they get favorable tax treatment in the US and Canada, we don't have that. Do you think that's going to stay?
Well, they don't. They don't get favorable tax treatment in the US that's marketing. And that's what in the early days our competitors were saying. Well, Vanguard's index funds are tax inefficient. And then our structure was such that the ETFs were tied into the index funds themselves. And so they were saying, "Well, therefore Vanguard's ETFs are going to be tax inefficient," but our ETFs are tax efficient. There are no tax laws that apply to ETFs. The tax laws apply to regulated investment companies, and an ETF is a regulated investment company just like a traditional mutual fund. So they have the exact same tax treatment. Vanguard's ETFs have never ... Well I say today, but I've been retired for 10 years. At least through my tenure there, we'd never distributed capital gain out of an ETF or out of the index funds, despite the fact that our competitors said we always used that. Every meeting we went into, people said, "Well, your index funds are going to be tax inefficient." I kept saying, "No. It's not true."
We still hear that pitch today.
It drove me crazy for 15 years. I had to retire.
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Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/
Cameron on Twitter — https://twitter.com/CameronPassmore
Gus Sauter — https://www.chicagobooth.edu/alumni/distinguished-alumni-award/honorees/george-u-sauter