Hello everyone, and welcome to Bogleheads on Investing, episode number five. Today, we have a special guest, Gus Sauter, former Chief Investment Officer of the Vanguard Group of Mutual Funds. My name is Rick Ferry, and I'm the host of Bogleheads on Investing. This podcast is brought to you by the John C.

Bogle Center for Financial Literacy, a 501(c)(3) corporation. Today, we have a special guest, Gus Sauter. Former Chief Investment Officer and head of Vanguard's indexing and quantitative strategies, as well as the creator of Vanguard's exchange traded funds, let's welcome Gus Sauter. Gus, welcome to our show. >> Thank you, Rick, glad to be with you.

>> Gus, you're a favorite among the Bogleheads, and you've got a really interesting background about how you got started in investing. Could you share with us some of your earlier ventures into the markets, as far back as you can remember? >> Yeah, I guess I was always intrigued with how money could make money for you.

I guess I used to travel to the bank with my parents, and watch them make deposits, and try to figure out what was going on in the banking system. This is back before I was ten years old, and I was really intrigued with the notion. So I actually started my own little bank, which probably violated hundreds of laws.

But I basically collected deposits, and then invested that in the bank, and earned a little bit of return, and then returned that to the investors. But it was really kind of my first foray into kind of the world of investing, if you will. And I was about, I'm gonna say I was about ten years old when I did that.

That really piqued my interest, and when I was 12 years old, I had had a paper route for a couple of years. And I made a fair amount of money for a little kid back in the 60s, and had some money to invest in my first stock was in a local firm called Rupp Industries.

They made snowmobiles, actually went under after a few years, so I didn't make much money on that. My second investment, I am proud to say I'm one of the original owners of the Cleveland Cavaliers. So they went public when they first came out, when they were first formed. And I invested in that stock, I think it was maybe 1969, so I was about 15 years old at that point in time.

But all of this really led to my strong interest in investing, and led to my academic career focusing on economics and finance. >> So your undergraduate was from Dartmouth College, and then right after that, you went to the University of Chicago for an MBA, or did you do something in between?

>> I worked for a couple of years, so really jobs that weren't really getting me towards my ultimate goal. I graduated from college in 1976, which was a tough job market. And so I kind of took what came along, and knew that I wanted to go back to business school anyway.

So I worked for two years, and then did go back to the University of Chicago. >> Back then, say early 1970s, when you were at the University of Chicago, I mean, was the culture there like it is now, where there was a belief in passive investing by one side of the finance department, and then there was also belief in active investing by the other side, is it as pronounced as it is today?

>> It was not as pronounced back then. There was a course in behavioral finance back then, wasn't widely taken, but that was kind of the initial seed towards belief in active as well. I would say that the belief in passive really dominated back in the 70s, at the University of Chicago.

Today, it is more balanced. The UChicago has a very large behavioral finance group now, led by Dick Thaler, who just recently won the Nobel Prize. And so it's more of a balance than it was back then. >> After you graduated from the University of Chicago, what did you do after that?

>> My initial job, I ended up as a commercial real estate developer, working for a national firm, but relatively small, called LaSalle Partners, which is now the LaSalle of Jones Lang LaSalle. They merged into Jones Lang. It was a great firm with very high quality professionals, and I did enjoy it a lot.

I was on the analysis side, on the development side, in building buildings, and I was doing all the financial analysis behind it. This was in the Denver office, I was transferred to the Denver office, and we built several large buildings while I was out there for a couple of years.

And then through a friend of a friend, I came across an opportunity to pursue gold mining, which reminds me a lot. It certainly does to me now. So I had this opportunity to put together a deal to create a gold mine. So I put a venture capital deal together, started the gold mine.

It was south of Las Vegas. Our options were to either live in Las Vegas or Needles, California. My wife agreed to go with me only if we went to Las Vegas. So I ended up in Las Vegas for three years. It took me three years to drive that company under, and at that point, it became clear to me I wanted to pursue a career in investing.

And I had a good friend at the University of Chicago who had gone immediately to work with Pimco, and he kept after me saying, you've got to get into the investment business. He said he would love it. And so I finally did pursue it in 1985 when the gold mine went under.

And is that when you interviewed with Vanguard? No. Actually, I interviewed with Pimco a couple of times, and I made the weird decision that I wanted to return back to my home state of Ohio. The unfortunate thing is there are not many investment management firms in Ohio, but I did move back to Ohio and work for a couple of years in a trust investment department.

And I was fortunate in that the head of the trust investment department wanted to develop a quantitative investing program. And I was the only person in the group that had quantitative investment skills because I had focused on quantitative finance at the University of Chicago. And so I basically got the opportunity to build that program.

And it turned out I ran into Jack Brennan, who subsequently became chairman and CEO of Vanguard many years later, ran into him at our 10th reunion at Dartmouth. We were classmates. He was asking what I was doing, and I told him about my work in the regional bank. And a couple of months later, got a call from Jeremy Duffield, who ended up hiring me into Vanguard.

And when you went to Vanguard to be hired, did you get a chance to meet with Jack Bogle? Yeah. I actually interviewed with Jack. I went out on a Friday afternoon, we were going to meet Saturday morning, and I was going directly from an event at my wife's employment.

And so I was wearing tennis shoes or basketball shoes, and I had my good shoes in the back of the car. When she drove me to the airport, I left my good shoes in the back of the car. I ended up interviewing in basketball shoes, which was a little nerve wracking.

I still ended up getting the job, but I guess Jack thought it was a little amusing. Well, you were going to be doing a lot of running at Vanguard anyway, so I guess it was appropriate. Yeah, good point. So then you started at Vanguard, and your first job there was to create a quantitative investing program at Vanguard?

That's right. Yeah, exactly. Vanguard had, at that point, one S&P 500 index fund, the 500 index fund, and a couple of separate accounts. And most of the money was in the S&P 500, about a billion, 1.2 billion, I think, to be exact. Jack wanted to expand the program dramatically.

His own son had gone into active quantitative investing, which is what I had been doing at the bank, and so he wanted to build both the index side and the active quant side. It turns out that active quant and indexing use many of the same techniques. I think of indexing as really passive quant versus active quant, and so I was in charge of trying to build out that entire program.

So Gus, in 1987 when you joined Vanguard, they had one index fund, it had less than a couple of billion dollars in it, and the focus was on building out a quant shop, and this was Jack Bogle's decision. So he was, even at that time, looking at straddling both sides of the fence.

Then indexing really began to expand, and you must have been given more and more direction to create all these different new index funds, international fund, even the real estate fund and so forth. So as you started out doing quant and you were expanding that, and then how did you pick up the role of expanding indexing as well?

Yes, so as you noted, we had one index fund, and actually that was the entirety of all of the internally managed equity funds. As you know, Vanguard uses external advisors for traditional active equity management, and we were trying to build out the internal management, both on the index side, the passive side, and the active quant side.

Jack wanted to build that out as well, and the common thread is that they both use very similar techniques, active quant versus passive quant. So initially, the one index fund, we followed that with a small cap index fund. That was in 1989, and then just kept expanding the offering over time as we gained critical mass within the lineup and felt the need to add to it.

We did launch new funds as an example, and I think in 1993, we launched Total Stock Market, and that really is the fund that people should most be focused on. It is the total U.S. market. I should say that actually, I started October 5th of 1987, and the crash happened two weeks later, October 19th of 1987.

In the meantime, we were trying to develop the extended market portfolio, and we ultimately launched that December 21st, 1987. So I was there for a total of two months. The equity group consisted of one other person and me, and I was trying to manage what was going on with the crash.

At the same time, develop the extended market portfolio. So there was a lot going on managing money under fire and trying to develop new funds. We kept rolling out more and more funds over the years. Indexing was not well accepted at the time. I remember going to conference after conference, so these would be retail-oriented back in the '90s, trying to talk about indexing, and the typical MO then was I'd be on a panel with one other active manager, and not coincidentally, that active manager would be a very successful active manager, and I would be debating the merits of indexing, and that active manager would be talking about how active management is so easy.

And so it was really a tough slog back in the '90s, so it was kind of built brick by brick, and we kept offering new funds, and our competition was kind of putting down the concept of indexing, but it slowly did take hold, and I think there were several reasons that ultimately, indexing has gotten to the point where it is today.

Just before we get to the growth of the indexing side, how did the quant side do during all of this? Were you able to develop programs or strategies that actually worked, or did you find that they worked for a while, and then they didn't work anymore? Yeah. So in 1989, a couple of years after I arrived at Vanguard, we actually did start working on our ActiveQuant program, and quite honestly, that was my true love.

Most managers want to try to beat the market and prove that they have some skill, and I guess I was no different from most other people in the industry in that regard. So it was very intriguing to me to try to put quantitative programs together. These would be computer programs that would actually pick stocks and then try to beat various market indexes.

We launched our first fund, I think, or our first portfolio, I think it was 1991. It was a portion of Windsor II, and we had some varying success with that. By and large, the program was successful. We kept adding more and more funds. We added a portion of Morgan, a portion of Explorer, and the Strategic Equity Fund.

I think Strategic Equity was 1994, and so we kept growing the quant side alongside of the index group, and we had reasonable success. Like any active manager, we'd have periods where we'd do pretty well, and periods where we'd experience a lot of difficulties. Over a longer time period, we were successful at adding some incremental value above and beyond a benchmark return, and that program continues to this day, and it is in the tens of billions of dollars, which pales in comparison to indexing, but is fairly large for an active quant shop.

And so I would say that it was ultimately a successful program, but then again with measured success. I mean, just like any active manager, it's a very difficult game to the extent you can outperform market benchmarks, you're doing fairly well. So can I drill down into something that you often hear about out in the public, and advisors say this all the time.

It's like, "Ah, I'm going to go out and index the easy stuff, the big stuff, the stuff that it's hard to find value, so I'm going to use index funds for U.S. large cap." But there is opportunity in U.S. small cap, because companies are not followed as closely on and on a lot of different reasons.

In your experience, is that true, that there are more opportunities to outperform for managers in, say, small cap than large cap? Well, it really isn't true. I understand that their argument really goes back to the beginning of modern portfolio theory back in the 60s and 70s, and is refuting the efficient market hypothesis that was developed by a number of academicians, primarily Gene Fama, who won the Nobel Prize for his work.

Most active managers say, "Well, the markets are not efficient, and therefore you can add value," and they say, "Well, maybe they're efficient in the large cap segment of the market, but they're not efficient in international markets, particularly emerging markets or small cap segment of the U.S. market." If the markets were perfectly efficient, then clearly the only thing you should do would be to index.

Personally, I believe markets are not perfectly efficient. I think they're reasonably efficient, and they are getting more efficient, but there might be some opportunities to add value. The interesting thing to me is that my belief and Vanguard's belief, I believe, about indexing is not based on the efficient market hypothesis.

It's based on what's become known as Bill Sharpe talked in the early 90s about the math behind indexing, and it's a really simple concept that in aggregate, all investors own the market. What rate of return can investors possibly get? That's the market rate of return, because collectively they own the market.

You might guess that some investors could do better than the market, but it would necessarily mean that others would have to underperform the market. Unfortunately, investors do have costs of getting the market rate of return, so collectively they don't get the market rate of return. They get something less than the market rate of return, and it's significantly less.

It's about 1% less. That's roughly the range of costs, and arguably even greater than that. Somebody who outperforms a little bit before costs ends up underperforming after costs, and it means the majority of investors will underperform a market benchmark. That argument does not apply to the S&P 500. It does not apply to large-cap stocks in the U.S.

It applies to the market, all of the market. Whether you're talking small-cap stocks in the U.S. or emerging markets or other international markets, that simple concept, Sharpe's math, still applies. In fact, we've seen that the data supports that. If you look at the performance of active managers in emerging markets relative to an emerging market benchmark, the majority will underperform.

The same is true when you look at small-cap segments within the U.S., whether it's small-cap value, small-cap blend, or small-cap growth, the small-cap managers have a very difficult time beating the small-cap segment of the market. While some can, in aggregate, they can't and don't and haven't. If active managers, before fees, have some skill and can outperform, for whatever reason, whether quantitative or going out and meeting with companies and picking stocks or whatever the reason, they actually do outperform, before fee, on average, but underperform net of fees, then why wouldn't we just go out, if we're going to look for active managers, and just hire the active managers who have the absolute rock-bottom lowest cost?

I think it's a great point. In fact, that is one that we argued at Vanguard, and Vanguard still supports that today, that really, while people think of Vanguard as an index shop, and many people think that's all Vanguard does, we thought of ourselves as low-cost investors, trying to provide low-cost investing to all of the investors in our funds, whether it was index funds or active funds.

As mentioned in the Bill Sharp math, the handicap that active management has is cost, and so it's very important to keep those costs as low as possible in order not to handicap your active managers. You can take a great active manager and make them a bad active manager by overcharging for them, and so you should focus on low-cost funds, and in fact, there have been many, many studies, Morningstar has done them, academics have done them, that show that the best predictor of future relative performance is cost.

So in other words, the lowest-cost funds will outperform the highest-cost funds on average, and so you should definitely be focusing on that segment of the market as you're going after active management, or index funds as well. There are high-cost index funds, which makes absolutely no sense, but I would also point out that even though you go to a low-cost manager, they have to have skill in addition to just being low-cost.

Low-cost isn't the only recipe, you need skill as well, because they have to be able to take advantage of other investors, and it turns out that if you're going to outperform, somebody else has to underperform. By definition, if in aggregate, everybody gets the market rate of return before cost, you're proposing that there's a greater fool out there that you're going to be able to take advantage of, and I think that people used to say, "Well, the retail investors were the greater fool, those who were investing their own money without the use of professionals," and it turns out that if you go back to the '70s, there were a lot of retail investors.

A large portion of the U.S. marketplace was dominated by retail investors. Today that's not the case. Today, it's really dominated by institutional investors. It's a very, very difficult game today because it's hard to find the greater fool out there today. I'm going to put one more item in there about low-fee active management.

My studies and my research in looking at that, it seems like some of the active management firms are gaming that because when you look at the performance of very low-fee active managers, and I'm not talking about Vanguard or any particular fund, but in the aggregate, the funds that have low fees, a lot of them tend to be closet index funds.

They're not really active management. They're just looking for investors who are looking for low fees, just buying into the argument, the Bill Sharp argument that fees are the main driver of return, and therefore you should be looking for active managers that have low fees, and so people are looking for that and they're hiring managers that have low fees, but they're not really looking at the skill side because a lot of these funds are just "closet index funds." Have you found that to be true?

I think it is true in some cases, and certainly factor funds are that, they're purely that, but you're right that you have to have that skill component if you're going to make any sense out of active management. Low cost is one requirement, but it's not the only requirement to add value and actually beat the marketplace.

Once people begin to find the good active managers that have skill, that also have low fees, then that's where all the money goes, and this also then changes the dynamics of the fund itself and makes it even more difficult for the active manager to outperform, so doesn't the fund have to close at some point?

Yes, there is no question to that. The size is very difficult to manage. Smaller funds, intermediate-sized funds, tend to outperform the mega funds, so a fund should close if it gets to be, or should be closed if it gets to be too large. The way we attacked that at Vanguard was to use multiple managers, so if you look at funds like Morgan and Windsor II and Explorer, as those funds got larger, we realized that one manager couldn't handle more and more assets, so we added additional managers in what are called multi-manager funds.

There are other funds like PrimeCap, where PrimeCap themselves recognize the detriment of having too much in the way of assets, and PrimeCap is always very aggressive about saying, "No, we've got to close the fund," and so the PrimeCap fund, capital opportunities, those are closed because of the difficulty that size poses on providing extra returns.

I'm going to shift gears here and start talking about exchange-traded funds, which was something that Jack Bogle was against initially, but Jack Brennan was for, and I believe he tasked you with figuring out how to do it, and you came up with, or you helped, and your group came up with this patent that allowed your open-end funds to issue ETF share classes and used to call them "vipers." Could you talk about all that evolution and how that came about?

Actually, it turns out that at the beginning, Jack Brennan wasn't really behind the concept of ETFs either, but you'll recall in 1997, we experienced a correction in the market in the fall time, which became known as the Asian contagion, a lot of difficulty in Southeast Asian communities that created some global turmoil.

Then in 1998, the summer of '98, we had the Russian debt crisis, the Russian bond crisis, and once again, creating turmoil in the marketplace. This is all with the backdrop of a very strong bull market in the U.S. that was the tech bubble building, but you had these corrections along the way.

I guess I was a bit of a product of when I started at Vanguard in 1987 and the crash hitting two weeks later, and I was responsible for the S&P 500 fund and trying to figure out how we were going to handle this. I started worrying as our index program was getting much, much larger a decade later by '97 and '98, I was thinking, "What if we had another crash and we had people running for the exits?

How would we be able to fund the redemptions on a much bigger base than we had back in 1987?" I started thinking about, "Well, if we could provide a vehicle for people who were less long-term oriented than we would like, those that might be inclined to jump ship, then that would be a good way to steer them away from our longer-term investors so that they wouldn't have a negative impact on those long-term investors." At the time, ETFs were starting to get a little bit of momentum.

They were started in 1993, but started off very, very slowly. I started thinking about the concept of creating a share class of our existing funds. The problem was, what happens if we have investors in our existing funds who got scared in a market pullback? I was talking to Walter Lenhard, who was in our group, we came up with the idea of, "Well, if we create this other share class and enable investors who might be shorter-term oriented to transfer from the regular share class into that other share class, that they could then sell out of that share class in the ETF marketplace at any point in time when they might become nervous." Our ETFs were very different from the other ETFs that existed then and exist to this day, that our ETFs were merely a part of the exact same fund as our traditional index funds.

They were simply another share class. To explain that a little bit more, in our various index funds, we have a lot of different share classes, the investor share class, the admiral share class, the institutional share class. They're all investing in the same pot of money, but just coming in through a different service door, if you will.

The ETF portal was just one more entrance into that same fund. The portfolio manager is managing one pot of money without really even the knowledge of where the money came from. The beauty of the ETF structure, the sidecar, if you will, was that if investors wanted to get out of their portfolio or their investment in the index fund, they could sell it on the exchange through the ETF share class and it had absolutely no impact on the other investors in the fund.

It accomplished what we were hoping to do, and that was enable investors who might not have the long-term orientation that we desire a way to exit the fund without impacting other investors. You went out and patented this idea, and you got a patent on it, and to this day, no other company can do that, exactly what you described, which is a great idea, a genius idea to do it that way, but other companies now can't do that.

Because of the patent, they would have to go to Vanguard and pay Vanguard something to use the patent. That's correct. I think in total, I might have five or six patents on that concept. They keep expanding them, but there is a statute of limitations that you can keep people away from using your patent, and it's about to run out.

I think it has maybe a couple of more years left. There were some mutual fund firms that approached us asking if they could use the concept, and we were willing to talk with them. Nothing ever came of it, and I don't know, it will be interesting to see if others adopt this structure once our patent does run out within the next several years.

I find it odd because I personally have approached a couple of big mutual fund companies who are competitors of Vanguard, and I said, "Why don't you just pay Vanguard to use their patent because if you have only open-end funds, you could really help to eliminate all of these capital gain distributions at the end of the year if you did the ETF plus open-end share strategy or concept that Vanguard has created." I don't know what Vanguard would charge, but if they charge a couple of basis points, just pay it because it would help the shareholders in your open-end fund.

They just didn't have any interest in paying Vanguard at all. Well, yes, and maybe that's not terribly surprising, paying a competitor who is having a lot of success in the marketplace anyways, you don't want to subsidize Vanguard's success. I would say that there were several unintended benefits from that ETF structure as well.

I was really looking for a way to insulate the fund from short-term investors' negative impacts on a fund, and the side benefit that you just mentioned is that it also enhanced the tax efficiency of the fund. We got a lot of benefits from it. It also opened up a whole marketplace for us that we really hadn't addressed previously, and that was the advisor market.

We were relatively small in the advisor channel, and this really gave us a platform that advisors really wanted to use. Actually, Rick, you may remember this. We had a meeting with advisors in the early 2000s in Chicago, and it was over dinner. I was sitting with about five or six advisors, and you happened to be one of them.

I asked the question why advisors were interested in active ETFs. I could understand the index ETFs, because the thought was that investors wanted to have the ability to move in and out of the market rather quickly. It turns out that the advisor group really didn't want that benefit. People said that's what it was all about, but it really wasn't, and every one of you sitting at the table said that the reason you liked ETFs was because of the platform it provided.

In other words, a mutual fund platform is difficult for advisors in that you buy a mutual fund. You place your order sometime throughout the day. You don't know how many shares you're going to be buying. You don't know what the price is going to be. You just know the dollar amount, and you find out about 5.30 at night how many shares you got at what price.

On the other hand, the ETF share class fits right into the advisor platform, which is typically a brokerage platform where you place your order at whatever time throughout the day, and within minutes or seconds, your order is executed, and you know how many shares you wanted to buy. You bought that many shares.

You know the price you paid instantly. All of you said that the platform was what really enticed you to that share class. That opened up a whole new world for us to serve the advisor community as well. >>COREY: Well, there was another complete new market that you were able to service.

I was an independent advisor. I wasn't at a brokerage firm, but by creating exchange-traded funds, you opened up Vanguard to the Merrill Lynches of the world and all of the different advisors that were working in the brokerage industry, the wire houses. All of a sudden, brokers now could start using Vanguard funds, whereas before, their companies would not allow them to buy Vanguard funds because Vanguard didn't pay them a commission and didn't pay 12B1 fees.

Well, now that Vanguard had exchange-traded funds, brokers from Merrill Lynch and Wells Fargo and so forth could all begin to use Vanguard funds, so it opened up a huge new distribution channel, and so it was another byproduct to doing that. >>STEVE: Yeah, that's kind of a funny story. Back in the early days, 2001 or something like that, I actually went around with some of our sales people or service people to talk to some of the major wire houses, and one of the very, very largest wire houses, I won't name them, was all excited.

They said, "You mean we can buy Vanguard funds because our clients have been asking for Vanguard funds and they hadn't provided them?" I said, "Yeah, absolutely. You can buy Vanguard funds now in this format, and we'd love for you to do that." They said, "Great, and how are you going to pay us?" I said, "We're not going to pay you.

You're going to have to figure that out with your clients, but we're not paying you, but you have access to the funds in the format you want them." >>STEVE: So let's continue on then. Great stories. So you stayed at Vanguard for several more years, and the ETF market just exploded, and the index funds continued to explode, and the quant group continued to expand, and eventually, after 25 years, you decided to retire.

>>JEREMY: Yeah, so I had talked with Jack Brennan when he stepped down in 2008. He was telling individually all of the members of his senior staff, and I was one of the members of his senior staff, that he was going to step down. Jack and I had been friends in college, so I was the last senior staff member that he told, and I was just totally flabbergasted when he told me he was stepping down because we were the same age, and we were only 54 at the time, so I thought he had lots and lots of years left.

One of the many reasons that he wanted to step down was because he felt you should only be CEO of a company for 10 years, and that somebody else should take over and enhance what you've been able to do. Another reason was he wanted to do other things as well, and so both of those weighed heavily on my decision to step down when I was 58 years old, and the third factor that weighed on my decision was my parents as well.

I wanted to be able to spend some meaningful time with them as they were in their 90s, and I'm glad I did have that opportunity. >>COREY: I remember the day talking with you when you announced that you were retiring, and I asked you what you were going to be doing, and of course, I asked you if you would work for me, and you kindly declined.

I knew that was never going to happen, but I had to ask anyway. But now you're back active again. You're involved in a lot of committees. You're working as a professor, if you will, or guest professor at University of Chicago. Could you tell us all the different things that you're doing?

>>JOHN: Yeah. So when I announced my retirement, I was contacted by the dean of the business school at Chicago, and I had remained close to the school after I graduated, and he asked me if I wanted to become an executive in residence at the school after I retired. What did that mean to you?

Because I'm not sure what it means, and he said, "Basically, you can come and do whatever you want and build your own program." So because of my parents' situation, I really couldn't pursue it for about a year, year and a half after I retired, and then finally, I did show up at the University of Chicago.

I actually only stayed for one quarter. I ended up doing some guest lecturing. I mentored a lot of students, spent time with the finance faculty. My office was right in the middle of the finance faculty. It was quite intimidating, in fact. Right across the hall from my office was Gene Fama, five doors down was Lars Hansen.

Both of them had won the Nobel Prize about five months earlier. Right next door to me was Dick Thaler. He won the Nobel Prize a year or so ago, and I knew he was going to win it. John Campbell was right next to Gene Fama. I believe he will win the Nobel Prize at some point in time.

So here I am among all of these super academics, and that's daunting. You have to be a little careful what you say, but I think at the same time, they were interested in my real-world experience. So while they had, obviously, lots of time to think about the academic side, they were intrigued with the real-world aspects of finance as well.

So it was a fun experience, but at the same time, I started hearing from firms. Some wanted me to consider going on boards. I decided I did not want to join a board of directors because there are lots of things that boards are involved with that I really didn't want to pursue.

My love was investing, and I really wanted to get back into that. In my career throughout Vanguard, I actually got pulled further and further away from the day-to-day investing. So I wanted to get back to that, and I focused on investment committees, and at this point in time, I have a portfolio of six different clients on their investment committees that keeps me more than busy enough.

I'm pretty much flunking retirement, and at the same time, I am on the dean's council at the Chicago Booth, which is the business school at the University of Chicago. So I spend a fair amount of time at UChicago as well, so I get to scratch that itch as well.

It sounds like you're very busy still, which is great because you've got so much experience. I'd like to turn the questions over to the Bogleheads forum members. Before I have a guest on the program, I post on bogleheads.org who I'm going to have about a week prior, and the community Boglehead members will come up and ask various questions.

So these questions will be based on what the Bogleheads want to know. One person wants to know how you feel about the Fidelity zero-fee index funds. The number one, are they really no cost, or are they just low-fee or zero-fee, and how that might impact the whole indexing industry, and this is a race to the bottom, and where does it end?

Yeah. Well, first of all, I guess if I were in one of their existing funds prior to the initiation of these new funds, I'd be a little upset that I'm paying the fee, and I'm not getting to participate in the zero-fee fund. In fact, I can't take my money out of the existing fund because I'd have to pay capital gains to move it to the zero-fee fund.

So it seems to me- I didn't realize that you can't just move it over, that you would actually have to sell one fund to just buy the exact same fund. It's not the same- Exactly. Yeah. It's not like Vanguard structure, where the ETF share class is just another share class of an existing fund, where you can move within share classes.

This is a whole new fund that you'd have to move to, and if you move to a new fund, you realize capital gains in your existing investments. So you're pretty well locked into your existing investments if you've been in there for any length of time. So to me, if I had been a loyal long-term investor, I'd be a little bit upset that the new investor was getting something that I couldn't get.

Now addressing the fee component, I do believe that there are actually zero fees being charged by Fidelity. There are some other fees that are paid by the fund. There may be some direct fees that are relatively minor, but I would also check to see how security lending is being handled.

Since funds have a big inventory of stocks, they can lend out those stocks to people who want to go short in the marketplace, and the funds earn a rate of return for doing that. At Vanguard, depending on the fund, you might pick up an extra basis point in return, or even as many as 10 or 12 basis points in return from securities lending.

That's just a free return that you're getting because the fund has this ability to lend out the stocks. I would check in to seeing how Fidelity is handling securities lending. It's obvious that Fidelity would have costs of managing these assets, and is Fidelity just willing to use the funds as lost leaders, or are they making money someplace else?

I would check to see if they're making money in securities lending, and I suspect that is where they're making the money. They would be the agent for the fund lending out the securities and being paid a fee for that. I suspect, I don't know this for a fact, I haven't checked into it, that Fidelity is still making a fee, or making revenue from the fund, it's just not in the expense ratio.

It's revenue for providing a different service to the fund. But to your other point, is this a race to the bottom? Yes, I think Vanguard created the race to the bottom back when Jack Bogle launched the first index fund, and Vanguard's had a dramatic effect on the industry, not just the index side of the industry, but the active side as well.

Fees have come down because of the threat that Vanguard has created in the industry, and now people are trying to, having against Vanguard on the active side, they've got to lower fees, and on the passive side, they're lowering fees, and it is a race to the bottom. I guess the advantage I've always felt that Vanguard has is Vanguard is the only fund company that is mutually owned.

So in other words, the funds own Vanguard, and the investors in those funds own the funds, so indirectly, the investors in the funds own Vanguard. That means Vanguard does not have to generate a profit. There's nobody else that owns Vanguard that's looking for a return on their capital. Every other firm has owners that are looking for a return on their investment, and so every other firm in aggregate somehow has to produce a profit.

Vanguard does not produce a profit because of the mutual structure, and therefore can offer funds at cost, and to the extent Vanguard has tremendous economies of scale, those costs are going to be spread across a very large base, and therefore costs will be very low just naturally. There's nothing being subsidized.

You don't have to have lost leaders in Vanguard. It's just a natural consequence of the structure. >>Corey: A lot of people always ask me, "What is the real true cost of running a mutual fund? What is the real cost to the company to run it?" Well, just look at Vanguard.

You look at their fees, and they're a mutual benefit company, so the cost of running the funds is the true cost of running a mutual fund. Other companies, which might be large, actively managed companies, who might be charging 0.6%, 0.7% versus 0.06%, what's the difference between the cost to run the fund and what they're getting?

That's called profit, or at least gross profit anyway. I want to go to a couple more things, and the time we have remaining. One of them is the idea of smart beta, or is it risk, or is it behavioral-based, and are the risk premiums, if it is a risk story, are they being compressed by the amount of "smart beta" or factor investing that's going on?

>>Mark: Yeah, so there's this large undertow in the mutual fund industry nowadays, and investing in these so-called smart beta products. They used to be called fundamental indexing, and the marketers just keep making better and better names to make it sell more and more. Typically what they are, they're investing in a segment of the market, and most of them, many of them, are really kind of focusing on the mid-cap value segment of the market.

We know that historically mid-cap value has outperformed the broader market, so not surprisingly when people do back tests and come out with these funds, the back tests look great because they focus on mid-cap value, which is outperformed. The big question is, to me, is would you expect this outperformance to continue into the future, and if so, why?

Is it based on risk? Modern portfolio theory tells us the greater the risk you take, the better the return you should get, and that's what a lot of people have said, is that you're taking additional risk and therefore you should get a greater return. The problem I have with that is there are two types of risk.

One is called systematic risk, and the other is non-systematic risk, and so systematic risk is really the risk of investing in the market itself, and then non-systematic risk would be investing in smaller segments of the market. It might even be extended to investing in individual stocks, so there's what's called an idiosyncratic risk component of an individual stock, and that would be non-systematic risk.

So the market risk of a stock, let's just call it Apple, if the market goes up, Apple will tend to go up. If the market goes down, Apple will tend to go down, but Apple will do differently from the market. It'll do better or worse based on its own characteristics.

That's the non-systematic portion of risk. So my question would be, should you be compensated for non-systematic risk? And portfolio theory tells us that you should not be. Non-systematic risk can be diversified away, and so if society does not bear a risk, why should society pay you to take that risk?

So society doesn't bear non-systematic risk. Society only bears systematic risk, in other words, society only bears market risk. Why should society pay anyone else to take on certain segments of risk? And taking that to, as an example, look at the, let's say there are 10 sectors of the market, the financial sector, the energy sector, the healthcare sector, and so on.

So let's say you divide the market into 10 broad sectors. Well, invariably, almost every one of the sectors will be riskier than the market as a whole. And I've actually done this exercise and shown that about seven or eight of the 10 or 11 sectors are historically riskier than the market itself.

So if you were to invest in every one of these sectors, instead of the one fund that covers the entire market, would you expect a greater return? Because they're riskier than the market, should they provide you a greater return than the market? Well, obviously, if you add them all up together, they are the market, so you can't get more than the market return, even though you're taking greater risk in almost all of these underlying funds.

So in other words, you're not being compensated for taking this non-systematic risk. And that's where I come down on this betting on mid-cap value or other segments that are called smart data. Are you being compensated for risk or is it something else? And we do know that historically, value has outperformed and smaller cap stocks have outperformed, going back to the mid-1920s.

And I think there's another reason why they have outperformed. It's not a risk explanation. To me, it's behavioral finance. We talked a little bit about that previously, the debate going on inside of the University of Chicago. So behavioral finance says that we all act irrationally in various aspects of our lives, and the reason that there are mispricings in the marketplace to begin with, the reason markets are not perfectly efficient, is because we act irrationally when we invest in various ways, and that creates mispricings.

You can imagine with, let's say, something that's a value stock. Value stocks tend to be under pressure. The performance of the company tends to be lagging as opposed to a gross stock. And so the stock market performance might be underperforming, and people tend to avoid those. Well, they avoid them to the point where they become an attractive opportunity.

At the same time, growth is the other side of that, where people love a good growth story, and they maybe overpriced a gross stock. So you end up with these mispricings because of behavioral aspects. And then that reverses back. Ultimately, the fundamentals will end the day, and gross stocks will underperform and value stocks will outperform.

The problem I have with all of this going forward is, once something like that is known and understood, it gets arbitraged away extremely quickly. And I believe that that's where we are, that it's being arbitraged away, and the markets are much more efficient today than they have been historically.

So I'm not a big fan of this concept of smart beta, because I think you're basically fighting the last battle. You've got to look forward when investing, not backwards. It's interesting you say that, because I've always wondered, when all of the data originally came out on microcap and small cap investing back in the late 1970s, I want to think, in early 1980s, and the first small cap funds started coming out, and then going forward after that, after the data came out on the outperformance of small cap, and people now then started taking advantage of it.

So that was the first factor of smart beta use of this data back then, that it hasn't happened since. I mean, there hasn't been an outperformance of small cap. So has it been arbitraged away? Because it is behavioral, like you're saying, or it may or may not be behavioral, but it's certainly a whole lot easier now to invest in those factors than it was 30 years ago or 25 years ago.

Do you want to buy a fund that has small cap exposure? Just go to one of the many different small cap factor funds. You could buy anything you want, even a microcap fund. If you wanted value, you could go to one of many, many, many different value factor funds and buy 100, 200, 500,000 stocks that have value in it.

So in other words, the ability to invest in these factors, number one, they've become known, and when they become known, they become arbitraged. And the ease and the ability to now do this is all, to me, squeezing out the premiums. Now, I don't know where it's going to go going forward, but that's my view is, I think I'm agreeing with you.

It's my view as well, that this is all being arbitraged away. Yeah, absolutely. Rob Arnott, a gentleman named Rob Arnott, really kind of created this cottage industry back in about 2003 or 2004, and I've known Rob for probably 30 years at this point in time. And he approached me because he wanted Vanguard to offer the first fundamental index fund.

And so that was the first name of this concept, fundamental indexing. And I looked at it, and I ultimately concluded, I said, "Rob, we already offer this fund. We have a mid-cap value fund." He contends that it's different from that. And Rob and I have had a couple of, I won't say heated debates, but kind of fun debates in big venues.

The Morningstar Advisor Conference, 2,000 people in the audience, Rob and I have debated this concept. We've actually become kind of friends over the whole thing, but we just agree to disagree on the concept. But I absolutely believe that once something's known, it can be arbitraged away extremely quickly. And, you know, you've noted the small cap phenomenon, the same has happened with value as well.

Interesting. I've got a couple more minutes, and I want to hit on just two last topics. This one is just a quick answer, because the next question I'm going to ask, it might be a little bit longer answer. This one happens to do with an individual investor. Should they buy the global market portfolio, which has almost 50% in international stocks, or should they limit their holdings in international to something less?

Personally, I believe you should have a home country bias. Think of if you're an Australian, you'd end up owning 4% of your investments in Australia and, you know, 96% elsewhere. That's an extreme. If you're in the U.S., I still believe you should have a U.S. bias. You should have an international component, but probably not the full international weight in the global portfolio.

And that's just because there are other risks globally that you don't have at home. You know, repatriation of funds can be difficult. Back in 1997, we couldn't get our money out of Malaysia in our emerging markets fund for a year. And, you know, for those types of reasons, I think you want to overweight your own home country.

Secondly, I would say you're investing in order to pay for your future expenditures, your future liabilities. And most of your future expenditures, most of your future liabilities will be domestic. So you want to make sure that your investments are performing in line with your liabilities or expenditures. Okay. And here is the last big one, and you may have been anticipating it.

How big can indexing get before it affects the market? And in addition to that, Jack Bogle recently came out with some comments about voting index funds and how there might be a risk or a danger in just a few companies voting all of the index shares. Yeah, so I've thought about how big indexing could be ever since I started at Vanguard back in the 80s.

You know, I was worried that if it got too big, I didn't have a job. Actually, I've spoken with Burt Malkiel and Charlie Ellis, two good thinkers about this, two strong advocates for indexing. And collectively, we have independently come to the agreement that 80 to 85% of the market could be indexed without creating any disruptions in the marketplace.

It's one of those things you kind of know when you get there, but I can tell you we're nowhere near close at this point in time. My intuition just says the markets will remain efficient even if indexing is 80% of the marketplace. So we've got a long way to go there.

You know, to Jack's point, if indexing becomes concentrated in a handful of firms who end up voting most of the proxies, as a manager of investors' assets, you have a fiduciary responsibility. You have a legal responsibility to manage those assets for the benefit of the investors. And I guess I tend to be an optimist.

I'm a glass half full type of person, and I think that the investment firms are doing what's best for their investors and will vote proxies accordingly. I can certainly tell you I feel that way strongly about what we were doing at Vanguard. I used to be very close to the proxy voting process.

In fact, in the late 80s and early 90s, among other things, I was also voting the proxies. And so, conceptually, if people got together and colluded and, you know, you could create a problem, I just tend to be an optimist. And I also know the competition between Vanguard and BlackRock and State Street, the three biggest indexers, I can't imagine those three firms would ever collude.

And I can't imagine them really shirking their fiduciary responsibility of doing what's best for the investors in their funds. Well, Gus, it's been a real pleasure. Thank you for being on the Bogleheads on Investing podcast, and good luck in your future endeavors. Great. Well, thank you so much, Rick.

Good to talk with you. This concludes the fifth episode of Bogleheads on Investing. I'm your host, Rick Ferry. Join us each month to hear a new special guest. In the meantime, visit Bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

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