Bogleheads® on Investing Podcast 005 – Gus Sauter, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC]

00:00:10.000 | Hello everyone, and welcome to Bogleheads on Investing,

00:00:14.600 | episode number five.

00:00:16.880 | Today, we have a special guest, Gus Sauter,

00:00:21.320 | former Chief Investment Officer of the Vanguard Group of Mutual Funds.

00:00:26.260 | [MUSIC]

00:00:36.260 | My name is Rick Ferry, and I'm the host of Bogleheads on Investing.

00:00:43.240 | This podcast is brought to you by the John C.

00:00:46.080 | Bogle Center for Financial Literacy, a 501(c)(3) corporation.

00:00:52.120 | Today, we have a special guest, Gus Sauter.

00:00:56.080 | Former Chief Investment Officer and head of Vanguard's indexing and

00:01:01.500 | quantitative strategies, as well as the creator of Vanguard's exchange traded

00:01:06.600 | funds, let's welcome Gus Sauter.

00:01:11.080 | Gus, welcome to our show.

00:01:13.240 | >> Thank you, Rick, glad to be with you.

00:01:15.280 | >> Gus, you're a favorite among the Bogleheads, and

00:01:18.560 | you've got a really interesting background about how you got started in investing.

00:01:23.400 | Could you share with us some of your earlier ventures into the markets,

00:01:28.040 | as far back as you can remember?

00:01:30.240 | >> Yeah, I guess I was always intrigued with how money could make money for you.

00:01:34.760 | I guess I used to travel to the bank with my parents, and watch them make deposits,

00:01:40.800 | and try to figure out what was going on in the banking system.

00:01:43.320 | This is back before I was ten years old, and I was really intrigued with the notion.

00:01:47.560 | So I actually started my own little bank,

00:01:51.440 | which probably violated hundreds of laws.

00:01:55.400 | But I basically collected deposits, and then invested that in the bank, and

00:02:00.240 | earned a little bit of return, and then returned that to the investors.

00:02:03.880 | But it was really kind of my first foray into kind of the world of investing,

00:02:09.200 | if you will.

00:02:09.720 | And I was about, I'm gonna say I was about ten years old when I did that.

00:02:13.400 | That really piqued my interest, and when I was 12 years old,

00:02:16.480 | I had had a paper route for a couple of years.

00:02:18.360 | And I made a fair amount of money for a little kid back in the 60s,

00:02:23.380 | and had some money to invest in my first stock was in a local

00:02:28.680 | firm called Rupp Industries.

00:02:31.320 | They made snowmobiles, actually went under after a few years, so

00:02:35.360 | I didn't make much money on that.

00:02:37.560 | My second investment, I am proud to say I'm one of the original owners of

00:02:41.320 | the Cleveland Cavaliers.

00:02:42.620 | So they went public when they first came out, when they were first formed.

00:02:47.360 | And I invested in that stock, I think it was maybe 1969, so

00:02:51.860 | I was about 15 years old at that point in time.

00:02:54.520 | But all of this really led to my strong interest in investing, and

00:02:58.480 | led to my academic career focusing on economics and finance.

00:03:04.160 | >> So your undergraduate was from Dartmouth College, and then right after

00:03:08.640 | that, you went to the University of Chicago for an MBA, or

00:03:12.560 | did you do something in between?

00:03:15.160 | >> I worked for a couple of years, so

00:03:17.000 | really jobs that weren't really getting me towards my ultimate goal.

00:03:21.200 | I graduated from college in 1976, which was a tough job market.

00:03:25.160 | And so I kind of took what came along, and

00:03:28.040 | knew that I wanted to go back to business school anyway.

00:03:29.920 | So I worked for two years, and then did go back to the University of Chicago.

00:03:34.720 | >> Back then, say early 1970s, when you were at the University of Chicago,

00:03:38.800 | I mean, was the culture there like it is now, where there was a belief in

00:03:43.760 | passive investing by one side of the finance department, and then there was also

00:03:48.520 | belief in active investing by the other side, is it as pronounced as it is today?

00:03:52.240 | >> It was not as pronounced back then.

00:03:55.840 | There was a course in behavioral finance back then, wasn't widely taken,

00:04:02.360 | but that was kind of the initial seed towards belief in active as well.

00:04:06.960 | I would say that the belief in passive really dominated back in the 70s,

00:04:13.200 | at the University of Chicago.

00:04:14.680 | Today, it is more balanced.

00:04:16.320 | The UChicago has a very large behavioral finance group now,

00:04:21.520 | led by Dick Thaler, who just recently won the Nobel Prize.

00:04:24.680 | And so it's more of a balance than it was back then.

00:04:28.200 | >> After you graduated from the University of Chicago, what did you do after that?

00:04:33.600 | >> My initial job, I ended up as a commercial real estate developer,

00:04:37.560 | working for a national firm, but relatively small, called LaSalle Partners,

00:04:42.200 | which is now the LaSalle of Jones Lang LaSalle.

00:04:45.560 | They merged into Jones Lang.

00:04:47.400 | It was a great firm with very high quality professionals, and

00:04:51.920 | I did enjoy it a lot.

00:04:53.280 | I was on the analysis side, on the development side, in building buildings,

00:04:57.400 | and I was doing all the financial analysis behind it.

00:05:00.520 | This was in the Denver office, I was transferred to the Denver office, and

00:05:03.920 | we built several large buildings while I was out there for a couple of years.

00:05:07.920 | And then through a friend of a friend,

00:05:10.640 | I came across an opportunity to pursue gold mining, which reminds me a lot.

00:05:16.240 | It certainly does to me now.

00:05:18.040 | So I had this opportunity to put together a deal to create a gold mine.

00:05:22.880 | So I put a venture capital deal together, started the gold mine.

00:05:25.880 | It was south of Las Vegas.

00:05:27.800 | Our options were to either live in Las Vegas or Needles, California.

00:05:32.480 | My wife agreed to go with me only if we went to Las Vegas.

00:05:35.480 | So I ended up in Las Vegas for three years.

00:05:37.160 | It took me three years to drive that company under, and at that point,

00:05:42.320 | it became clear to me I wanted to pursue a career in investing.

00:05:49.200 | And I had a good friend at the University of Chicago who had gone immediately

00:05:53.840 | to work with Pimco, and he kept after me saying,

00:05:56.600 | you've got to get into the investment business.

00:05:58.440 | He said he would love it.

00:05:59.440 | And so I finally did pursue it in 1985 when the gold mine went under.

00:06:04.840 | And is that when you interviewed with Vanguard?

00:06:07.800 | No.

00:06:08.800 | Actually, I interviewed with Pimco a couple of times, and I made the weird decision that

00:06:14.440 | I wanted to return back to my home state of Ohio.

00:06:17.960 | The unfortunate thing is there are not many investment management firms in Ohio, but I

00:06:21.520 | did move back to Ohio and work for a couple of years in a trust investment department.

00:06:27.000 | And I was fortunate in that the head of the trust investment department wanted to develop

00:06:32.440 | a quantitative investing program.

00:06:34.520 | And I was the only person in the group that had quantitative investment skills because

00:06:38.080 | I had focused on quantitative finance at the University of Chicago.

00:06:42.280 | And so I basically got the opportunity to build that program.

00:06:46.160 | And it turned out I ran into Jack Brennan, who subsequently became chairman and CEO of

00:06:52.840 | Vanguard many years later, ran into him at our 10th reunion at Dartmouth.

00:06:58.480 | We were classmates.

00:06:59.480 | He was asking what I was doing, and I told him about my work in the regional bank.

00:07:05.400 | And a couple of months later, got a call from Jeremy Duffield, who ended up hiring me into

00:07:10.400 | Vanguard.

00:07:11.400 | And when you went to Vanguard to be hired, did you get a chance to meet with Jack Bogle?

00:07:16.520 | Yeah.

00:07:17.520 | I actually interviewed with Jack.

00:07:20.120 | I went out on a Friday afternoon, we were going to meet Saturday morning, and I was

00:07:24.040 | going directly from an event at my wife's employment.

00:07:28.960 | And so I was wearing tennis shoes or basketball shoes, and I had my good shoes in the back

00:07:35.640 | of the car.

00:07:36.640 | When she drove me to the airport, I left my good shoes in the back of the car.

00:07:40.360 | I ended up interviewing in basketball shoes, which was a little nerve wracking.

00:07:46.920 | I still ended up getting the job, but I guess Jack thought it was a little amusing.

00:07:51.800 | Well, you were going to be doing a lot of running at Vanguard anyway, so I guess it

00:07:55.480 | was appropriate.

00:07:56.480 | Yeah, good point.

00:07:58.560 | So then you started at Vanguard, and your first job there was to create a quantitative

00:08:06.680 | investing program at Vanguard?

00:08:09.240 | That's right.

00:08:10.800 | Yeah, exactly.

00:08:12.240 | Vanguard had, at that point, one S&P 500 index fund, the 500 index fund, and a couple of

00:08:20.040 | separate accounts.

00:08:22.040 | And most of the money was in the S&P 500, about a billion, 1.2 billion, I think, to

00:08:27.360 | be exact.

00:08:29.480 | Jack wanted to expand the program dramatically.

00:08:32.440 | His own son had gone into active quantitative investing, which is what I had been doing

00:08:36.940 | at the bank, and so he wanted to build both the index side and the active quant side.

00:08:43.560 | It turns out that active quant and indexing use many of the same techniques.

00:08:48.840 | I think of indexing as really passive quant versus active quant, and so I was in charge

00:08:54.560 | of trying to build out that entire program.

00:08:57.760 | So Gus, in 1987 when you joined Vanguard, they had one index fund, it had less than

00:09:03.160 | a couple of billion dollars in it, and the focus was on building out a quant shop, and

00:09:07.840 | this was Jack Bogle's decision.

00:09:09.560 | So he was, even at that time, looking at straddling both sides of the fence.

00:09:14.980 | Then indexing really began to expand, and you must have been given more and more direction

00:09:21.880 | to create all these different new index funds, international fund, even the real estate fund

00:09:29.320 | and so forth.

00:09:30.320 | So as you started out doing quant and you were expanding that, and then how did you

00:09:34.200 | pick up the role of expanding indexing as well?

00:09:36.920 | Yes, so as you noted, we had one index fund, and actually that was the entirety of all

00:09:43.720 | of the internally managed equity funds.

00:09:46.640 | As you know, Vanguard uses external advisors for traditional active equity management,

00:09:51.760 | and we were trying to build out the internal management, both on the index side, the passive

00:09:58.000 | side, and the active quant side.

00:10:00.920 | Jack wanted to build that out as well, and the common thread is that they both use very

00:10:06.560 | similar techniques, active quant versus passive quant.

00:10:10.160 | So initially, the one index fund, we followed that with a small cap index fund.

00:10:17.560 | That was in 1989, and then just kept expanding the offering over time as we gained critical

00:10:27.480 | mass within the lineup and felt the need to add to it.

00:10:33.920 | We did launch new funds as an example, and I think in 1993, we launched Total Stock Market,

00:10:40.080 | and that really is the fund that people should most be focused on.

00:10:45.600 | It is the total U.S. market.

00:10:48.040 | I should say that actually, I started October 5th of 1987, and the crash happened two weeks

00:10:56.880 | later, October 19th of 1987.

00:10:59.840 | In the meantime, we were trying to develop the extended market portfolio, and we ultimately

00:11:04.400 | launched that December 21st, 1987.

00:11:07.480 | So I was there for a total of two months.

00:11:10.600 | The equity group consisted of one other person and me, and I was trying to manage what was

00:11:17.320 | going on with the crash.

00:11:18.320 | At the same time, develop the extended market portfolio.

00:11:23.120 | So there was a lot going on managing money under fire and trying to develop new funds.

00:11:29.240 | We kept rolling out more and more funds over the years.

00:11:33.240 | Indexing was not well accepted at the time.

00:11:35.200 | I remember going to conference after conference, so these would be retail-oriented back in

00:11:40.040 | the '90s, trying to talk about indexing, and the typical MO then was I'd be on a panel

00:11:46.160 | with one other active manager, and not coincidentally, that active manager would be a very successful

00:11:51.040 | active manager, and I would be debating the merits of indexing, and that active manager

00:11:55.320 | would be talking about how active management is so easy.

00:12:00.080 | And so it was really a tough slog back in the '90s, so it was kind of built brick

00:12:07.040 | by brick, and we kept offering new funds, and our competition was kind of putting down

00:12:12.200 | the concept of indexing, but it slowly did take hold, and I think there were several

00:12:18.520 | reasons that ultimately, indexing has gotten to the point where it is today.

00:12:25.000 | Just before we get to the growth of the indexing side, how did the quant side do during all

00:12:29.120 | of this?

00:12:30.120 | Were you able to develop programs or strategies that actually worked, or did you find that

00:12:36.400 | they worked for a while, and then they didn't work anymore?

00:12:39.120 | Yeah.

00:12:40.760 | So in 1989, a couple of years after I arrived at Vanguard, we actually did start working

00:12:47.200 | on our ActiveQuant program, and quite honestly, that was my true love.

00:12:52.080 | Most managers want to try to beat the market and prove that they have some skill, and I

00:12:56.960 | guess I was no different from most other people in the industry in that regard.

00:13:01.660 | So it was very intriguing to me to try to put quantitative programs together.

00:13:07.100 | These would be computer programs that would actually pick stocks and then try to beat

00:13:12.100 | various market indexes.

00:13:14.240 | We launched our first fund, I think, or our first portfolio, I think it was 1991.

00:13:19.180 | It was a portion of Windsor II, and we had some varying success with that.

00:13:25.780 | By and large, the program was successful.

00:13:28.060 | We kept adding more and more funds.

00:13:29.580 | We added a portion of Morgan, a portion of Explorer, and the Strategic Equity Fund.

00:13:35.980 | I think Strategic Equity was 1994, and so we kept growing the quant side alongside of

00:13:42.300 | the index group, and we had reasonable success.

00:13:46.060 | Like any active manager, we'd have periods where we'd do pretty well, and periods where

00:13:51.980 | we'd experience a lot of difficulties.

00:13:54.980 | Over a longer time period, we were successful at adding some incremental value above and

00:14:01.180 | beyond a benchmark return, and that program continues to this day, and it is in the tens

00:14:07.580 | of billions of dollars, which pales in comparison to indexing, but is fairly large for an active

00:14:15.420 | quant shop.

00:14:16.940 | And so I would say that it was ultimately a successful program, but then again with

00:14:22.380 | measured success.

00:14:23.380 | I mean, just like any active manager, it's a very difficult game to the extent you can

00:14:28.740 | outperform market benchmarks, you're doing fairly well.

00:14:32.200 | So can I drill down into something that you often hear about out in the public, and advisors

00:14:37.820 | say this all the time.

00:14:38.820 | It's like, "Ah, I'm going to go out and index the easy stuff, the big stuff, the stuff that

00:14:42.980 | it's hard to find value, so I'm going to use index funds for U.S. large cap."

00:14:47.940 | But there is opportunity in U.S. small cap, because companies are not followed as closely

00:14:54.860 | on and on a lot of different reasons.

00:14:56.620 | In your experience, is that true, that there are more opportunities to outperform for managers

00:15:04.340 | in, say, small cap than large cap?

00:15:07.420 | Well, it really isn't true.

00:15:10.500 | I understand that their argument really goes back to the beginning of modern portfolio

00:15:16.300 | theory back in the 60s and 70s, and is refuting the efficient market hypothesis that was developed

00:15:22.820 | by a number of academicians, primarily Gene Fama, who won the Nobel Prize for his work.

00:15:30.900 | Most active managers say, "Well, the markets are not efficient, and therefore you can add

00:15:34.580 | value," and they say, "Well, maybe they're efficient in the large cap segment of the

00:15:37.780 | market, but they're not efficient in international markets, particularly emerging markets or

00:15:41.500 | small cap segment of the U.S. market."

00:15:45.180 | If the markets were perfectly efficient, then clearly the only thing you should do would

00:15:50.260 | be to index.

00:15:51.260 | Personally, I believe markets are not perfectly efficient.

00:15:54.140 | I think they're reasonably efficient, and they are getting more efficient, but there

00:15:58.580 | might be some opportunities to add value.

00:16:01.340 | The interesting thing to me is that my belief and Vanguard's belief, I believe, about indexing

00:16:09.500 | is not based on the efficient market hypothesis.

00:16:12.540 | It's based on what's become known as Bill Sharpe talked in the early 90s about the math

00:16:20.460 | behind indexing, and it's a really simple concept that in aggregate, all investors own

00:16:27.740 | the market.

00:16:29.820 | What rate of return can investors possibly get?

00:16:32.980 | That's the market rate of return, because collectively they own the market.

00:16:36.840 | You might guess that some investors could do better than the market, but it would necessarily

00:16:40.240 | mean that others would have to underperform the market.

00:16:43.220 | Unfortunately, investors do have costs of getting the market rate of return, so collectively

00:16:47.580 | they don't get the market rate of return.

00:16:49.180 | They get something less than the market rate of return, and it's significantly less.

00:16:53.060 | It's about 1% less.

00:16:54.940 | That's roughly the range of costs, and arguably even greater than that.

00:17:00.820 | Somebody who outperforms a little bit before costs ends up underperforming after costs,

00:17:05.660 | and it means the majority of investors will underperform a market benchmark.

00:17:10.860 | That argument does not apply to the S&P 500.

00:17:13.660 | It does not apply to large-cap stocks in the U.S.

00:17:16.900 | It applies to the market, all of the market.

00:17:19.540 | Whether you're talking small-cap stocks in the U.S. or emerging markets or other international

00:17:25.220 | markets, that simple concept, Sharpe's math, still applies.

00:17:31.140 | In fact, we've seen that the data supports that.

00:17:33.500 | If you look at the performance of active managers in emerging markets relative to an emerging

00:17:38.440 | market benchmark, the majority will underperform.

00:17:42.300 | The same is true when you look at small-cap segments within the U.S., whether it's small-cap

00:17:46.660 | value, small-cap blend, or small-cap growth, the small-cap managers have a very difficult

00:17:52.060 | time beating the small-cap segment of the market.

00:17:55.980 | While some can, in aggregate, they can't and don't and haven't.

00:18:02.180 | If active managers, before fees, have some skill and can outperform, for whatever reason,

00:18:07.540 | whether quantitative or going out and meeting with companies and picking stocks or whatever

00:18:12.180 | the reason, they actually do outperform, before fee, on average, but underperform net of fees,

00:18:21.660 | then why wouldn't we just go out, if we're going to look for active managers, and just

00:18:25.620 | hire the active managers who have the absolute rock-bottom lowest cost?

00:18:31.100 | I think it's a great point.

00:18:33.420 | In fact, that is one that we argued at Vanguard, and Vanguard still supports that today, that

00:18:39.100 | really, while people think of Vanguard as an index shop, and many people think that's

00:18:45.700 | all Vanguard does, we thought of ourselves as low-cost investors, trying to provide low-cost

00:18:52.180 | investing to all of the investors in our funds, whether it was index funds or active funds.

00:18:59.740 | As mentioned in the Bill Sharp math, the handicap that active management has is cost, and so

00:19:06.940 | it's very important to keep those costs as low as possible in order not to handicap your

00:19:12.900 | active managers.

00:19:14.180 | You can take a great active manager and make them a bad active manager by overcharging

00:19:18.940 | for them, and so you should focus on low-cost funds, and in fact, there have been many,

00:19:26.300 | many studies, Morningstar has done them, academics have done them, that show that the best predictor

00:19:33.340 | of future relative performance is cost.

00:19:36.780 | So in other words, the lowest-cost funds will outperform the highest-cost funds on average,

00:19:43.380 | and so you should definitely be focusing on that segment of the market as you're going

00:19:47.220 | after active management, or index funds as well.

00:19:51.600 | There are high-cost index funds, which makes absolutely no sense, but I would also point

00:19:56.100 | out that even though you go to a low-cost manager, they have to have skill in addition

00:20:02.100 | to just being low-cost.

00:20:04.740 | Low-cost isn't the only recipe, you need skill as well, because they have to be able to take

00:20:11.860 | advantage of other investors, and it turns out that if you're going to outperform, somebody

00:20:17.860 | else has to underperform.

00:20:20.700 | By definition, if in aggregate, everybody gets the market rate of return before cost,

00:20:25.540 | you're proposing that there's a greater fool out there that you're going to be able to

00:20:30.500 | take advantage of, and I think that people used to say, "Well, the retail investors were

00:20:35.620 | the greater fool, those who were investing their own money without the use of professionals,"

00:20:40.220 | and it turns out that if you go back to the '70s, there were a lot of retail investors.

00:20:44.780 | A large portion of the U.S. marketplace was dominated by retail investors.

00:20:49.540 | Today that's not the case.

00:20:51.220 | Today, it's really dominated by institutional investors.

00:20:55.060 | It's a very, very difficult game today because it's hard to find the greater fool out there

00:20:59.380 | today.

00:21:00.380 | I'm going to put one more item in there about low-fee active management.

00:21:04.960 | My studies and my research in looking at that, it seems like some of the active management

00:21:11.060 | firms are gaming that because when you look at the performance of very low-fee active

00:21:16.820 | managers, and I'm not talking about Vanguard or any particular fund, but in the aggregate,

00:21:20.940 | the funds that have low fees, a lot of them tend to be closet index funds.

00:21:26.180 | They're not really active management.

00:21:28.080 | They're just looking for investors who are looking for low fees, just buying into the

00:21:32.900 | argument, the Bill Sharp argument that fees are the main driver of return, and therefore

00:21:39.460 | you should be looking for active managers that have low fees, and so people are looking

00:21:44.140 | for that and they're hiring managers that have low fees, but they're not really looking

00:21:47.580 | at the skill side because a lot of these funds are just "closet index funds."

00:21:53.100 | Have you found that to be true?

00:21:55.740 | I think it is true in some cases, and certainly factor funds are that, they're purely that,

00:22:03.420 | but you're right that you have to have that skill component if you're going to make any

00:22:10.140 | sense out of active management.

00:22:11.980 | Low cost is one requirement, but it's not the only requirement to add value and actually

00:22:18.900 | beat the marketplace.

00:22:22.240 | Once people begin to find the good active managers that have skill, that also have low

00:22:27.540 | fees, then that's where all the money goes, and this also then changes the dynamics of

00:22:33.380 | the fund itself and makes it even more difficult for the active manager to outperform, so doesn't

00:22:39.740 | the fund have to close at some point?

00:22:42.620 | Yes, there is no question to that.

00:22:45.980 | The size is very difficult to manage.

00:22:50.260 | Smaller funds, intermediate-sized funds, tend to outperform the mega funds, so a fund should

00:22:56.860 | close if it gets to be, or should be closed if it gets to be too large.

00:23:01.780 | The way we attacked that at Vanguard was to use multiple managers, so if you look at funds

00:23:07.140 | like Morgan and Windsor II and Explorer, as those funds got larger, we realized that one

00:23:12.980 | manager couldn't handle more and more assets, so we added additional managers in what are

00:23:20.500 | called multi-manager funds.

00:23:22.380 | There are other funds like PrimeCap, where PrimeCap themselves recognize the detriment

00:23:28.780 | of having too much in the way of assets, and PrimeCap is always very aggressive about saying,

00:23:34.620 | "No, we've got to close the fund," and so the PrimeCap fund, capital opportunities, those

00:23:39.740 | are closed because of the difficulty that size poses on providing extra returns.

00:23:47.340 | I'm going to shift gears here and start talking about exchange-traded funds, which was something

00:23:52.020 | that Jack Bogle was against initially, but Jack Brennan was for, and I believe he tasked

00:24:00.020 | you with figuring out how to do it, and you came up with, or you helped, and your group

00:24:06.380 | came up with this patent that allowed your open-end funds to issue ETF share classes

00:24:16.220 | and used to call them "vipers."

00:24:18.180 | Could you talk about all that evolution and how that came about?

00:24:21.460 | Actually, it turns out that at the beginning, Jack Brennan wasn't really behind the concept

00:24:26.060 | of ETFs either, but you'll recall in 1997, we experienced a correction in the market

00:24:32.540 | in the fall time, which became known as the Asian contagion, a lot of difficulty in Southeast

00:24:38.900 | Asian communities that created some global turmoil.

00:24:43.180 | Then in 1998, the summer of '98, we had the Russian debt crisis, the Russian bond crisis,

00:24:51.260 | and once again, creating turmoil in the marketplace.

00:24:53.820 | This is all with the backdrop of a very strong bull market in the U.S. that was the tech

00:24:59.780 | bubble building, but you had these corrections along the way.

00:25:03.580 | I guess I was a bit of a product of when I started at Vanguard in 1987 and the crash

00:25:07.900 | hitting two weeks later, and I was responsible for the S&P 500 fund and trying to figure

00:25:11.980 | out how we were going to handle this.

00:25:15.020 | I started worrying as our index program was getting much, much larger a decade later by

00:25:19.740 | '97 and '98, I was thinking, "What if we had another crash and we had people running

00:25:27.420 | for the exits?

00:25:28.420 | How would we be able to fund the redemptions on a much bigger base than we had back in

00:25:35.060 | 1987?"

00:25:36.060 | I started thinking about, "Well, if we could provide a vehicle for people who were less

00:25:42.620 | long-term oriented than we would like, those that might be inclined to jump ship, then

00:25:49.220 | that would be a good way to steer them away from our longer-term investors so that they

00:25:55.220 | wouldn't have a negative impact on those long-term investors."

00:25:58.180 | At the time, ETFs were starting to get a little bit of momentum.

00:26:02.340 | They were started in 1993, but started off very, very slowly.

00:26:07.100 | I started thinking about the concept of creating a share class of our existing funds.

00:26:12.980 | The problem was, what happens if we have investors in our existing funds who got scared in a

00:26:18.660 | market pullback?

00:26:19.660 | I was talking to Walter Lenhard, who was in our group, we came up with the idea of, "Well,

00:26:26.180 | if we create this other share class and enable investors who might be shorter-term oriented

00:26:33.180 | to transfer from the regular share class into that other share class, that they could then

00:26:38.860 | sell out of that share class in the ETF marketplace at any point in time when they might become

00:26:44.300 | nervous."

00:26:45.300 | Our ETFs were very different from the other ETFs that existed then and exist to this day,

00:26:53.340 | that our ETFs were merely a part of the exact same fund as our traditional index funds.

00:27:00.620 | They were simply another share class.

00:27:03.460 | To explain that a little bit more, in our various index funds, we have a lot of different

00:27:08.580 | share classes, the investor share class, the admiral share class, the institutional share

00:27:12.620 | class.

00:27:13.620 | They're all investing in the same pot of money, but just coming in through a different service

00:27:18.300 | door, if you will.

00:27:20.500 | The ETF portal was just one more entrance into that same fund.

00:27:24.420 | The portfolio manager is managing one pot of money without really even the knowledge

00:27:29.300 | of where the money came from.

00:27:31.820 | The beauty of the ETF structure, the sidecar, if you will, was that if investors wanted

00:27:37.380 | to get out of their portfolio or their investment in the index fund, they could sell it on the

00:27:45.380 | exchange through the ETF share class and it had absolutely no impact on the other investors

00:27:51.140 | in the fund.

00:27:52.140 | It accomplished what we were hoping to do, and that was enable investors who might not

00:27:58.940 | have the long-term orientation that we desire a way to exit the fund without impacting other

00:28:06.020 | investors.

00:28:07.020 | You went out and patented this idea, and you got a patent on it, and to this day, no other

00:28:13.780 | company can do that, exactly what you described, which is a great idea, a genius idea to do

00:28:19.540 | it that way, but other companies now can't do that.

00:28:24.940 | Because of the patent, they would have to go to Vanguard and pay Vanguard something

00:28:28.700 | to use the patent.

00:28:30.480 | That's correct.

00:28:31.480 | I think in total, I might have five or six patents on that concept.

00:28:36.380 | They keep expanding them, but there is a statute of limitations that you can keep people away

00:28:42.480 | from using your patent, and it's about to run out.

00:28:45.780 | I think it has maybe a couple of more years left.

00:28:48.720 | There were some mutual fund firms that approached us asking if they could use the concept, and

00:28:53.660 | we were willing to talk with them.

00:28:56.500 | Nothing ever came of it, and I don't know, it will be interesting to see if others adopt

00:29:03.220 | this structure once our patent does run out within the next several years.

00:29:08.540 | I find it odd because I personally have approached a couple of big mutual fund companies who

00:29:14.380 | are competitors of Vanguard, and I said, "Why don't you just pay Vanguard to use their patent

00:29:19.940 | because if you have only open-end funds, you could really help to eliminate all of these

00:29:26.140 | capital gain distributions at the end of the year if you did the ETF plus open-end share

00:29:31.860 | strategy or concept that Vanguard has created."

00:29:36.420 | I don't know what Vanguard would charge, but if they charge a couple of basis points, just

00:29:40.340 | pay it because it would help the shareholders in your open-end fund.

00:29:44.580 | They just didn't have any interest in paying Vanguard at all.

00:29:48.700 | Well, yes, and maybe that's not terribly surprising, paying a competitor who is having a lot of

00:29:54.980 | success in the marketplace anyways, you don't want to subsidize Vanguard's success.

00:30:02.180 | I would say that there were several unintended benefits from that ETF structure as well.

00:30:10.140 | I was really looking for a way to insulate the fund from short-term investors' negative

00:30:16.540 | impacts on a fund, and the side benefit that you just mentioned is that it also enhanced

00:30:23.820 | the tax efficiency of the fund.

00:30:27.900 | We got a lot of benefits from it.

00:30:30.860 | It also opened up a whole marketplace for us that we really hadn't addressed previously,

00:30:35.900 | and that was the advisor market.

00:30:37.500 | We were relatively small in the advisor channel, and this really gave us a platform that advisors

00:30:44.660 | really wanted to use.

00:30:46.700 | Actually, Rick, you may remember this.

00:30:49.900 | We had a meeting with advisors in the early 2000s in Chicago, and it was over dinner.

00:30:57.380 | I was sitting with about five or six advisors, and you happened to be one of them.

00:31:04.100 | I asked the question why advisors were interested in active ETFs.

00:31:09.940 | I could understand the index ETFs, because the thought was that investors wanted to have

00:31:18.020 | the ability to move in and out of the market rather quickly.

00:31:22.620 | It turns out that the advisor group really didn't want that benefit.

00:31:27.460 | People said that's what it was all about, but it really wasn't, and every one of you

00:31:30.500 | sitting at the table said that the reason you liked ETFs was because of the platform

00:31:36.380 | it provided.

00:31:37.380 | In other words, a mutual fund platform is difficult for advisors in that you buy a mutual

00:31:43.940 | fund.

00:31:44.940 | You place your order sometime throughout the day.

00:31:46.180 | You don't know how many shares you're going to be buying.

00:31:48.020 | You don't know what the price is going to be.

00:31:49.520 | You just know the dollar amount, and you find out about 5.30 at night how many shares you

00:31:54.940 | got at what price.

00:31:56.980 | On the other hand, the ETF share class fits right into the advisor platform, which is

00:32:01.740 | typically a brokerage platform where you place your order at whatever time throughout the

00:32:06.260 | day, and within minutes or seconds, your order is executed, and you know how many shares

00:32:12.500 | you wanted to buy.

00:32:13.500 | You bought that many shares.

00:32:14.580 | You know the price you paid instantly.

00:32:18.500 | All of you said that the platform was what really enticed you to that share class.

00:32:23.780 | That opened up a whole new world for us to serve the advisor community as well.

00:32:29.180 | >>COREY: Well, there was another complete new market that you were able to service.

00:32:33.100 | I was an independent advisor.

00:32:35.220 | I wasn't at a brokerage firm, but by creating exchange-traded funds, you opened up Vanguard

00:32:42.260 | to the Merrill Lynches of the world and all of the different advisors that were working

00:32:47.700 | in the brokerage industry, the wire houses.

00:32:50.620 | All of a sudden, brokers now could start using Vanguard funds, whereas before, their companies

00:32:57.460 | would not allow them to buy Vanguard funds because Vanguard didn't pay them a commission

00:33:01.300 | and didn't pay 12B1 fees.

00:33:02.900 | Well, now that Vanguard had exchange-traded funds, brokers from Merrill Lynch and Wells

00:33:09.060 | Fargo and so forth could all begin to use Vanguard funds, so it opened up a huge new

00:33:15.500 | distribution channel, and so it was another byproduct to doing that.

00:33:19.620 | >>STEVE: Yeah, that's kind of a funny story.

00:33:22.780 | Back in the early days, 2001 or something like that, I actually went around with some

00:33:28.140 | of our sales people or service people to talk to some of the major wire houses, and one

00:33:34.580 | of the very, very largest wire houses, I won't name them, was all excited.

00:33:39.900 | They said, "You mean we can buy Vanguard funds because our clients have been asking for Vanguard

00:33:43.980 | funds and they hadn't provided them?"

00:33:45.420 | I said, "Yeah, absolutely.

00:33:46.420 | You can buy Vanguard funds now in this format, and we'd love for you to do that."

00:33:50.300 | They said, "Great, and how are you going to pay us?"

00:33:52.900 | I said, "We're not going to pay you.

00:33:56.900 | You're going to have to figure that out with your clients, but we're not paying you, but

00:34:00.860 | you have access to the funds in the format you want them."

00:34:03.620 | >>STEVE: So let's continue on then.

00:34:05.860 | Great stories.

00:34:07.180 | So you stayed at Vanguard for several more years, and the ETF market just exploded, and

00:34:11.620 | the index funds continued to explode, and the quant group continued to expand, and eventually,

00:34:18.100 | after 25 years, you decided to retire.

00:34:20.900 | >>JEREMY: Yeah, so I had talked with Jack Brennan when he stepped down in 2008.

00:34:29.500 | He was telling individually all of the members of his senior staff, and I was one of the

00:34:33.500 | members of his senior staff, that he was going to step down.

00:34:37.100 | Jack and I had been friends in college, so I was the last senior staff member that he

00:34:41.780 | told, and I was just totally flabbergasted when he told me he was stepping down because

00:34:46.340 | we were the same age, and we were only 54 at the time, so I thought he had lots and

00:34:53.020 | lots of years left.

00:34:56.300 | One of the many reasons that he wanted to step down was because he felt you should only

00:35:00.260 | be CEO of a company for 10 years, and that somebody else should take over and enhance

00:35:06.220 | what you've been able to do.

00:35:08.340 | Another reason was he wanted to do other things as well, and so both of those weighed heavily

00:35:13.040 | on my decision to step down when I was 58 years old, and the third factor that weighed

00:35:20.220 | on my decision was my parents as well.

00:35:22.340 | I wanted to be able to spend some meaningful time with them as they were in their 90s,

00:35:28.660 | and I'm glad I did have that opportunity.

00:35:31.460 | >>COREY: I remember the day talking with you when you announced that you were retiring,

00:35:36.100 | and I asked you what you were going to be doing, and of course, I asked you if you would

00:35:40.540 | work for me, and you kindly declined.

00:35:43.220 | I knew that was never going to happen, but I had to ask anyway.

00:35:46.900 | But now you're back active again.

00:35:49.460 | You're involved in a lot of committees.

00:35:51.220 | You're working as a professor, if you will, or guest professor at University of Chicago.

00:35:59.020 | Could you tell us all the different things that you're doing?

00:36:01.180 | >>JOHN: Yeah.

00:36:02.180 | So when I announced my retirement, I was contacted by the dean of the business school at Chicago,

00:36:08.700 | and I had remained close to the school after I graduated, and he asked me if I wanted to

00:36:16.100 | become an executive in residence at the school after I retired.

00:36:21.940 | What did that mean to you?

00:36:22.940 | Because I'm not sure what it means, and he said, "Basically, you can come and do whatever

00:36:28.460 | you want and build your own program."

00:36:31.700 | So because of my parents' situation, I really couldn't pursue it for about a year, year

00:36:37.460 | and a half after I retired, and then finally, I did show up at the University of Chicago.

00:36:44.220 | I actually only stayed for one quarter.

00:36:46.820 | I ended up doing some guest lecturing.

00:36:49.460 | I mentored a lot of students, spent time with the finance faculty.

00:36:55.540 | My office was right in the middle of the finance faculty.

00:36:58.180 | It was quite intimidating, in fact.

00:37:01.380 | Right across the hall from my office was Gene Fama, five doors down was Lars Hansen.

00:37:06.460 | Both of them had won the Nobel Prize about five months earlier.

00:37:09.860 | Right next door to me was Dick Thaler.

00:37:12.500 | He won the Nobel Prize a year or so ago, and I knew he was going to win it.

00:37:18.260 | John Campbell was right next to Gene Fama.

00:37:20.740 | I believe he will win the Nobel Prize at some point in time.

00:37:23.340 | So here I am among all of these super academics, and that's daunting.

00:37:31.100 | You have to be a little careful what you say, but I think at the same time, they were interested

00:37:35.540 | in my real-world experience.

00:37:37.220 | So while they had, obviously, lots of time to think about the academic side, they were

00:37:41.700 | intrigued with the real-world aspects of finance as well.

00:37:45.980 | So it was a fun experience, but at the same time, I started hearing from firms.

00:37:54.060 | Some wanted me to consider going on boards.

00:37:57.020 | I decided I did not want to join a board of directors because there are lots of things

00:38:01.940 | that boards are involved with that I really didn't want to pursue.

00:38:06.280 | My love was investing, and I really wanted to get back into that.

00:38:09.780 | In my career throughout Vanguard, I actually got pulled further and further away from the

00:38:13.380 | day-to-day investing.

00:38:14.500 | So I wanted to get back to that, and I focused on investment committees, and at this point

00:38:19.180 | in time, I have a portfolio of six different clients on their investment committees that

00:38:26.940 | keeps me more than busy enough.

00:38:29.460 | I'm pretty much flunking retirement, and at the same time, I am on the dean's council

00:38:35.780 | at the Chicago Booth, which is the business school at the University of Chicago.

00:38:39.900 | So I spend a fair amount of time at UChicago as well, so I get to scratch that itch as

00:38:45.820 | well.

00:38:46.820 | It sounds like you're very busy still, which is great because you've got so much experience.

00:38:53.420 | I'd like to turn the questions over to the Bogleheads forum members.

00:39:00.460 | Before I have a guest on the program, I post on bogleheads.org who I'm going to have about

00:39:04.980 | a week prior, and the community Boglehead members will come up and ask various questions.

00:39:12.520 | So these questions will be based on what the Bogleheads want to know.

00:39:20.020 | One person wants to know how you feel about the Fidelity zero-fee index funds.

00:39:25.220 | The number one, are they really no cost, or are they just low-fee or zero-fee, and how

00:39:31.860 | that might impact the whole indexing industry, and this is a race to the bottom, and where

00:39:36.300 | does it end?

00:39:37.300 | Yeah.

00:39:38.300 | Well, first of all, I guess if I were in one of their existing funds prior to the initiation

00:39:44.020 | of these new funds, I'd be a little upset that I'm paying the fee, and I'm not getting

00:39:51.460 | to participate in the zero-fee fund.

00:39:53.940 | In fact, I can't take my money out of the existing fund because I'd have to pay capital

00:39:59.780 | gains to move it to the zero-fee fund.

00:40:02.060 | So it seems to me-

00:40:03.060 | I didn't realize that you can't just move it over, that you would actually have to sell

00:40:08.260 | one fund to just buy the exact same fund.

00:40:11.120 | It's not the same-

00:40:12.120 | Exactly.

00:40:13.120 | Yeah.

00:40:14.120 | It's not like Vanguard structure, where the ETF share class is just another share class

00:40:20.180 | of an existing fund, where you can move within share classes.

00:40:25.940 | This is a whole new fund that you'd have to move to, and if you move to a new fund, you

00:40:31.020 | realize capital gains in your existing investments.

00:40:34.020 | So you're pretty well locked into your existing investments if you've been in there for any

00:40:39.460 | length of time.

00:40:40.460 | So to me, if I had been a loyal long-term investor, I'd be a little bit upset that the

00:40:46.580 | new investor was getting something that I couldn't get.

00:40:51.980 | Now addressing the fee component, I do believe that there are actually zero fees being charged

00:41:00.360 | by Fidelity.

00:41:01.360 | There are some other fees that are paid by the fund.

00:41:04.660 | There may be some direct fees that are relatively minor, but I would also check to see how security

00:41:12.380 | lending is being handled.

00:41:15.780 | Since funds have a big inventory of stocks, they can lend out those stocks to people who

00:41:21.300 | want to go short in the marketplace, and the funds earn a rate of return for doing that.

00:41:27.140 | At Vanguard, depending on the fund, you might pick up an extra basis point in return, or

00:41:31.860 | even as many as 10 or 12 basis points in return from securities lending.

00:41:38.160 | That's just a free return that you're getting because the fund has this ability to lend

00:41:43.060 | out the stocks.

00:41:45.200 | I would check in to seeing how Fidelity is handling securities lending.

00:41:51.460 | It's obvious that Fidelity would have costs of managing these assets, and is Fidelity

00:41:57.700 | just willing to use the funds as lost leaders, or are they making money someplace else?

00:42:04.980 | I would check to see if they're making money in securities lending, and I suspect that

00:42:08.420 | is where they're making the money.

00:42:10.340 | They would be the agent for the fund lending out the securities and being paid a fee for

00:42:17.460 | that.

00:42:18.780 | I suspect, I don't know this for a fact, I haven't checked into it, that Fidelity is

00:42:25.100 | still making a fee, or making revenue from the fund, it's just not in the expense ratio.

00:42:31.500 | It's revenue for providing a different service to the fund.

00:42:36.740 | But to your other point, is this a race to the bottom?

00:42:39.660 | Yes, I think Vanguard created the race to the bottom back when Jack Bogle launched the

00:42:43.700 | first index fund, and Vanguard's had a dramatic effect on the industry, not just the index

00:42:49.380 | side of the industry, but the active side as well.

00:42:52.460 | Fees have come down because of the threat that Vanguard has created in the industry,

00:42:56.820 | and now people are trying to, having against Vanguard on the active side, they've got to

00:43:01.620 | lower fees, and on the passive side, they're lowering fees, and it is a race to the bottom.

00:43:05.620 | I guess the advantage I've always felt that Vanguard has is Vanguard is the only fund

00:43:11.580 | company that is mutually owned.

00:43:14.260 | So in other words, the funds own Vanguard, and the investors in those funds own the funds,

00:43:18.420 | so indirectly, the investors in the funds own Vanguard.

00:43:22.260 | That means Vanguard does not have to generate a profit.

00:43:25.660 | There's nobody else that owns Vanguard that's looking for a return on their capital.

00:43:30.740 | Every other firm has owners that are looking for a return on their investment, and so every

00:43:37.580 | other firm in aggregate somehow has to produce a profit.

00:43:41.220 | Vanguard does not produce a profit because of the mutual structure, and therefore can

00:43:47.860 | offer funds at cost, and to the extent Vanguard has tremendous economies of scale, those costs

00:43:55.020 | are going to be spread across a very large base, and therefore costs will be very low

00:44:01.300 | just naturally.

00:44:02.660 | There's nothing being subsidized.

00:44:05.740 | You don't have to have lost leaders in Vanguard.

00:44:07.620 | It's just a natural consequence of the structure.

00:44:10.060 | >>Corey: A lot of people always ask me, "What is the real true cost of running a mutual

00:44:15.980 | fund?

00:44:16.980 | What is the real cost to the company to run it?"

00:44:20.340 | Well, just look at Vanguard.

00:44:23.340 | You look at their fees, and they're a mutual benefit company, so the cost of running the

00:44:27.220 | funds is the true cost of running a mutual fund.

00:44:31.220 | Other companies, which might be large, actively managed companies, who might be charging 0.6%,

00:44:36.860 | 0.7% versus 0.06%, what's the difference between the cost to run the fund and what they're

00:44:44.940 | getting?

00:44:46.500 | That's called profit, or at least gross profit anyway.

00:44:50.580 | I want to go to a couple more things, and the time we have remaining.

00:44:57.020 | One of them is the idea of smart beta, or is it risk, or is it behavioral-based, and

00:45:05.180 | are the risk premiums, if it is a risk story, are they being compressed by the amount of

00:45:12.980 | "smart beta" or factor investing that's going on?

00:45:16.540 | >>Mark: Yeah, so there's this large undertow in the mutual fund industry nowadays, and

00:45:24.460 | investing in these so-called smart beta products.

00:45:27.100 | They used to be called fundamental indexing, and the marketers just keep making better

00:45:32.220 | and better names to make it sell more and more.

00:45:36.540 | Typically what they are, they're investing in a segment of the market, and most of them,

00:45:42.100 | many of them, are really kind of focusing on the mid-cap value segment of the market.

00:45:48.540 | We know that historically mid-cap value has outperformed the broader market, so not surprisingly

00:45:53.420 | when people do back tests and come out with these funds, the back tests look great because

00:45:58.500 | they focus on mid-cap value, which is outperformed.

00:46:02.900 | The big question is, to me, is would you expect this outperformance to continue into the future,

00:46:10.420 | and if so, why?

00:46:12.180 | Is it based on risk?

00:46:13.620 | Modern portfolio theory tells us the greater the risk you take, the better the return you

00:46:18.660 | should get, and that's what a lot of people have said, is that you're taking additional

00:46:24.540 | risk and therefore you should get a greater return.

00:46:27.820 | The problem I have with that is there are two types of risk.

00:46:31.100 | One is called systematic risk, and the other is non-systematic risk, and so systematic

00:46:35.700 | risk is really the risk of investing in the market itself, and then non-systematic risk

00:46:41.500 | would be investing in smaller segments of the market.

00:46:44.580 | It might even be extended to investing in individual stocks, so there's what's called

00:46:50.660 | an idiosyncratic risk component of an individual stock, and that would be non-systematic risk.

00:46:58.180 | So the market risk of a stock, let's just call it Apple, if the market goes up, Apple

00:47:05.680 | will tend to go up.

00:47:06.680 | If the market goes down, Apple will tend to go down, but Apple will do differently from

00:47:10.300 | the market.

00:47:11.300 | It'll do better or worse based on its own characteristics.

00:47:13.980 | That's the non-systematic portion of risk.

00:47:18.300 | So my question would be, should you be compensated for non-systematic risk?

00:47:24.660 | And portfolio theory tells us that you should not be.

00:47:28.580 | Non-systematic risk can be diversified away, and so if society does not bear a risk, why

00:47:35.140 | should society pay you to take that risk?

00:47:39.540 | So society doesn't bear non-systematic risk.

00:47:42.060 | Society only bears systematic risk, in other words, society only bears market risk.

00:47:46.200 | Why should society pay anyone else to take on certain segments of risk?

00:47:51.900 | And taking that to, as an example, look at the, let's say there are 10 sectors of the

00:47:59.340 | market, the financial sector, the energy sector, the healthcare sector, and so on.

00:48:04.140 | So let's say you divide the market into 10 broad sectors.

00:48:07.780 | Well, invariably, almost every one of the sectors will be riskier than the market as

00:48:12.860 | a whole.

00:48:13.860 | And I've actually done this exercise and shown that about seven or eight of the 10 or 11

00:48:20.940 | sectors are historically riskier than the market itself.

00:48:24.740 | So if you were to invest in every one of these sectors, instead of the one fund that covers

00:48:32.540 | the entire market, would you expect a greater return?

00:48:35.340 | Because they're riskier than the market, should they provide you a greater return than the

00:48:40.460 | market?

00:48:41.460 | Well, obviously, if you add them all up together, they are the market, so you can't get more

00:48:45.020 | than the market return, even though you're taking greater risk in almost all of these

00:48:50.740 | underlying funds.

00:48:51.780 | So in other words, you're not being compensated for taking this non-systematic risk.

00:48:57.180 | And that's where I come down on this betting on mid-cap value or other segments that are

00:49:03.740 | called smart data.

00:49:06.060 | Are you being compensated for risk or is it something else?

00:49:09.320 | And we do know that historically, value has outperformed and smaller cap stocks have outperformed,

00:49:16.460 | going back to the mid-1920s.

00:49:20.260 | And I think there's another reason why they have outperformed.

00:49:22.820 | It's not a risk explanation.

00:49:24.380 | To me, it's behavioral finance.

00:49:27.360 | We talked a little bit about that previously, the debate going on inside of the University

00:49:32.620 | of Chicago.

00:49:33.620 | So behavioral finance says that we all act irrationally in various aspects of our lives,

00:49:38.740 | and the reason that there are mispricings in the marketplace to begin with, the reason

00:49:43.020 | markets are not perfectly efficient, is because we act irrationally when we invest in various

00:49:48.740 | ways, and that creates mispricings.

00:49:52.420 | You can imagine with, let's say, something that's a value stock.

00:49:56.340 | Value stocks tend to be under pressure.

00:49:59.460 | The performance of the company tends to be lagging as opposed to a gross stock.

00:50:06.440 | And so the stock market performance might be underperforming, and people tend to avoid

00:50:11.900 | those.

00:50:12.900 | Well, they avoid them to the point where they become an attractive opportunity.

00:50:17.380 | At the same time, growth is the other side of that, where people love a good growth story,

00:50:23.020 | and they maybe overpriced a gross stock.

00:50:25.820 | So you end up with these mispricings because of behavioral aspects.

00:50:30.380 | And then that reverses back.

00:50:31.940 | Ultimately, the fundamentals will end the day, and gross stocks will underperform and

00:50:36.700 | value stocks will outperform.

00:50:38.780 | The problem I have with all of this going forward is, once something like that is known

00:50:43.340 | and understood, it gets arbitraged away extremely quickly.

00:50:47.460 | And I believe that that's where we are, that it's being arbitraged away, and the markets

00:50:53.500 | are much more efficient today than they have been historically.

00:50:57.400 | So I'm not a big fan of this concept of smart beta, because I think you're basically fighting

00:51:05.660 | the last battle.

00:51:06.660 | You've got to look forward when investing, not backwards.

00:51:11.100 | It's interesting you say that, because I've always wondered, when all of the data originally

00:51:18.060 | came out on microcap and small cap investing back in the late 1970s, I want to think, in

00:51:23.660 | early 1980s, and the first small cap funds started coming out, and then going forward

00:51:29.500 | after that, after the data came out on the outperformance of small cap, and people now

00:51:34.540 | then started taking advantage of it.

00:51:35.940 | So that was the first factor of smart beta use of this data back then, that it hasn't

00:51:42.540 | happened since.

00:51:43.540 | I mean, there hasn't been an outperformance of small cap.

00:51:46.860 | So has it been arbitraged away?

00:51:50.280 | Because it is behavioral, like you're saying, or it may or may not be behavioral, but it's

00:51:57.660 | certainly a whole lot easier now to invest in those factors than it was 30 years ago

00:52:04.660 | or 25 years ago.

00:52:06.140 | Do you want to buy a fund that has small cap exposure?

00:52:10.900 | Just go to one of the many different small cap factor funds.

00:52:13.700 | You could buy anything you want, even a microcap fund.

00:52:16.420 | If you wanted value, you could go to one of many, many, many different value factor funds

00:52:21.220 | and buy 100, 200, 500,000 stocks that have value in it.

00:52:28.300 | So in other words, the ability to invest in these factors, number one, they've become

00:52:32.300 | known, and when they become known, they become arbitraged.

00:52:37.060 | And the ease and the ability to now do this is all, to me, squeezing out the premiums.

00:52:43.460 | Now, I don't know where it's going to go going forward, but that's my view is, I think I'm

00:52:48.660 | agreeing with you.

00:52:49.660 | It's my view as well, that this is all being arbitraged away.

00:52:52.660 | Yeah, absolutely.

00:52:55.460 | Rob Arnott, a gentleman named Rob Arnott, really kind of created this cottage industry

00:52:59.840 | back in about 2003 or 2004, and I've known Rob for probably 30 years at this point in

00:53:05.980 | time.

00:53:06.980 | And he approached me because he wanted Vanguard to offer the first fundamental index fund.

00:53:11.960 | And so that was the first name of this concept, fundamental indexing.

00:53:17.060 | And I looked at it, and I ultimately concluded, I said, "Rob, we already offer this fund.

00:53:21.240 | We have a mid-cap value fund."

00:53:23.860 | He contends that it's different from that.

00:53:27.100 | And Rob and I have had a couple of, I won't say heated debates, but kind of fun debates

00:53:32.940 | in big venues.

00:53:34.600 | The Morningstar Advisor Conference, 2,000 people in the audience, Rob and I have debated

00:53:39.980 | this concept.

00:53:41.540 | We've actually become kind of friends over the whole thing, but we just agree to disagree

00:53:47.140 | on the concept.

00:53:48.140 | But I absolutely believe that once something's known, it can be arbitraged away extremely

00:53:53.580 | quickly.

00:53:54.580 | And, you know, you've noted the small cap phenomenon, the same has happened with value

00:53:59.940 | as well.

00:54:00.940 | Interesting.

00:54:01.940 | I've got a couple more minutes, and I want to hit on just two last topics.

00:54:06.100 | This one is just a quick answer, because the next question I'm going to ask, it might be

00:54:09.620 | a little bit longer answer.

00:54:11.180 | This one happens to do with an individual investor.

00:54:14.860 | Should they buy the global market portfolio, which has almost 50% in international stocks,

00:54:20.860 | or should they limit their holdings in international to something less?

00:54:25.780 | Personally, I believe you should have a home country bias.

00:54:31.500 | Think of if you're an Australian, you'd end up owning 4% of your investments in Australia

00:54:36.000 | and, you know, 96% elsewhere.

00:54:40.260 | That's an extreme.

00:54:41.980 | If you're in the U.S., I still believe you should have a U.S. bias.

00:54:45.620 | You should have an international component, but probably not the full international weight

00:54:50.500 | in the global portfolio.

00:54:51.500 | And that's just because there are other risks globally that you don't have at home.

00:54:58.260 | You know, repatriation of funds can be difficult.

00:55:03.420 | Back in 1997, we couldn't get our money out of Malaysia in our emerging markets fund for

00:55:08.380 | a year.

00:55:09.380 | And, you know, for those types of reasons, I think you want to overweight your own home

00:55:16.340 | country.

00:55:17.340 | Secondly, I would say you're investing in order to pay for your future expenditures,

00:55:23.420 | your future liabilities.

00:55:25.340 | And most of your future expenditures, most of your future liabilities will be domestic.

00:55:29.500 | So you want to make sure that your investments are performing in line with your liabilities

00:55:33.220 | or expenditures.

00:55:34.220 | Okay.

00:55:35.220 | And here is the last big one, and you may have been anticipating it.

00:55:38.900 | How big can indexing get before it affects the market?

00:55:43.100 | And in addition to that, Jack Bogle recently came out with some comments about voting index

00:55:50.220 | funds and how there might be a risk or a danger in just a few companies voting all of the

00:55:57.060 | index shares.

00:55:58.660 | Yeah, so I've thought about how big indexing could be ever since I started at Vanguard

00:56:06.980 | back in the 80s.

00:56:07.980 | You know, I was worried that if it got too big, I didn't have a job.

00:56:11.180 | Actually, I've spoken with Burt Malkiel and Charlie Ellis, two good thinkers about this,

00:56:18.180 | two strong advocates for indexing.

00:56:21.380 | And collectively, we have independently come to the agreement that 80 to 85% of the market

00:56:28.840 | could be indexed without creating any disruptions in the marketplace.

00:56:35.300 | It's one of those things you kind of know when you get there, but I can tell you we're

00:56:38.420 | nowhere near close at this point in time.

00:56:41.260 | My intuition just says the markets will remain efficient even if indexing is 80% of the marketplace.

00:56:49.980 | So we've got a long way to go there.

00:56:52.480 | You know, to Jack's point, if indexing becomes concentrated in a handful of firms who end

00:56:57.680 | up voting most of the proxies, as a manager of investors' assets, you have a fiduciary

00:57:06.180 | responsibility.

00:57:07.180 | You have a legal responsibility to manage those assets for the benefit of the investors.

00:57:16.140 | And I guess I tend to be an optimist.

00:57:19.820 | I'm a glass half full type of person, and I think that the investment firms are doing

00:57:27.660 | what's best for their investors and will vote proxies accordingly.

00:57:31.620 | I can certainly tell you I feel that way strongly about what we were doing at Vanguard.

00:57:35.620 | I used to be very close to the proxy voting process.

00:57:39.020 | In fact, in the late 80s and early 90s, among other things, I was also voting the proxies.

00:57:47.180 | And so, conceptually, if people got together and colluded and, you know, you could create

00:57:55.820 | a problem, I just tend to be an optimist.

00:57:58.340 | And I also know the competition between Vanguard and BlackRock and State Street, the three

00:58:03.220 | biggest indexers, I can't imagine those three firms would ever collude.

00:58:09.580 | And I can't imagine them really shirking their fiduciary responsibility of doing what's best

00:58:14.260 | for the investors in their funds.

00:58:16.420 | Well, Gus, it's been a real pleasure.

00:58:18.780 | Thank you for being on the Bogleheads on Investing podcast, and good luck in your future endeavors.

00:58:24.100 | Great.

00:58:25.100 | Well, thank you so much, Rick.

00:58:26.500 | Good to talk with you.

00:58:28.580 | This concludes the fifth episode of Bogleheads on Investing.

00:58:32.420 | I'm your host, Rick Ferry.

00:58:34.860 | Join us each month to hear a new special guest.

00:58:38.140 | In the meantime, visit Bogleheads.org and the Bogleheads wiki.

00:58:43.260 | Participate in the forum and help others find the forum.

00:58:47.420 | Thanks for listening.

00:59:00.260 | (upbeat music)

Bogleheads® on Investing Podcast 005 – Gus Sauter, host Rick Ferri (audio only)

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