Bogleheads® on Investing Podcast 037 - Gerry O‘Reilly and Rich Powers, Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:10.780 | Welcome to Bogleheads on Investing, podcast number 37.

00:00:14.000 | Today, we have two special guests, the Vanguard Total

00:00:17.440 | Stock Market Index Fund lead manager, Jerry O'Reilly,

00:00:21.600 | and the head of ETF and index product management, Rich Powers.

00:00:26.200 | And today, we're going to get a behind-the-scenes look

00:00:28.760 | at how the largest index fund in the world operates.

00:00:32.040 | [MUSIC PLAYING]

00:00:43.080 | Hi, everyone.

00:00:43.760 | My name is Rick Ferry, and I'm the host

00:00:45.380 | of Bogleheads on Investing.

00:00:47.040 | This episode, as with all episodes,

00:00:49.600 | is brought to you by the John C. Bogle Center

00:00:51.720 | for Financial Literacy, a 501(c)(3) nonprofit corporation

00:00:57.160 | that can be found at boglecenter.net.

00:01:01.160 | Your tax-deductible contributions

00:01:03.000 | keep programs like this going.

00:01:05.840 | Today, I'm very pleased to have Jerry O'Reilly and Rich Powers

00:01:10.600 | from Vanguard.

00:01:12.380 | When you listen to this podcast, you

00:01:13.960 | will be amazed at the candor these two people provide

00:01:17.960 | to us about behind-the-scenes operations of how the largest

00:01:22.560 | index fund in the world, the $1.3 trillion Vanguard Total

00:01:27.880 | Stock Market Index Fund, operates and is managed.

00:01:31.600 | We're covering a lot of ground today.

00:01:33.200 | We're going to be talking about daily operations

00:01:35.800 | and how money flows in and out of the fund,

00:01:38.280 | how securities flow in and out of the fund in kind

00:01:41.600 | through ETFs and through large institutions.

00:01:44.480 | We'll talk about how microcap stocks are traded

00:01:47.360 | in the fund, which is a difficult part of the market.

00:01:50.040 | We'll talk about proxy voting.

00:01:51.740 | We'll talk about fees and how security lending helps

00:01:55.680 | reduce the cost to investors.

00:01:57.840 | We'll talk about several tax-saving strategies

00:02:00.040 | used to manage the fund.

00:02:01.720 | We'll talk about the history of this fund

00:02:03.760 | and the three different indexes that

00:02:05.960 | it tracked during its history, now tracking the CRISP Total

00:02:10.440 | Stock Market Index.

00:02:12.280 | We've got a lot to talk about today, so let's get to it.

00:02:16.880 | With no further ado, I am extremely

00:02:19.960 | pleased to have Jerry O'Reilly and Rich Powers from Vanguard.

00:02:25.640 | Jerry is the portfolio manager for the Vanguard Total Stock

00:02:30.720 | Market Fund and ETF.

00:02:33.520 | And Rich is the head of ETFs and index product management

00:02:38.200 | at Vanguard.

00:02:39.000 | So welcome, Jerry and Rich, to Bogleheads on Investing.

00:02:43.400 | Thanks, Rick.

00:02:44.240 | Great to be here.

00:02:45.360 | Well, before we get into this fund, which

00:02:47.680 | is the largest fund when you look at all of share classes

00:02:51.840 | of any mutual fund in the world, I just

00:02:54.000 | wanted to find out a little bit about your background, Jerry,

00:02:57.480 | and a little bit about your background, Rich.

00:02:59.320 | So Jerry, I understand that you were an Olympic athlete.

00:03:02.560 | Yeah, that was a few years ago, Rick.

00:03:05.000 | Back in 1988, I represented Ireland in the Seoul Olympics

00:03:08.920 | in the 1,500 meters.

00:03:10.560 | Grew up in Ireland and came over to the US,

00:03:14.120 | went to school at Villanova on a track scholarship.

00:03:17.320 | And after I graduated in 1987, my job

00:03:21.400 | was a full-time track athlete.

00:03:22.920 | So for a few years, I would go to Europe in the summers.

00:03:25.720 | And my goal was--

00:03:27.440 | I always had this desire from a young kid

00:03:29.480 | to someday, hopefully, try and make an Olympic team.

00:03:32.160 | So fortunate enough that in 1988,

00:03:35.400 | I ran fast enough that qualified for the Olympics

00:03:38.480 | and made it to Seoul.

00:03:40.880 | A year or so after that, it became evident

00:03:43.480 | that I might want to think about another job

00:03:46.000 | if I was going to be able to afford a mortgage and a car

00:03:49.280 | payment and insurance and things like that.

00:03:51.400 | So fortunately, a very good friend, Jim Norris,

00:03:53.960 | was working at Vanguard at the time.

00:03:55.560 | And he said, hey, I'll drop your resume off.

00:03:58.160 | So I thought I'd be here maybe three or four years

00:04:00.320 | and find something else.

00:04:01.680 | Little did I think that I'd be here--

00:04:03.800 | I'll be here 30 years next March.

00:04:05.800 | And it's been a great place to work.

00:04:08.120 | And started off entry-level at Vanguard.

00:04:10.000 | And within a couple of years, made my way over

00:04:12.440 | to be an assistant trader and have

00:04:14.680 | been on the desk for 27-odd years now, yeah.

00:04:17.720 | That's a fantastic story.

00:04:19.920 | What about you, Rich?

00:04:20.760 | I mean, you've really made your way up,

00:04:22.440 | been there a long time as well.

00:04:24.280 | Yeah, I can't compete with Jerry as it relates

00:04:26.680 | to kind of a pre-Vanguard story.

00:04:28.880 | But our paths have some similarities

00:04:31.240 | in that we both started on entry-level positions

00:04:34.320 | in our retail phone area.

00:04:35.920 | And so I made my way from our phone group

00:04:38.640 | over to our portfolio review department,

00:04:41.240 | really think of that as kind of our product group.

00:04:43.920 | And for most of my 22-year career,

00:04:46.080 | I've spent focus on our active lineup.

00:04:48.480 | So we work with firms like Wellington and Primecap

00:04:52.760 | and have them run active equity portfolios for us.

00:04:55.600 | And we have internal active capabilities

00:04:57.880 | in our fixed income group.

00:04:59.040 | And so I was part of a team that looked after those managers,

00:05:02.400 | chose managers to deliver active mutual funds to our clients.

00:05:06.880 | And then about six years ago, I moved into this role,

00:05:09.120 | where my team and I are leading the ETF and index product

00:05:12.480 | management function.

00:05:13.320 | And really, that has three dimensions to it.

00:05:15.880 | We work with some of our larger and sophisticated clients

00:05:18.800 | to help them understand our product

00:05:20.400 | relative to the marketplace.

00:05:22.480 | Two, we do surveillance of the marketplace.

00:05:24.600 | As Frick, as you know really well,

00:05:26.520 | the indexing landscape has changed pretty dramatically

00:05:28.840 | over the last decade or so.

00:05:30.560 | And so we were the eyes and ears for the organization

00:05:33.240 | as it relates to that.

00:05:34.440 | And then the last part of our job is designing new products

00:05:37.000 | and improving existing products.

00:05:39.280 | It's really a testament to Vanguard

00:05:41.720 | that they retain people for so long.

00:05:43.840 | I mean, you've both been there more than 20 years.

00:05:45.880 | Jerry, you'll be there 30 years here soon.

00:05:48.360 | That's really fantastic.

00:05:49.840 | I've heard it's a great place to work.

00:05:51.640 | I want to get into the Vanguard Total Stock Market Index Fund.

00:05:55.680 | And by that, I mean everything-- the institutional shares,

00:05:59.360 | the admiral shares, the ETF class shares.

00:06:02.120 | Altogether, it's the same portfolio.

00:06:05.240 | Am I not mistaken?

00:06:06.200 | I mean, this is the same portfolio, just different share

00:06:08.520 | classes, correct?

00:06:09.960 | Correct, yes.

00:06:11.360 | On the actual managing of the fund, Rick,

00:06:14.920 | if you think about it this way, to me, it's one pool of assets.

00:06:19.120 | And so whether cash flow is coming in in the form of--

00:06:22.520 | if it's institutional, if it's admiral,

00:06:24.520 | whatever the class might be--

00:06:26.280 | it's just cash flow coming into the fund.

00:06:28.000 | So I, in terms of managing the fund,

00:06:30.720 | I don't need to concern myself like, oh,

00:06:32.600 | which channel is this coming through?

00:06:34.600 | Because it's just cash flow into the fund.

00:06:37.040 | So obviously, my goal as the manager

00:06:39.160 | is to make sure that the fund is really keeping tight

00:06:43.240 | tracking with the benchmark.

00:06:45.200 | And so that sounds pretty easy, but there's

00:06:47.480 | a lot of moving parts in there.

00:06:49.040 | So there's cash flow, like I mentioned.

00:06:52.000 | We work with a data team that gets in here

00:06:54.280 | at 7 o'clock in the morning to make sure

00:06:56.080 | that the data, the indexes that we're actually looking at,

00:06:58.840 | that all of the corporate actions that

00:07:00.440 | might have happened the previous night,

00:07:01.720 | that they're all accounted for.

00:07:03.200 | So that when I get in, that I make sure

00:07:05.800 | that the index I'm tracking is the exact index.

00:07:08.280 | And we're talking like a spot on,

00:07:10.760 | like no discrepancies whatsoever.

00:07:12.880 | Then throughout the course of the day,

00:07:14.480 | you have all these different index changes

00:07:17.040 | that we get notified that are going to be effective

00:07:19.880 | at the end of the day.

00:07:21.440 | And so we need to position the portfolio so that 4 o'clock,

00:07:24.720 | our fund replicates the index spot on.

00:07:27.560 | And so any index changes, we need to factor that in.

00:07:30.440 | And usually, that's going to mean that I need to buy.

00:07:32.560 | So I'm going to have to sell something to fund that buy.

00:07:35.480 | And so we could have a dozen of those

00:07:38.880 | that happen on any given day.

00:07:40.280 | And it could be syndicate offerings.

00:07:42.720 | It could be Dutch auctions.

00:07:45.040 | It could be numerous different corporate actions

00:07:47.200 | that you need to incorporate that into it.

00:07:49.720 | And then you get to the point around 3 o'clock, Rick,

00:07:52.160 | where you actually generate your trade list.

00:07:53.920 | So if I have $600 million coming into the fund,

00:07:57.080 | some of it's institutional money.

00:07:58.520 | Some of it's admiral.

00:08:00.480 | Some of it is cash tenders that might

00:08:02.120 | be going on in the portfolio.

00:08:03.360 | I sum it all up.

00:08:04.520 | I have my trade list.

00:08:05.840 | Let's say it's $600 million.

00:08:08.040 | And now it's up to me to trade that.

00:08:09.960 | I know my benchmark is the close.

00:08:12.360 | I then-- because at Vanguard, we kind of wear two hats.

00:08:15.560 | You're both the trader and the portfolio manager.

00:08:18.080 | So I know exactly what the strategy needs to be.

00:08:22.560 | I know that it's a cash flow trade.

00:08:24.800 | So most of that trading, I want to be

00:08:26.520 | able to participate in the auction,

00:08:28.040 | because that's how our funds price--

00:08:30.720 | whatever the closing price is in the particular--

00:08:35.920 | whatever exchange that a stock happens to be in,

00:08:38.800 | the primary listing, that's the benchmark for us.

00:08:41.120 | So I know that that's what I need

00:08:42.760 | to be able to buy at that price or maybe even better.

00:08:46.320 | And so we put a portion of it into the auction.

00:08:49.200 | And you need to have your orders down there

00:08:51.120 | by a certain cutoff time, depending

00:08:52.960 | whether a stock is a New York-listed stock or NASDAQ.

00:08:56.960 | And any residual names, then it's

00:08:58.360 | up to me to put a strategy together how

00:09:00.160 | I plan to trade these names.

00:09:01.840 | So there's lots of moving parts.

00:09:03.120 | And the great thing is we have a fantastic team.

00:09:05.320 | We have about 25 traders on the desk,

00:09:08.200 | roughly split half and half--

00:09:10.080 | well, maybe a couple more on the domestic side.

00:09:13.440 | And so that if my plate gets too full, Rick,

00:09:16.920 | I know that I have two or three traders that I can count off

00:09:19.320 | to help me with the workload to make sure

00:09:21.680 | that at the end of the day, we're 100% invested.

00:09:24.480 | And that's really ideally what you want to be in an index fund.

00:09:27.200 | You don't want to have any kind of a cash drag.

00:09:29.120 | You want to make sure that you're 100% invested.

00:09:31.520 | And then at the end of the day, we basically can run reports.

00:09:35.840 | We have multiple eyes that sign off.

00:09:37.680 | I sign off.

00:09:38.920 | We have a desk supervisor that sign off.

00:09:40.720 | And we have someone from our risk area

00:09:42.320 | that signs off to make sure that the fund is

00:09:44.320 | where it needs to be.

00:09:45.240 | So lots of moving parts.

00:09:47.360 | Just to circle back to the fund itself,

00:09:51.000 | based on what's on the Vanguard website at this time,

00:09:54.840 | the fund value is $1.3 trillion.

00:10:02.440 | That's all different share classes.

00:10:04.400 | But in aggregate, this pool of assets is $1.3 trillion.

00:10:07.720 | Now, I went to the indexers website

00:10:12.520 | and calculated that the value of the index, the total US stock

00:10:18.040 | market index, which is a float adjusted--

00:10:20.680 | and we'll get to what that is in a minute--

00:10:22.880 | right now is about $45 trillion, $45 trillion.

00:10:27.240 | So this fund, the way I calculate it,

00:10:29.920 | this fund, total stock market index funded Vanguard,

00:10:33.240 | is about 3% of the US market float adjusted.

00:10:39.160 | And by float adjusted, it's the shares

00:10:41.400 | that are outstanding and available to rate.

00:10:43.200 | Is that fairly accurate?

00:10:44.560 | You're in the ballpark.

00:10:46.000 | You are in charge of 3% of the entire US stock

00:10:51.040 | market with just this one fund, which is incredible,

00:10:55.040 | quite frankly.

00:10:57.080 | It's a lot of responsibility.

00:10:58.800 | Now, Vanguard in aggregate has about $8 trillion.

00:11:02.720 | How much of that is in US equity of the $8 trillion?

00:11:08.800 | Well, on our desk, which is the indexing desk,

00:11:15.280 | we're $4.5 trillion, roughly.

00:11:18.320 | Now, I think we also have plenty of external managers,

00:11:21.640 | and we have our internal QEG, which is quantitative group.

00:11:27.200 | They would be on top of that.

00:11:29.840 | I don't know what the total equity would be.

00:11:33.200 | I don't know, Rich, if you would know what the bond portion is

00:11:36.640 | that we could subtract that out of the 8?

00:11:39.880 | I would ballpark it, that US equity investment's probably

00:11:43.400 | in that $4 to $4.5 trillion level

00:11:46.000 | when you sum up what the equity indexing group runs

00:11:49.200 | across the funds and ETFs, as well as the active equity

00:11:52.760 | strategies that Wellington or PrimeCat run for us.

00:11:56.120 | So it's fair to say that about 10% of the investable US

00:12:01.520 | market is owned in some way, form, or fashion

00:12:05.640 | by Vanguard investors.

00:12:08.320 | Is that accurate?

00:12:09.080 | I would say you're in the right zip code.

00:12:11.320 | Yeah.

00:12:13.240 | OK.

00:12:13.760 | OK, well, I just want to get it all done.

00:12:15.480 | It's a phenomenal amount, and a lot of responsibility.

00:12:19.720 | A lot of people's retirements at stake, if you will,

00:12:23.280 | based on what you guys are doing.

00:12:24.640 | So we all greatly appreciate it, including myself, by the way.

00:12:27.720 | Full disclosure, I own a couple of the Vanguard funds,

00:12:31.520 | including the total stock market index funds.

00:12:33.520 | So you are my portfolio manager.

00:12:36.560 | Let's get into the index itself, because it really

00:12:38.640 | has a kind of a history.

00:12:39.600 | And I've been involved a little bit of this,

00:12:41.760 | because I followed the indexing industry for over 25 years,

00:12:46.160 | and especially this particular fund.

00:12:47.920 | It started in 1992, which, Jerry, that was the year

00:12:52.480 | that you joined Vanguard, if I'm not mistaken.

00:12:55.400 | That's right.

00:12:55.920 | 1992.

00:12:58.000 | And the original index that it tracked

00:13:01.320 | was called, at that time, the Wilshire 5000.

00:13:05.120 | Now, there wasn't 5,000 stocks, but the company, Wilshire,

00:13:08.600 | called it 5,000.

00:13:09.600 | There was actually more than that at the time.

00:13:11.840 | Now, that index is the Dow Jones US Total Stock Market Index.

00:13:17.080 | So this was the original index.

00:13:18.440 | And, Jerry, when you came on board

00:13:21.080 | to start working with this fund, it was 1994.

00:13:23.520 | So you were there kind of at the beginning of it,

00:13:25.920 | when assets started to flow in, because it

00:13:27.680 | did take a little bit of time before people

00:13:29.760 | realized what it was.

00:13:31.080 | But it was the first total US stock market index fund

00:13:33.600 | to be created.

00:13:35.000 | And I was excited about it at the time, I recall.

00:13:38.400 | But there was--

00:13:39.640 | I had a conversation with Gus Sauter

00:13:42.480 | after this fund changed indexes.

00:13:46.040 | And I asked why you left the Wilshire 5000 back in 2005,

00:13:52.920 | and you went to something called the MSCI Broad Market.

00:13:56.560 | And he said that you, at Vanguard,

00:13:59.880 | were the ones who had to make a lot of changes to the index,

00:14:02.840 | because there were some real problems with the index.

00:14:05.720 | Is that fairly accurate?

00:14:07.240 | It is.

00:14:08.000 | I mean, I would say back then-- your memory is correct, Rick.

00:14:13.120 | Back then, the Wilshire 5000, there were a couple of things

00:14:16.880 | I would point out.

00:14:18.280 | So number one, in terms of managing money towards it,

00:14:21.680 | one of the big issues that we had

00:14:23.440 | is that it was not float-adjusted.

00:14:26.120 | So you could have a name that was getting added

00:14:28.800 | to the index-- and let's just use round numbers, Rick.

00:14:31.280 | Let's say there's 100 million shares outstanding,

00:14:34.080 | and insiders owned 70%.

00:14:37.160 | So really, the float was 30 million shares

00:14:39.320 | available to the public.

00:14:41.040 | The way that it was managed back then

00:14:43.640 | is that we would be forced to buy it as if 100 million shares

00:14:46.680 | was outstanding.

00:14:48.280 | And obviously, that would be problematic.

00:14:50.680 | As assets grew, you're trying to buy this name as if 100 million

00:14:55.360 | shares are outstanding.

00:14:57.160 | 70 million shares are held by insiders or some private equity

00:15:01.760 | firms, whatever the case might be.

00:15:03.880 | And we had massive impact on names

00:15:06.200 | when they were getting added to the index.

00:15:08.600 | So Gus, I know, at the time, was very much in favor of, hey,

00:15:12.520 | we need to be in a position where

00:15:15.800 | we need to talk about float-adjusting the indexes.

00:15:18.800 | And so once we went to float-adjusted indexes,

00:15:22.480 | it became much more manageable to trade names

00:15:25.280 | when they got added to the index.

00:15:27.360 | And I would say the other big change--

00:15:28.840 | Rick, and you mentioned it already--

00:15:30.360 | was that there was far more constituents back then.

00:15:32.920 | And there was well over 5,000 names in the benchmark.

00:15:37.440 | And so I would say, from managing it,

00:15:39.560 | there was probably more of an optimization tilt

00:15:41.840 | to managing the fund, where it's difficult to own

00:15:44.320 | every single name when you have that many.

00:15:46.640 | And if you look at today, the CRISP index,

00:15:50.640 | it's 3,800-odd names in there.

00:15:53.240 | And so that has been a problem with just US market structure

00:15:56.640 | in general, that just the number of names going public.

00:16:00.080 | Private equity was relatively small back then.

00:16:02.520 | So if you needed capital, you became

00:16:04.840 | a publicly listed company, whereas there's

00:16:07.080 | lots and lots of companies that are very, very large today

00:16:10.840 | that are private.

00:16:12.240 | They're not trading publicly.

00:16:14.000 | And I think the exchanges are aware of that

00:16:17.280 | and trying to come up with ways to entice more people to go

00:16:19.680 | public sooner.

00:16:20.840 | But I would expect that number in the CRISP index

00:16:23.200 | to rise over time as well.

00:16:25.160 | Before we went from the Wilshire 5,000 to CRISP,

00:16:29.200 | there was an index in the middle.

00:16:32.160 | And that index was the MSCI Broad Market.

00:16:35.080 | And this change created a problem.

00:16:38.280 | I had written a book called All About Index Funds.

00:16:40.280 | And I realized right away that there

00:16:42.760 | was a whole bunch of micro-cap stocks in the Wilshire 5,000

00:16:47.080 | that you had to sell to get to the MSCI Broad Market.

00:16:51.960 | Because the MSCI Broad Market was 3,000 names.

00:16:55.960 | It was fairly close to the Russell 3,000.

00:16:58.680 | So you had 1,000 or 1,500, whatever, micro-cap stocks

00:17:03.480 | that needed to be sold.

00:17:05.640 | And I remember that whole process going on,

00:17:09.280 | where it took you, I don't know, what, two years?

00:17:11.280 | Or it took you quite a long time to liquidate

00:17:13.920 | all of those micro-cap positions,

00:17:15.880 | only to turn around and buy them back again in 2013,

00:17:21.480 | when you switched indexes again and went to the CRISP.

00:17:25.480 | And CRISP is the Center for Research and Security Prices,

00:17:29.480 | CRSP, which is kind of an affiliate

00:17:32.920 | of the University of Chicago.

00:17:34.320 | So explain, how do you deal with all this micro-cap?

00:17:37.640 | I mean, you had to sell it.

00:17:38.800 | Then you turned around, and you had to rebuy it.

00:17:40.360 | I mean, micro-cap is a fairly illiquid market.

00:17:42.360 | And I got a lot of questions on the Bogle Heads

00:17:44.600 | about, how do you manage the micro-cap side of this?

00:17:47.200 | Yeah, so you're right.

00:17:48.560 | Micro-caps, if we look at it, those

00:17:51.200 | are by far the most difficult.

00:17:52.920 | And back when we did that transition,

00:17:54.800 | I mean, the thing we did, Rick, was we took our time.

00:17:58.240 | We were opportunistic.

00:17:59.280 | Some of these micro-caps, there are days

00:18:01.080 | when they don't even trade.

00:18:02.240 | Or if they trade, it's for a couple of hundred shares,

00:18:05.720 | 1,000 shares.

00:18:07.120 | And if we had size and a name, we would certainly--

00:18:10.760 | one of the things about trading is there's a trade-off, right?

00:18:13.400 | So if you have a name that is a relatively small weight, which

00:18:16.560 | most of these micro-caps tend to be--

00:18:19.120 | you're talking fractions of a basis point--

00:18:21.120 | it doesn't make sense that if you need to sell it,

00:18:24.520 | to have huge impact on that name,

00:18:26.920 | since it's not really going to cause much

00:18:29.080 | in the way of any kind of significant tracking

00:18:31.520 | error to the fund.

00:18:32.760 | So the way we thought about that was,

00:18:34.880 | let's be smart about how we trade these names.

00:18:37.680 | And if it takes time, it takes time.

00:18:39.560 | But we will be opportunistic.

00:18:41.040 | We're going to be out there.

00:18:42.200 | I mean, the US market structure is fairly complex.

00:18:44.920 | You've got 16 different exchanges.

00:18:46.800 | You've got 45 different pools of liquidity.

00:18:50.040 | You've got dark pools that are available.

00:18:53.240 | We've got brokers sending us indications of interest

00:18:55.720 | where they can tell us, here are names

00:18:57.680 | that we're trafficking in today.

00:18:59.440 | So we would take our time and trade those names

00:19:02.760 | if we were opportunistic.

00:19:03.800 | So I find a buyer in one of the dark pools.

00:19:06.680 | Boom, I may be able to trade five days worth of volume

00:19:10.240 | in a minute because the other side showed up.

00:19:12.840 | But we certainly weren't going to,

00:19:14.760 | if we were selling those names, have a lot of impact,

00:19:17.000 | push the prices down, just because on a particular day

00:19:20.400 | we were out there, there didn't happen

00:19:21.920 | to be any buyers out there.

00:19:23.080 | So we were opportunistic about it,

00:19:24.680 | working with our peers in investment risk

00:19:27.800 | that let us know, hey, these names,

00:19:29.440 | even though they might be a lot,

00:19:30.560 | they really represent very little risk to the portfolio.

00:19:33.280 | So we really were just opportunistic

00:19:34.880 | in terms of how we got into them.

00:19:37.040 | And then, you know, CRISP came along.

00:19:38.960 | And I would say CRISP methodology

00:19:40.840 | was probably the closest align to what we thought,

00:19:44.080 | here's what proper indexing is

00:19:45.800 | in terms of how you manage index funds.

00:19:48.280 | They had buffers in there

00:19:50.080 | so that you didn't have too much in the way of turnover.

00:19:52.880 | When we have rebalances now,

00:19:54.360 | we're able to do it over an extended period of time,

00:19:56.640 | we're able to do it over five days.

00:19:58.880 | So the idea of doing that and, you know,

00:20:00.720 | being able to spread that trade over five days

00:20:03.080 | rather than doing it in one day

00:20:04.920 | was a huge benefit to our shareholders

00:20:07.240 | because we were able to minimize the impact

00:20:09.720 | you would otherwise have if it was done in one day.

00:20:12.040 | So there were lots of things

00:20:13.000 | that we liked about CRISP methodology,

00:20:15.520 | how they handled large IPOs, how they handled syndicate.

00:20:19.640 | We were able to take advantage

00:20:20.720 | of the liquidity available in the market

00:20:22.600 | so that they would get added sooner to CRISP

00:20:24.320 | maybe than some of the competitors.

00:20:26.280 | So there were lots of things we liked about it

00:20:27.800 | and we think we're at a good spot today, Rick.

00:20:30.240 | - Another thing we like about it

00:20:31.400 | is they're not charging as much money

00:20:33.040 | as some of the other index providers for the index.

00:20:36.800 | (laughs)

00:20:37.640 | You know, saves us a little money.

00:20:39.240 | Okay, very good.

00:20:40.760 | Rich, I wanna jump to exchange traded funds

00:20:43.720 | because in 2001, Vipers were launched

00:20:48.000 | and Vipers were the, at the time the code name,

00:20:51.080 | the word exchange traded fund

00:20:52.360 | didn't really exist back in 2001.

00:20:54.720 | So Vanguard came up with this thing, Vipers,

00:20:57.360 | and I forgot what it stood for, but it's an ETF

00:21:00.280 | and they eventually dropped the Vipers name

00:21:02.400 | and just went with exchange traded fund or ETF.

00:21:05.080 | But these were launched in 2001

00:21:06.880 | and they were launched as a share class of an existing fund

00:21:11.880 | which was completely unique, a brilliant idea, by the way,

00:21:15.240 | which Vanguard patented.

00:21:16.960 | And could you talk about this

00:21:18.960 | and then as you talk about it,

00:21:21.840 | also talk about the benefit

00:21:24.160 | to even the open-end share class holders because of ETFs.

00:21:28.320 | - Yeah, Rick, it really was a really seminal moment

00:21:30.320 | for Vanguard in terms of entering the ETF category

00:21:34.160 | as it allowed us to reach more and more investors

00:21:37.280 | that we couldn't access through our index mutual funds

00:21:39.800 | because of payment for distribution dynamics,

00:21:42.120 | but ETFs allowed us to reach advisors and individuals

00:21:46.280 | at a much lower cost

00:21:47.560 | through different discount brokerage platforms.

00:21:50.240 | Interestingly, we just celebrated our 20th anniversary

00:21:52.520 | in ETFs back in May.

00:21:54.480 | The total stock market ETF, ETI,

00:21:56.960 | just hit that 20-year anniversary

00:21:59.120 | and it's one of the largest ETFs today.

00:22:01.200 | We have 1.9 trillion in ETF assets in our US lineup.

00:22:05.680 | The benefits of the multi-share class structure

00:22:08.440 | were really compelling for our ETF lineup very early on.

00:22:12.240 | So what we were able to do is attach an ETF share class

00:22:16.120 | to an existing large fund, like the total stock market fund,

00:22:19.320 | and on day one, have that ETF have a very low expense ratio,

00:22:23.880 | incredibly broad diversification

00:22:26.040 | because it's simply a share class

00:22:28.480 | and existing big pool of assets

00:22:30.600 | that Jerry now manages today.

00:22:32.560 | And what that means,

00:22:33.440 | it allows the fund to track its benchmark really well.

00:22:36.400 | And so all that created a nice tailwind for our early ETFs

00:22:41.400 | and that they were able to hang it off in the existing fund.

00:22:44.800 | They track well, they're inexpensive,

00:22:46.960 | and investors were able to access the US market

00:22:49.440 | in a really low cost way and get great tracking.

00:22:52.640 | So 70 of our 82 US ETFs

00:22:56.760 | have that multi-share class structure.

00:22:58.840 | The more recent vintages of our ETFs that we've launched

00:23:03.440 | are standalone ETFs.

00:23:04.560 | So more conventional,

00:23:05.840 | like many of our peers in the industry offer.

00:23:10.000 | And that just speaks to the fact

00:23:11.160 | that where we had a mutual fund, an index mutual fund,

00:23:14.320 | we hung an ETF off of that mutual fund where we could.

00:23:17.200 | And now we're in the midst of launching some new strategies

00:23:20.680 | where a mutual fund didn't exist.

00:23:23.040 | So launching the ETF is the better answer

00:23:25.840 | given where we see client interest aligning.

00:23:28.920 | Your point around tax efficiencies is a compelling one

00:23:32.480 | in that one of the things that happens with an ETF,

00:23:36.080 | there's probably layers of tax efficiency

00:23:38.040 | that we can talk about with respect to an ETF.

00:23:40.600 | The first of which is the ETF is based upon

00:23:44.280 | an index-based strategy, right?

00:23:46.160 | We know by and large,

00:23:47.320 | most index-based strategies are lower turnover.

00:23:50.000 | So that in and of itself creates tax efficiency

00:23:52.600 | for our portfolio.

00:23:54.000 | But with respect to the ETF,

00:23:55.160 | there's two other really important dimensions to it

00:23:57.960 | that give it that extra ability

00:24:00.360 | to minimize capital gains distributions.

00:24:03.520 | First, the training of the ETF shares in the secondary market.

00:24:07.560 | So we'll stick with total stock market as an example,

00:24:10.400 | but if Rich Powers owns VTI

00:24:13.440 | and he wants to sell that exposure

00:24:15.680 | and I go into my brokerage account and I decide to sell it,

00:24:18.560 | there's a market maker on the exchange

00:24:21.000 | who's gonna see that order come through

00:24:23.040 | and then they're gonna pair that sell order

00:24:25.480 | with say a buy order from Jerry O'Reilly

00:24:27.680 | who wants to buy that same VTI ETF in the marketplace.

00:24:30.720 | So that training activity amounts

00:24:33.160 | to almost a billion dollars a day in our ETFs,

00:24:36.960 | which means that activity never makes its way

00:24:39.440 | to the portfolio.

00:24:40.760 | Jerry doesn't have to lift a finger

00:24:42.320 | to trade that activity in the portfolio, buy or sell,

00:24:46.640 | because it's just simply exchanging shares on the exchange.

00:24:50.720 | So that really creates part of the compelling nature of ETFs

00:24:54.440 | when it comes to tax efficiency.

00:24:56.920 | The other component is how ETFs transact.

00:24:59.520 | At the point at which maybe there is more buy activity

00:25:03.600 | for an ETF on the exchange,

00:25:06.240 | a market maker is going to say,

00:25:07.560 | "Well, I need to go and acquire more shares from Vanguard

00:25:11.560 | "to satisfy this greater buy activity.

00:25:14.640 | "And so I'm going to go out and accumulate

00:25:16.280 | "the underlying stocks that represent that index,

00:25:20.440 | "hand them to Vanguard,

00:25:21.720 | "and Vanguard's gonna give me shares in exchange

00:25:24.240 | "to sell to investors out in the marketplace."

00:25:27.560 | The same thing happens on the way out.

00:25:29.400 | And this is where the power comes in,

00:25:31.040 | where if there's a lot more sell activity

00:25:33.520 | on the ETF in the secondary market,

00:25:35.960 | instead of having to sell the couple thousand stocks

00:25:38.720 | in total stock,

00:25:39.840 | Jerry's team is gonna hand the market maker those stocks,

00:25:44.280 | they're gonna sell them into the marketplace

00:25:46.680 | to satisfy that redemption activity

00:25:49.000 | that's happening in the market.

00:25:49.920 | So shareholder impact on terms of the tax efficiency

00:25:53.920 | and positioning of the portfolio doesn't happen

00:25:56.560 | because there is no selling stocks in the portfolio

00:25:59.960 | to meet that redemption.

00:26:01.360 | We're handing those stocks to the market maker

00:26:03.480 | who then sells them outside of the portfolio.

00:26:06.400 | - And let me put my two cents with you.

00:26:08.400 | And I call it a double-edged sword here on taxes

00:26:11.880 | because, correct me if I'm wrong, Jerry,

00:26:15.080 | when you get a cash redemption through the mutual fund side,

00:26:20.080 | you could sell shares of stock

00:26:23.920 | that are at a high cost basis

00:26:26.040 | so that there's very little impact, if any, on the fund.

00:26:30.440 | There might even be a loss to the fund

00:26:32.200 | because some of the shares you may have bought

00:26:33.760 | at a higher cost.

00:26:35.000 | And then when there is a redemption on the ETF side,

00:26:38.960 | a creation unit redemption,

00:26:40.960 | you can push out stock that's at a low cost basis.

00:26:45.240 | So again, pushing out some of the tax liability,

00:26:49.320 | unrealized tax liability in the fund.

00:26:52.200 | Is that close to what you do?

00:26:54.480 | - Yes, yep.

00:26:55.360 | Every day, Rick, we're going to basically net

00:26:58.080 | all of our cash flows coming into the fund.

00:27:00.360 | Let's say you have a redemption coming in today.

00:27:03.240 | I very well might have a corporate action going on

00:27:06.720 | where one of the stocks in my portfolio

00:27:08.520 | is being acquired by someone else for cash.

00:27:11.280 | Or we could have some other corporate action,

00:27:14.320 | and part of it is, hey, you're going to get

00:27:16.000 | X number of shares of this stock, the acquirer,

00:27:19.320 | and you're also going to get X number of dollars per share.

00:27:22.800 | So I kind of net everything together.

00:27:24.680 | Around three o'clock, I'm going to know,

00:27:26.200 | hey, do I actually have to sell today

00:27:27.680 | or am I actually in a buy mode?

00:27:29.560 | And I can tell you through 27 years on the desk,

00:27:33.080 | it's been massively skewed towards the buy side

00:27:35.760 | where cash flow is coming into Vanguard.

00:27:38.320 | The ETF activity that Rich just referred to,

00:27:42.000 | I could get a billion coming into total stock today

00:27:44.800 | in ETF creates.

00:27:46.600 | I actually don't see it at all.

00:27:48.320 | I just know that my assets have increased,

00:27:50.400 | but I'm also receiving a basket of stocks,

00:27:52.680 | and obviously we're then giving them shares of the ETF.

00:27:56.320 | It's going on, I'm aware of it, but it doesn't impact.

00:27:58.840 | There's no trading involved whatsoever.

00:28:01.280 | If I do need to sell, I need to sell.

00:28:03.040 | And whether that, you know, sell futures

00:28:06.040 | or sell a basket of stocks, at three o'clock,

00:28:08.760 | it's like, hey, there's 300 million leaving the fund today.

00:28:11.720 | I am going to need that fund redemption.

00:28:13.560 | Otherwise, I'm going to leave the fund levered

00:28:15.160 | tomorrow morning, which would not be good

00:28:17.120 | because then you start to introduce tracking error.

00:28:19.680 | But the number of, I would say, sell days

00:28:21.720 | are few and far between relative to,

00:28:24.000 | I mainly tend to be on the buy side

00:28:25.720 | as cash flow is coming in.

00:28:27.320 | And ironically, the stronger the market's doing,

00:28:29.440 | it tends to be people want to buy even more and more,

00:28:32.040 | you know, coming into the fund.

00:28:33.920 | - Let me ask a question about the basket of stocks

00:28:37.080 | that comes in as an ETF, because the way that it works

00:28:40.360 | is the authorized participant looks at the basket of stocks

00:28:45.000 | they have to put together.

00:28:46.560 | Now, that basket is not 3,900 stocks.

00:28:51.560 | That basket is much smaller than that,

00:28:53.400 | maybe half that size.

00:28:55.200 | - Yeah, I think it's actually right around 1,900, yeah.

00:28:58.440 | - So they send in a basket of 1,900 stocks,

00:29:01.160 | which 1,900 are probably the most liquid stocks,

00:29:03.560 | which leaves another thousand stocks

00:29:05.480 | in order to make this portfolio balance out.

00:29:09.240 | It means if you're getting a lot of money coming in

00:29:12.720 | through the ETF side, that you then, your desk,

00:29:17.400 | would have to go out and start buying

00:29:18.960 | a lot of micro-cap stocks, I would imagine.

00:29:21.920 | - Yeah, well, so the way that we would think about that,

00:29:25.080 | Rick, is this, you're right, most of those 1,900,

00:29:27.920 | obviously they start off large cap, go down to mid, small,

00:29:31.600 | and maybe even a little below that.

00:29:33.600 | But you're right that if all you got was ETF activity

00:29:37.520 | for months and months and months,

00:29:39.280 | you would start to notice like, hey, the tail,

00:29:41.440 | the micro-cap, the smaller cap,

00:29:43.120 | and you're starting to fall behind a little bit here.

00:29:46.360 | So what we do, you know, what I do as the portfolio manager

00:29:49.880 | on the fund is every week, I basically run a trade list

00:29:53.960 | Monday morning that focuses on the bottom two deciles

00:29:58.080 | of my portfolio, which is kind of that small cap,

00:30:01.640 | bottom of small cap, and these are the names

00:30:04.840 | that are difficult to buy, they're illiquid,

00:30:07.320 | and I split them up between a number of traders

00:30:09.280 | on the desk, and we hold them for the week.

00:30:10.940 | We trade them Monday through Friday.

00:30:13.280 | And we are totally opportunistic.

00:30:15.440 | So if a name happens for whatever reason,

00:30:18.140 | you find a natural, so I'm a buyer and, you know,

00:30:21.120 | on Wednesday, a huge seller shows up, we'll get done.

00:30:24.620 | Now those names, they may not represent a huge weight

00:30:28.680 | in the index, but we focus on that tail throughout the week

00:30:33.680 | to avoid exactly the point that you're bringing up

00:30:36.600 | is if all you're doing is getting your 1900 shares

00:30:39.360 | or basket, you know, stocks in every day from the ETF,

00:30:42.360 | at some point, you're gonna look a little light

00:30:45.160 | on the lower end of small cap and maybe even below that.

00:30:48.940 | And so the way we get around that is we consistently

00:30:51.740 | trade them, we break it into small groups,

00:30:54.300 | and we have brokers who specialize in micro cap,

00:30:57.860 | small cap names, and believe me, on days when they have

00:31:01.060 | the other side, we're trading with them.

00:31:03.020 | And so we use all of the different tools at our disposal,

00:31:06.580 | dark pools, you know, different type of ATSs.

00:31:10.580 | If there happens to be someone who has a big liquidation

00:31:13.100 | going on, and we find out about it, we'll see if we can pair

00:31:16.700 | off with any of our buys versus a big sell that might be

00:31:19.380 | going on in the market.

00:31:20.500 | So we do that every week to make sure that we never do fall

00:31:23.180 | behind there.

00:31:24.340 | So obviously the tracking error of the fund,

00:31:27.080 | that's of paramount importance to managing the fund.

00:31:30.380 | And we make sure that that stays as tight as possible.

00:31:33.540 | And that's how we get around that issue of making sure

00:31:36.300 | that on the smaller names that we're right

00:31:38.300 | where we need to be.

00:31:39.300 | - I wanna talk one more time about taxes,

00:31:42.020 | because this fund does have a fairly sizable

00:31:45.780 | unrealized gain.

00:31:47.020 | And I calculate something like a $700 billion capital gain.

00:31:52.020 | I looked at the annual report and the fund cost

00:31:57.380 | to acquire the stocks was about 550 billion.

00:32:01.540 | And the value of the fund is around 1.3 billion.

00:32:03.960 | So call that $750 billion of unrealized gains.

00:32:09.820 | And as long as money's coming into the fund,

00:32:12.380 | it's not a problem.

00:32:14.220 | But at what point, you know, money starts coming out,

00:32:18.220 | will you end up having to realize some of these capital gains

00:32:20.980 | and distribute them to shareholders?

00:32:23.220 | - I'll get us started and Jerry for the job.

00:32:26.260 | Well, if you look at the current position of the fund,

00:32:28.260 | also from a realized gain perspective,

00:32:30.140 | you would see about a 1% realized loss in the portfolio

00:32:33.660 | for this fiscal year.

00:32:34.780 | And so, you know, what Jerry's team is able to do there

00:32:38.100 | is look selectively at different names

00:32:40.980 | where we can maybe harvest some losses along the way

00:32:43.460 | to ensure that if we know there's a big corporate action

00:32:47.700 | coming down the road that's gonna result in a capital gain,

00:32:50.240 | we have a little bit of an offset there

00:32:51.780 | that doesn't require us to bear any type of,

00:32:54.980 | or minimizes the amount of risk that we're gonna bear

00:32:57.800 | in the portfolio.

00:32:59.180 | Now, so there's different levers we can pull there.

00:33:01.360 | Obviously, we talked about the in-kind nature of the ETF

00:33:04.660 | that allows us to export out different cost slots

00:33:08.140 | as shareholders redeem from the portfolio.

00:33:11.140 | But I think maybe the place I would kind of finish here

00:33:13.620 | and Jerry, please jump in would be,

00:33:15.540 | you'd have to think through like

00:33:16.580 | what would precipitate investors to begin to redeem

00:33:20.380 | in some significant way, right?

00:33:22.180 | And so usually when that happens,

00:33:24.820 | and our shareholders are as well-behaved as any,

00:33:27.020 | but when that would happen,

00:33:29.180 | it would likely be when the markets are going down.

00:33:32.020 | And so that would put us in a position

00:33:33.660 | where the tax basis of the portfolio and complexion

00:33:37.100 | has changed pretty meaningfully

00:33:38.540 | so that that unrealized gain you mentioned, Rick,

00:33:42.780 | is gonna be meaningfully less

00:33:43.980 | and we can be much more selective

00:33:45.340 | as we kind of fund those redemption.

00:33:47.660 | And then the last thing I'll say is that

00:33:52.220 | we have the ability to in-kind in the mutual fund side.

00:33:55.300 | So sometimes plan sponsors will move their 401(k) plan

00:33:59.300 | or their pension plan from the Vanguard product

00:34:01.460 | to someone else's.

00:34:02.660 | And more often than not,

00:34:04.780 | we are in-kinding those assets to the new provider

00:34:07.940 | rather than Jerry and his team selling those down.

00:34:10.580 | And so I think you look at the unrealized number,

00:34:13.220 | you'd say, wow, that's kind of a scary prospect.

00:34:16.860 | You have to think about how we got here.

00:34:18.580 | We've had an incredible bull market and strong cash flows,

00:34:21.540 | but the unwind to that in terms of

00:34:23.820 | why investors will walk out the door,

00:34:25.180 | we have different levers to pull,

00:34:26.740 | be it the market, the tax basis of the fund has changed,

00:34:30.820 | and/or we can in-kind on the mutual fund side

00:34:32.900 | for those large institutions.

00:34:34.460 | - Yeah, that's a great answer.

00:34:37.860 | I would say, Rick, the number one thing,

00:34:40.300 | if I'm on the desk today and I find out,

00:34:42.660 | hey, someone is looking to redeem substantial size

00:34:46.300 | out of one of our portfolios,

00:34:48.620 | you try and get some color.

00:34:50.140 | And then the first question I'm gonna ask,

00:34:51.820 | is this something that is,

00:34:52.940 | are they open to doing an in-kind?

00:34:54.980 | And a lot of times it's not on the day.

00:34:56.700 | It maybe is two weeks ahead of time.

00:34:58.740 | XYZ is looking to move money wherever.

00:35:01.740 | The first question that we're gonna ask on the desk,

00:35:03.620 | is it open to in-kind?

00:35:04.700 | Obviously it's favorable for us from a tax point of view

00:35:08.420 | and from a trading point of view.

00:35:09.700 | And a lot of times for the client who's leaving,

00:35:12.340 | rather than them receiving cash

00:35:13.940 | and then turning around with whoever

00:35:15.540 | the new asset manager might be and buying again,

00:35:18.500 | it's easier for them as well,

00:35:19.740 | as long as they have,

00:35:20.980 | we're going from one, the same light benchmark

00:35:23.380 | or a benchmark that's very close to it.

00:35:25.980 | And Rich also mentioned tax loss harvesting.

00:35:28.660 | We have a great accounting team

00:35:31.380 | that notifies us multiple times a week where we stand.

00:35:34.900 | And so there are times throughout the year

00:35:37.580 | where it may be opportunistic to put on a tax harvest.

00:35:41.340 | So if we see, hey, we have a number of names here

00:35:44.700 | that we have huge losses on,

00:35:46.420 | that we can harvest those names.

00:35:48.380 | You do have to be aware

00:35:49.300 | that there's a wash sale period of 30 days.

00:35:52.980 | So we work very closely with the risk teams

00:35:55.620 | to make sure that you don't have any kind of sector bets

00:35:58.820 | where you're selling a huge amount of names in one sector.

00:36:02.660 | So we do that in such a way

00:36:04.100 | that even if you do have a tax harvest,

00:36:07.060 | that in terms of potential tracking error,

00:36:10.540 | it is minute.

00:36:12.460 | And so that's something that we have available as well,

00:36:15.380 | as well as some of the other tools

00:36:16.980 | that Rich spoke about as well.

00:36:19.500 | - Let's get into the cost of running this fund.

00:36:23.020 | This is news to me when I was doing my research

00:36:27.220 | prior to the call,

00:36:29.420 | that the cost of running the fund

00:36:31.620 | according to the 2020 annual report

00:36:35.300 | was around $422 million.

00:36:40.700 | That was the total cost to run the fund.

00:36:42.860 | Of that, 176 million was attributed

00:36:47.860 | to the investor share class.

00:36:51.980 | So this share class is really expensive.

00:36:56.220 | It's like 41% of the cost of the fund.

00:36:59.620 | And I was actually surprised

00:37:02.300 | that there are still people in the investor share class.

00:37:05.460 | I mean, why hasn't everybody moved over

00:37:07.060 | to the admiral share class, which is less expensive?

00:37:09.740 | - Yeah, a couple of things to inform that, Rick.

00:37:12.620 | One, the investor share class is used

00:37:15.540 | by target date portfolios that Vanguard offers.

00:37:19.060 | And so there's a range of different target date portfolios

00:37:21.740 | that we offer for individuals, institutions,

00:37:24.700 | and it scales as AUM scales.

00:37:27.100 | And so for a portion of our clients,

00:37:30.020 | they're using the, in the target dates,

00:37:31.860 | they're using the investor share class.

00:37:34.340 | There's a portion of clients who can't access admiral shares

00:37:38.300 | on other brokerage platforms.

00:37:40.060 | So because there's kind of minimum holding,

00:37:44.540 | minimum size requirements to get into admiral shares

00:37:47.940 | and some other brokerage platforms

00:37:49.180 | aren't able to conform to that,

00:37:50.740 | the only available option for them would be

00:37:52.620 | to utilize the investor shares with those portfolios.

00:37:55.380 | So those are kind of the two kind of drivers

00:37:57.780 | as to where the vast majority of investor AUM would occupy.

00:38:02.540 | But certainly I've been here

00:38:04.340 | and Jerry's been here long enough to know

00:38:05.900 | that that was 100% of the AUM 20 years ago.

00:38:08.780 | And then over time, it's slowly whittling down.

00:38:11.420 | And I would expect that trend to continue.

00:38:13.420 | If you just look at the organic activity

00:38:16.500 | within the portfolio, the preponderance of the assets

00:38:20.420 | are coming through the ETF,

00:38:22.540 | then through institutional and admiral,

00:38:24.460 | secondarily with investor shares,

00:38:26.580 | mostly being a function of rebalancing or new plans

00:38:30.980 | that decide to use a targeting fund.

00:38:33.540 | - I find it interesting that ETF is so cost efficient

00:38:38.340 | at Vanguard.

00:38:39.940 | The total cost for a management and administration

00:38:44.660 | of the ETF share class was only 36 million.

00:38:48.140 | So it was a fraction of what the investor share class

00:38:52.460 | or the admiral share class was,

00:38:54.540 | clearly very cost efficient to Vanguard

00:38:59.540 | to have people in the ETF share class.

00:39:02.860 | And Rich, you could discuss that.

00:39:06.180 | - Sure, when you think about who the historical users

00:39:10.100 | of ETFs have been, financial advisors have carried the water

00:39:14.140 | as it relates to their adoption at Vanguard

00:39:16.620 | and elsewhere in the marketplace.

00:39:18.300 | And most of those financial advisors

00:39:19.780 | will custody their assets

00:39:21.740 | at some other discount brokerage platform,

00:39:23.940 | or they might be at a broker dealer.

00:39:25.900 | And so when you're thinking about kind of the scale benefits

00:39:29.020 | that come from hundreds of millions or billions of dollars

00:39:32.620 | being in other platforms,

00:39:34.340 | it certainly removes some costs from how Vanguard

00:39:37.700 | has to support those products day-to-day administratively.

00:39:40.820 | And so the rough number here is about 10%

00:39:45.460 | of our ETF AUM is on a Vanguard platform

00:39:49.180 | and the balance is held at some other discount brokerage.

00:39:52.340 | And so as you'd expect,

00:39:54.380 | the cost that would come with those types of assets

00:39:57.380 | would be pretty materially lower

00:39:58.700 | than where those kind of directly sold

00:40:01.100 | or directly held clients that might be in a Vanguard platform

00:40:04.620 | either in a 401k plan or in a direct investor relationship.

00:40:09.140 | - And one of the reasons why ETF share classes

00:40:14.020 | have a lower expense ratio,

00:40:15.740 | although it's only one basis point lower than Admiral shares

00:40:19.140 | is because it doesn't cost as much, correct?

00:40:22.460 | - That's exactly right, right?

00:40:23.460 | So a couple of years ago,

00:40:25.700 | some of our investors would have noticed that

00:40:28.020 | historically the Admiral shares and our ETF shares

00:40:30.980 | of the same fund would have had the same expense ratio.

00:40:33.420 | So I think total stock a number of years ago

00:40:35.940 | would have had a five basis point expense ratio

00:40:38.140 | for Admiral and ETF.

00:40:40.020 | But now as we sit here today,

00:40:41.580 | we've seen the, because of the growth and adoption of ETFs,

00:40:45.060 | we've seen the ETF expense ratio, because it's scaled,

00:40:48.100 | move down to three basis points

00:40:49.900 | and the Admiral shares is at four basis points,

00:40:51.900 | both incredibly compelling,

00:40:53.580 | but certainly highlights the cost that we bear

00:40:56.940 | in managing those portfolios,

00:40:58.300 | administering those portfolios is different for the ETF.

00:41:01.820 | - One other thing about cost

00:41:03.020 | is that you're able to do security lending.

00:41:06.700 | And I noticed again in your annual report

00:41:09.100 | that you had about $6 billion out of security lending

00:41:14.100 | and you're able to acquire from that

00:41:17.700 | about $170 million of income to the fund,

00:41:22.580 | which helped to offset the expenses at the fund.

00:41:26.580 | So, Richard, if you could talk about security lending

00:41:29.860 | and how that helps to offset the cost.

00:41:33.260 | - Yeah, so securities lending is an exercise

00:41:35.580 | that we've been involved with for a long time.

00:41:36.900 | We only lend securities

00:41:38.940 | on our equity portion of our portfolios.

00:41:40.940 | We don't lend any fixed income securities.

00:41:43.740 | Our analysis there is that the cost to administer

00:41:47.220 | is not worth it relative to the benefit that you got.

00:41:49.740 | And so, but there is clearly a benefit for,

00:41:52.940 | on the equity side.

00:41:53.940 | And so what we'll do is we have a securities lending desk

00:41:56.900 | that's operates on behalf of our funds

00:41:59.500 | and goes out and lends those securities

00:42:01.300 | that are in great demand.

00:42:02.780 | And there could be any number of reasons

00:42:04.060 | why those securities could be in demand

00:42:05.460 | because of a opportunity from a corporate action

00:42:08.420 | that's coming up.

00:42:09.260 | Perhaps there's activity from a hedge fund

00:42:11.660 | that maybe is interested in acquiring additional shares.

00:42:14.180 | And so we'll lend those securities in our portfolio

00:42:17.140 | up to a limit where we see that there's value.

00:42:20.180 | We actually approach securities lending

00:42:22.140 | from a value-based approach.

00:42:23.660 | Some of our peers will basically lend everything they have

00:42:26.940 | and try to just maximize the amount of income

00:42:30.060 | they generate by lending

00:42:31.580 | as much of the portfolios available.

00:42:33.540 | We only look for those opportunities

00:42:34.740 | that are really ripe, have a big return for minimal lending.

00:42:39.540 | And so we employ this approach

00:42:41.420 | where we'll lend those securities out in the marketplace.

00:42:43.700 | In return for that lending,

00:42:45.380 | we'll effectively get back cash

00:42:47.700 | that we'll invest in a money market instrument

00:42:49.860 | that will earn a yield.

00:42:51.820 | And the return to our shareholders

00:42:54.820 | for that special name that we've lent out in the marketplace,

00:42:57.980 | there's a premium that was likely paid,

00:43:00.260 | but then also there's a capture of the yield

00:43:02.220 | that happens for the duration

00:43:04.860 | of that lending on that security.

00:43:06.540 | And so that income that is generated

00:43:10.180 | is returned to the fund that is lending that security.

00:43:14.180 | And so about 95% of the income that's generated

00:43:18.140 | goes back into the fund NAV.

00:43:20.620 | That five or so percent

00:43:21.980 | that doesn't go back into the fund NAV

00:43:23.740 | covers the cost of us administering the program.

00:43:25.980 | And so that's a hallmark of the Vanguard program

00:43:28.580 | that differentiates us from many of our peers

00:43:32.180 | because other firms will lend securities out

00:43:35.820 | and they'll do a 50/50 split

00:43:38.100 | between the management firm and the lending fund.

00:43:41.580 | And so we believe that if you're lending securities

00:43:44.860 | and you're bearing some level of risk in the marketplace,

00:43:47.780 | you should be compensated with all the rewards after cost.

00:43:51.260 | And so that's the approach

00:43:52.860 | that we take in our lending program.

00:43:54.580 | Jerry, I know you have a couple things to add there.

00:43:56.700 | - Yeah, absolutely, Rich, great summary there.

00:43:59.580 | So we work very, very closely, Rick,

00:44:01.500 | with our counterparts in SEC lending.

00:44:04.620 | And there's certain funds

00:44:06.740 | where there's huge demand for the holdings

00:44:09.500 | from the sell side who are,

00:44:11.060 | and maybe it's someone who's looking to short a stock, right?

00:44:13.300 | And you have to secure the borrow,

00:44:14.500 | so they'll call Vanguard, as Rich mentioned.

00:44:16.700 | They have to put up collateral.

00:44:18.460 | A lot of times, 102% of whatever it is

00:44:20.780 | that you're looking to borrow.

00:44:22.340 | And then we're gonna invest that with our fixed income teams

00:44:25.220 | to make sure that, and the one thing I would point out there,

00:44:28.100 | they're very conservative

00:44:29.060 | in terms of how they invest that money.

00:44:30.580 | And I know if you go all the way back to '08,

00:44:33.420 | some asset managers were trying to swing for the fences

00:44:36.020 | in terms of how they invested that money,

00:44:37.700 | and it came back to bite them a little bit.

00:44:39.900 | So SEC lending is one way,

00:44:42.020 | and if you look at some of our small cap,

00:44:43.780 | particularly in the small cap growth in value,

00:44:47.740 | it's meaningful, the amount of dollars

00:44:49.740 | that they receive from SEC lending,

00:44:51.140 | to the point where, I've seen it in years

00:44:53.420 | where it's north of eight basis points,

00:44:55.660 | nine basis points to the fund

00:44:57.780 | that's coming in from SEC loan.

00:44:59.540 | And as Rich mentioned, 95% of that

00:45:01.420 | is going directly to the funds that loaned it out.

00:45:04.260 | So that's one way, you mentioned earlier,

00:45:07.180 | Rick, about the four basis points

00:45:09.100 | for the expense ratio and total stock.

00:45:10.620 | So I would say SEC lending is one way

00:45:12.820 | that we try to eat into that in terms of,

00:45:15.700 | can we do better than the four basis points

00:45:17.660 | that we should underperform the benchmark?

00:45:20.180 | SEC lending is gonna help with that.

00:45:22.220 | We've also, we have a very, very experienced desk.

00:45:25.380 | I think the average tenure on the desk is about 13 years.

00:45:28.540 | So over time, you learn strategies,

00:45:30.740 | proprietary strategies about how to work index changes,

00:45:33.900 | rebalances, complex corporate actions.

00:45:37.460 | And so we've also been heavily involved

00:45:40.580 | in syndicate offerings, whether that's just a company

00:45:43.540 | that is issuing new shares to maybe pay off debt,

00:45:46.420 | or whether it's IPOs that are coming along.

00:45:48.980 | And we have a team that focuses on that.

00:45:52.380 | So every day, here around 10 after four,

00:45:54.260 | you're gonna get the phones will start lighting up

00:45:56.180 | with brokers calling us about syndicate offerings

00:45:59.060 | that are happening.

00:45:59.900 | And obviously, Vanguard's gonna be a top three holder

00:46:03.060 | in almost every name out there.

00:46:04.380 | So we tend to get the call.

00:46:06.380 | And as long as it's greater than 5% of the shares outstanding

00:46:10.500 | index providers are gonna make the share change.

00:46:13.180 | Crisp will make it tomorrow if we get the call tonight.

00:46:15.860 | And so we will participate if we think it's going

00:46:19.300 | to add incremental value to the fund.

00:46:21.700 | So very, very busy here around 4/15

00:46:25.220 | with calls coming in on syndicate offering.

00:46:27.700 | And 2020 was probably one of the busiest years

00:46:29.740 | we've ever had on that front.

00:46:30.860 | I think we had over 400 between syndicate and IPOs.

00:46:34.220 | So very busy.

00:46:35.460 | Those are some of the ways that we'll try

00:46:37.460 | and eat into that expense ratio.

00:46:40.100 | And so if we can do that in a risk control manner,

00:46:43.620 | it's a win-win.

00:46:45.300 | - From what I understand from reading the numbers

00:46:47.580 | in the annual report, about 170 million of income

00:46:50.700 | came in from security lending.

00:46:52.780 | The total expenses of the fund were around 420 million.

00:46:55.700 | So about 40% of the expenses of the fund

00:46:59.260 | were made up with security lending.

00:47:01.260 | Is that fairly accurate?

00:47:03.260 | - Yeah, I mean, I would say, Rick,

00:47:04.820 | that you're looking at total stock.

00:47:06.500 | But depending on the fund, that's not at all surprising

00:47:09.900 | because that group, as Rich mentioned earlier,

00:47:13.220 | 95% of the revenue that they bring in

00:47:16.380 | goes directly to the funds that loaned out those securities.

00:47:19.940 | And in terms of total stock,

00:47:22.100 | I've seen that number be a basis point,

00:47:26.140 | maybe a one and a half basis points.

00:47:27.900 | And when you consider that our expense ratio is four,

00:47:31.140 | that's a meaningful contribution to the value add

00:47:34.100 | for the fund.

00:47:35.300 | - Let's go into just a couple more things

00:47:36.980 | because I know we don't have much time left.

00:47:38.900 | I wanna touch on this because it is a little bit

00:47:41.460 | of a controversial topic.

00:47:42.860 | And I know that you may or may not be involved in this

00:47:47.860 | to what extent you are, you could let me know,

00:47:50.620 | but it has to do with voting proxies.

00:47:53.100 | And Vanguard is a large part of the US market,

00:47:56.380 | 10% of the market, if you will.

00:47:58.380 | And how does that all work at Vanguard

00:48:01.740 | so that shareholders understand

00:48:03.860 | how proxies are voted at Vanguard?

00:48:06.660 | - Yeah, so a lot of times, Rick,

00:48:08.940 | we will get a call here on the desk from an issuer

00:48:12.020 | looking to talk about a proxy issue.

00:48:13.900 | And we are fortunate, you can imagine,

00:48:17.420 | like say Total Stock where we have 3,800 securities,

00:48:19.780 | if every company, if I was to be involved in that,

00:48:22.260 | I couldn't do my job, right?

00:48:23.580 | Because a lot of these are not simple issues,

00:48:25.220 | they can be complex.

00:48:27.380 | So fortunately, we have an investment stewardship group

00:48:30.500 | run by John Galloway at Vanguard and his team,

00:48:34.540 | and they will analyze all of these proxies.

00:48:38.340 | That is a team that's dedicated

00:48:40.820 | to everything proxy related.

00:48:43.620 | So if a call comes in, immediately we send that call

00:48:46.940 | or give them the email address for John's group.

00:48:49.740 | This is the team you wanna get in front of,

00:48:51.500 | and they will then obviously reach out,

00:48:53.860 | either email conversations about what it is the issue is.

00:48:59.140 | And there are certain things that that group,

00:49:01.540 | in terms of their principles,

00:49:03.620 | if you think about it, we are the ultimate owner, right?

00:49:06.460 | We're gonna own companies potentially forever.

00:49:10.140 | So it's in our best interest to make sure

00:49:11.700 | that the boards are gonna represent

00:49:13.980 | the interests of shareholders.

00:49:15.980 | So that group that John runs,

00:49:18.380 | they look at things like executive compensation,

00:49:22.100 | board composition, oversight of strategy and risk,

00:49:25.940 | as well as shareholder rights.

00:49:27.300 | So those are some of the key principle things

00:49:29.620 | that they would look at.

00:49:30.820 | I know they subscribe to some of the proxy advisors

00:49:34.180 | like ISS and Glass Lewis,

00:49:36.220 | but that's just one of the tools that they use.

00:49:38.820 | And they're gonna make decisions

00:49:40.500 | what they feel are in the best interest of our shareholders.

00:49:43.580 | And it's not always aligned with the companies.

00:49:46.940 | You know, one of the high profile ones

00:49:48.740 | that we recently just had was the Exxon proposal,

00:49:51.580 | proxy fight.

00:49:52.940 | And, you know, Vanguard voted

00:49:54.140 | with the dissidents on this one,

00:49:55.500 | where they supported two dissident director nominees.

00:49:59.340 | And I would also say it's very transparent.

00:50:01.460 | If you wanna see how did Vanguard vote

00:50:03.620 | on a particular proxy,

00:50:05.140 | you have the ability to go online

00:50:06.740 | and see exactly how we voted on it.

00:50:08.980 | And so fortunately from my point of view, Rick,

00:50:13.180 | I really just passed those calls

00:50:15.780 | onto that investment stewardship team

00:50:18.180 | and they do a fantastic job analyzing it.

00:50:20.980 | And I know they have folks who specialize

00:50:23.020 | in certain regions.

00:50:24.820 | I know there's a team in the UK as well

00:50:27.100 | that handles same thing for our European counterparts,

00:50:30.780 | but it's a robust team that works very closely

00:50:34.140 | with the issuers

00:50:35.340 | and they'll hear all sides of the argument

00:50:37.100 | and then they will make decisions

00:50:38.580 | based on what they feel is in the best interest

00:50:41.060 | of our shareholders.

00:50:42.540 | - Thank you for that answer, Jerry.

00:50:44.220 | I appreciate the thoroughness of it.

00:50:46.860 | And there's also always a lot of noise out there

00:50:50.260 | about these types of things.

00:50:52.180 | So thank you for covering that.

00:50:53.740 | I wanna get into one last question

00:50:54.980 | and this could be a little bit personal on this.

00:50:57.940 | You've heard the charges of indexing.

00:51:02.740 | In fact, the worst one I guess you could say

00:51:04.540 | was in the Atlantic Magazine called,

00:51:07.980 | "Could index funds be worse than Marxism?"

00:51:11.980 | Indexing is ruining the market

00:51:14.460 | and indexing is creating corporate slots

00:51:18.740 | and shareholder gorillas and so forth.

00:51:21.620 | And this is bad and Congress needs to look at this

00:51:25.060 | and they need to break up these index funds.

00:51:27.500 | You're there and every day doing this.

00:51:29.980 | I mean, is any of this something to worry about?

00:51:32.580 | - Sure, Rick.

00:51:34.620 | I think there's a couple of things we can look at

00:51:36.260 | to kind of disprove this notion

00:51:39.540 | that indexing is creating some type of harmful effects

00:51:42.860 | in the marketplace.

00:51:43.700 | So first one you would look at is the impact on trading,

00:51:47.860 | right?

00:51:48.700 | Equity indexing is an example.

00:51:50.300 | About 5% of all trading that happens in the marketplace

00:51:53.340 | can be tied to an equity index.

00:51:55.180 | That in and of itself tells you

00:51:56.300 | that while indexing as a strategy has grown remarkably,

00:51:59.780 | the nature of indexing as a long-term buy and hold

00:52:03.700 | certainly isn't kind of infusing itself

00:52:05.340 | into terms of how price discovery

00:52:07.300 | is happening in the marketplace.

00:52:09.100 | You can look at dispersion of returns over time

00:52:13.020 | over this last 20 or so years.

00:52:14.820 | Not a noticeable difference in dispersion of stock returns

00:52:18.340 | over that period.

00:52:19.820 | - When you're talking about dispersion of returns,

00:52:21.460 | you're referring to dispersion between stocks, correct?

00:52:25.020 | - That's correct.

00:52:26.100 | Rick, if you look at the Russell 3000, for example,

00:52:29.620 | and we define dispersion as plus or minus 10%

00:52:33.100 | over the index.

00:52:34.700 | If you go back to the early '90s,

00:52:36.740 | when indexing was still,

00:52:38.740 | if you wanna talk about indexing

00:52:40.500 | in terms of what does it represent of mutual funds,

00:52:43.620 | that was maybe around the 10% back then.

00:52:46.580 | It's now growing to about 50%

00:52:48.420 | in terms of ownership of mutual funds.

00:52:51.300 | And over that time period, the dispersion,

00:52:54.500 | so plus or minus 10% of the Russell 3000,

00:52:58.460 | that's remained consistent at 70%.

00:53:01.060 | So the argument you sometimes hear

00:53:02.580 | on top of the Marxism argument is that,

00:53:04.100 | hey, indexing is lifting all boats, right?

00:53:06.780 | As indexing, they're just buying

00:53:08.060 | and they don't even care about it.

00:53:09.140 | When you have dispersion levels at 70%,

00:53:11.460 | that tells me that there's opportunities there

00:53:13.860 | for good active managers to outperform.

00:53:16.140 | So the rise of indexing,

00:53:18.220 | I don't think is hurting that at all

00:53:20.620 | in terms of opportunities available.

00:53:22.620 | And on the trading side, as Rich mentioned,

00:53:25.500 | if I think about,

00:53:26.900 | Rich mentioned the number 5% of daily trading,

00:53:29.940 | that's a very, very small portion of the overall pie.

00:53:33.300 | If I think about even on our desk,

00:53:34.780 | on some of our busiest days,

00:53:36.500 | $2 billion is not that unusual

00:53:38.900 | that I might trade here on the desk.

00:53:41.220 | If you think about an average trading day, Rick,

00:53:44.060 | it's about $450 billion.

00:53:46.820 | So my $2 billion that I'm spending total stock,

00:53:49.740 | it's less than half a percent of an average daily volume.

00:53:53.660 | And it's spread out over 1,200, 1,500 names.

00:53:57.420 | And believe me, those names,

00:53:58.420 | I'm making sure that whatever I put in the auction,

00:54:00.900 | it's not gonna be too impactful.

00:54:02.780 | So price discovery is alive.

00:54:05.820 | There are names, if I think about our REIT fund,

00:54:07.940 | probably in terms of ownership,

00:54:09.900 | it's probably highest among our REIT names,

00:54:12.340 | especially if that REIT happens to be in total stock

00:54:14.540 | and it's maybe an index 500.

00:54:16.700 | There are lots of names that are massively underperforming

00:54:20.740 | where we're at today.

00:54:22.100 | And even though the ownership level might be

00:54:24.740 | in the high 20s, 30% in terms of passive ownership

00:54:27.460 | across the board.

00:54:28.580 | So the fact that that name happens to be in an index,

00:54:31.140 | there's bad news that's coming out,

00:54:32.820 | that fund is gonna get it.

00:54:34.740 | I've seen lots of different things out there.

00:54:36.780 | I tend to focus on what are the positives

00:54:38.700 | that indexing has brought to the market here?

00:54:40.540 | I attended a number of these Boglehead forums

00:54:43.900 | when you were on campus.

00:54:45.460 | And the number of people who came up to me and said,

00:54:47.020 | "Hey, I've been investing in your 500 fund

00:54:49.060 | "for 30 odd years.

00:54:50.580 | "It's put my kids through college.

00:54:52.180 | "It's helped my retirement."

00:54:53.780 | I mean, you wanna talk about walking back on air

00:54:56.100 | after that conference when you get a bunch of those stories.

00:54:58.700 | That makes you feel pretty good about the fact

00:55:00.900 | what indexing has brought to so many people.

00:55:03.620 | I just feel really passionate about the fact

00:55:05.740 | that indexing absolutely benefits absolutely hugely

00:55:10.740 | over any kind of detractors that you might see out there.

00:55:13.620 | And a lot of the stuff that I read out there

00:55:15.380 | doesn't hold any water at all.

00:55:18.100 | - We all thank you for everything you're doing

00:55:20.980 | and your dedication to helping us as investors.

00:55:24.180 | I know we've run out of time.

00:55:26.180 | I wanna thank you, Jerry and Rich, very much

00:55:29.660 | for taking the time today to talk with us

00:55:31.820 | about Total Stock Market, Index Fund,

00:55:35.180 | and a lot of things having to do

00:55:37.180 | with how things work at Vanguard,

00:55:40.020 | including the proxy voting, which I appreciate you

00:55:42.900 | chiming in on.

00:55:44.300 | On behalf of all the Bogleheads,

00:55:46.380 | thank you so much for everything you do

00:55:47.900 | and keep up the great work.

00:55:49.620 | And thanks for being our guest.

00:55:51.380 | - Thank you, Rick.

00:55:52.220 | It's been our pleasure.

00:55:53.300 | - Thanks, Rick.

00:55:54.860 | - This concludes "Bogleheads on Investing,"

00:55:56.660 | podcast number 37.

00:55:58.660 | Join us each month as we have a new guest

00:56:01.140 | and talk about a new topic.

00:56:02.820 | In the meantime, visit bogleheads.org

00:56:05.620 | and the Boglehead Wiki.

00:56:07.300 | Check out the Bogleheads' new YouTube channel,

00:56:10.380 | Bogleheads Twitter, Bogleheads Facebook,

00:56:13.260 | and find out about your local Bogleheads chapter

00:56:16.820 | and tell others about it.

00:56:18.540 | Thanks for listening.

00:56:19.580 | (upbeat music)

00:56:22.180 | (upbeat music fades)

00:56:25.260 | (upbeat music)

00:56:27.840 | [MUSIC PLAYING]

Bogleheads® on Investing Podcast 037 - Gerry O‘Reilly and Rich Powers, Rick Ferri (audio only)

Chapters