Welcome to Bogleheads on Investing, podcast number 37. Today, we have two special guests, the Vanguard Total Stock Market Index Fund lead manager, Jerry O'Reilly, and the head of ETF and index product management, Rich Powers. And today, we're going to get a behind-the-scenes look at how the largest index fund in the world operates.

Hi, everyone. My name is Rick Ferry, and I'm the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) nonprofit corporation that can be found at boglecenter.net. Your tax-deductible contributions keep programs like this going.

Today, I'm very pleased to have Jerry O'Reilly and Rich Powers from Vanguard. When you listen to this podcast, you will be amazed at the candor these two people provide to us about behind-the-scenes operations of how the largest index fund in the world, the $1.3 trillion Vanguard Total Stock Market Index Fund, operates and is managed.

We're covering a lot of ground today. We're going to be talking about daily operations and how money flows in and out of the fund, how securities flow in and out of the fund in kind through ETFs and through large institutions. We'll talk about how microcap stocks are traded in the fund, which is a difficult part of the market.

We'll talk about proxy voting. We'll talk about fees and how security lending helps reduce the cost to investors. We'll talk about several tax-saving strategies used to manage the fund. We'll talk about the history of this fund and the three different indexes that it tracked during its history, now tracking the CRISP Total Stock Market Index.

We've got a lot to talk about today, so let's get to it. With no further ado, I am extremely pleased to have Jerry O'Reilly and Rich Powers from Vanguard. Jerry is the portfolio manager for the Vanguard Total Stock Market Fund and ETF. And Rich is the head of ETFs and index product management at Vanguard.

So welcome, Jerry and Rich, to Bogleheads on Investing. Thanks, Rick. Great to be here. Well, before we get into this fund, which is the largest fund when you look at all of share classes of any mutual fund in the world, I just wanted to find out a little bit about your background, Jerry, and a little bit about your background, Rich.

So Jerry, I understand that you were an Olympic athlete. Yeah, that was a few years ago, Rick. Back in 1988, I represented Ireland in the Seoul Olympics in the 1,500 meters. Grew up in Ireland and came over to the US, went to school at Villanova on a track scholarship.

And after I graduated in 1987, my job was a full-time track athlete. So for a few years, I would go to Europe in the summers. And my goal was-- I always had this desire from a young kid to someday, hopefully, try and make an Olympic team. So fortunate enough that in 1988, I ran fast enough that qualified for the Olympics and made it to Seoul.

A year or so after that, it became evident that I might want to think about another job if I was going to be able to afford a mortgage and a car payment and insurance and things like that. So fortunately, a very good friend, Jim Norris, was working at Vanguard at the time.

And he said, hey, I'll drop your resume off. So I thought I'd be here maybe three or four years and find something else. Little did I think that I'd be here-- I'll be here 30 years next March. And it's been a great place to work. And started off entry-level at Vanguard.

And within a couple of years, made my way over to be an assistant trader and have been on the desk for 27-odd years now, yeah. That's a fantastic story. What about you, Rich? I mean, you've really made your way up, been there a long time as well. Yeah, I can't compete with Jerry as it relates to kind of a pre-Vanguard story.

But our paths have some similarities in that we both started on entry-level positions in our retail phone area. And so I made my way from our phone group over to our portfolio review department, really think of that as kind of our product group. And for most of my 22-year career, I've spent focus on our active lineup.

So we work with firms like Wellington and Primecap and have them run active equity portfolios for us. And we have internal active capabilities in our fixed income group. And so I was part of a team that looked after those managers, chose managers to deliver active mutual funds to our clients.

And then about six years ago, I moved into this role, where my team and I are leading the ETF and index product management function. And really, that has three dimensions to it. We work with some of our larger and sophisticated clients to help them understand our product relative to the marketplace.

Two, we do surveillance of the marketplace. As Frick, as you know really well, the indexing landscape has changed pretty dramatically over the last decade or so. And so we were the eyes and ears for the organization as it relates to that. And then the last part of our job is designing new products and improving existing products.

It's really a testament to Vanguard that they retain people for so long. I mean, you've both been there more than 20 years. Jerry, you'll be there 30 years here soon. That's really fantastic. I've heard it's a great place to work. I want to get into the Vanguard Total Stock Market Index Fund.

And by that, I mean everything-- the institutional shares, the admiral shares, the ETF class shares. Altogether, it's the same portfolio. Am I not mistaken? I mean, this is the same portfolio, just different share classes, correct? Correct, yes. On the actual managing of the fund, Rick, if you think about it this way, to me, it's one pool of assets.

And so whether cash flow is coming in in the form of-- if it's institutional, if it's admiral, whatever the class might be-- it's just cash flow coming into the fund. So I, in terms of managing the fund, I don't need to concern myself like, oh, which channel is this coming through?

Because it's just cash flow into the fund. So obviously, my goal as the manager is to make sure that the fund is really keeping tight tracking with the benchmark. And so that sounds pretty easy, but there's a lot of moving parts in there. So there's cash flow, like I mentioned.

We work with a data team that gets in here at 7 o'clock in the morning to make sure that the data, the indexes that we're actually looking at, that all of the corporate actions that might have happened the previous night, that they're all accounted for. So that when I get in, that I make sure that the index I'm tracking is the exact index.

And we're talking like a spot on, like no discrepancies whatsoever. Then throughout the course of the day, you have all these different index changes that we get notified that are going to be effective at the end of the day. And so we need to position the portfolio so that 4 o'clock, our fund replicates the index spot on.

And so any index changes, we need to factor that in. And usually, that's going to mean that I need to buy. So I'm going to have to sell something to fund that buy. And so we could have a dozen of those that happen on any given day. And it could be syndicate offerings.

It could be Dutch auctions. It could be numerous different corporate actions that you need to incorporate that into it. And then you get to the point around 3 o'clock, Rick, where you actually generate your trade list. So if I have $600 million coming into the fund, some of it's institutional money.

Some of it's admiral. Some of it is cash tenders that might be going on in the portfolio. I sum it all up. I have my trade list. Let's say it's $600 million. And now it's up to me to trade that. I know my benchmark is the close. I then-- because at Vanguard, we kind of wear two hats.

You're both the trader and the portfolio manager. So I know exactly what the strategy needs to be. I know that it's a cash flow trade. So most of that trading, I want to be able to participate in the auction, because that's how our funds price-- whatever the closing price is in the particular-- whatever exchange that a stock happens to be in, the primary listing, that's the benchmark for us.

So I know that that's what I need to be able to buy at that price or maybe even better. And so we put a portion of it into the auction. And you need to have your orders down there by a certain cutoff time, depending whether a stock is a New York-listed stock or NASDAQ.

And any residual names, then it's up to me to put a strategy together how I plan to trade these names. So there's lots of moving parts. And the great thing is we have a fantastic team. We have about 25 traders on the desk, roughly split half and half-- well, maybe a couple more on the domestic side.

And so that if my plate gets too full, Rick, I know that I have two or three traders that I can count off to help me with the workload to make sure that at the end of the day, we're 100% invested. And that's really ideally what you want to be in an index fund.

You don't want to have any kind of a cash drag. You want to make sure that you're 100% invested. And then at the end of the day, we basically can run reports. We have multiple eyes that sign off. I sign off. We have a desk supervisor that sign off.

And we have someone from our risk area that signs off to make sure that the fund is where it needs to be. So lots of moving parts. Just to circle back to the fund itself, based on what's on the Vanguard website at this time, the fund value is $1.3 trillion.

That's all different share classes. But in aggregate, this pool of assets is $1.3 trillion. Now, I went to the indexers website and calculated that the value of the index, the total US stock market index, which is a float adjusted-- and we'll get to what that is in a minute-- right now is about $45 trillion, $45 trillion.

So this fund, the way I calculate it, this fund, total stock market index funded Vanguard, is about 3% of the US market float adjusted. And by float adjusted, it's the shares that are outstanding and available to rate. Is that fairly accurate? You're in the ballpark. You are in charge of 3% of the entire US stock market with just this one fund, which is incredible, quite frankly.

It's a lot of responsibility. Now, Vanguard in aggregate has about $8 trillion. How much of that is in US equity of the $8 trillion? Well, on our desk, which is the indexing desk, we're $4.5 trillion, roughly. Now, I think we also have plenty of external managers, and we have our internal QEG, which is quantitative group.

They would be on top of that. I don't know what the total equity would be. I don't know, Rich, if you would know what the bond portion is that we could subtract that out of the 8? I would ballpark it, that US equity investment's probably in that $4 to $4.5 trillion level when you sum up what the equity indexing group runs across the funds and ETFs, as well as the active equity strategies that Wellington or PrimeCat run for us.

So it's fair to say that about 10% of the investable US market is owned in some way, form, or fashion by Vanguard investors. Is that accurate? I would say you're in the right zip code. Yeah. OK. OK, well, I just want to get it all done. It's a phenomenal amount, and a lot of responsibility.

A lot of people's retirements at stake, if you will, based on what you guys are doing. So we all greatly appreciate it, including myself, by the way. Full disclosure, I own a couple of the Vanguard funds, including the total stock market index funds. So you are my portfolio manager.

Let's get into the index itself, because it really has a kind of a history. And I've been involved a little bit of this, because I followed the indexing industry for over 25 years, and especially this particular fund. It started in 1992, which, Jerry, that was the year that you joined Vanguard, if I'm not mistaken.

That's right. 1992. And the original index that it tracked was called, at that time, the Wilshire 5000. Now, there wasn't 5,000 stocks, but the company, Wilshire, called it 5,000. There was actually more than that at the time. Now, that index is the Dow Jones US Total Stock Market Index.

So this was the original index. And, Jerry, when you came on board to start working with this fund, it was 1994. So you were there kind of at the beginning of it, when assets started to flow in, because it did take a little bit of time before people realized what it was.

But it was the first total US stock market index fund to be created. And I was excited about it at the time, I recall. But there was-- I had a conversation with Gus Sauter after this fund changed indexes. And I asked why you left the Wilshire 5000 back in 2005, and you went to something called the MSCI Broad Market.

And he said that you, at Vanguard, were the ones who had to make a lot of changes to the index, because there were some real problems with the index. Is that fairly accurate? It is. I mean, I would say back then-- your memory is correct, Rick. Back then, the Wilshire 5000, there were a couple of things I would point out.

So number one, in terms of managing money towards it, one of the big issues that we had is that it was not float-adjusted. So you could have a name that was getting added to the index-- and let's just use round numbers, Rick. Let's say there's 100 million shares outstanding, and insiders owned 70%.

So really, the float was 30 million shares available to the public. The way that it was managed back then is that we would be forced to buy it as if 100 million shares was outstanding. And obviously, that would be problematic. As assets grew, you're trying to buy this name as if 100 million shares are outstanding.

70 million shares are held by insiders or some private equity firms, whatever the case might be. And we had massive impact on names when they were getting added to the index. So Gus, I know, at the time, was very much in favor of, hey, we need to be in a position where we need to talk about float-adjusting the indexes.

And so once we went to float-adjusted indexes, it became much more manageable to trade names when they got added to the index. And I would say the other big change-- Rick, and you mentioned it already-- was that there was far more constituents back then. And there was well over 5,000 names in the benchmark.

And so I would say, from managing it, there was probably more of an optimization tilt to managing the fund, where it's difficult to own every single name when you have that many. And if you look at today, the CRISP index, it's 3,800-odd names in there. And so that has been a problem with just US market structure in general, that just the number of names going public.

Private equity was relatively small back then. So if you needed capital, you became a publicly listed company, whereas there's lots and lots of companies that are very, very large today that are private. They're not trading publicly. And I think the exchanges are aware of that and trying to come up with ways to entice more people to go public sooner.

But I would expect that number in the CRISP index to rise over time as well. Before we went from the Wilshire 5,000 to CRISP, there was an index in the middle. And that index was the MSCI Broad Market. And this change created a problem. I had written a book called All About Index Funds.

And I realized right away that there was a whole bunch of micro-cap stocks in the Wilshire 5,000 that you had to sell to get to the MSCI Broad Market. Because the MSCI Broad Market was 3,000 names. It was fairly close to the Russell 3,000. So you had 1,000 or 1,500, whatever, micro-cap stocks that needed to be sold.

And I remember that whole process going on, where it took you, I don't know, what, two years? Or it took you quite a long time to liquidate all of those micro-cap positions, only to turn around and buy them back again in 2013, when you switched indexes again and went to the CRISP.

And CRISP is the Center for Research and Security Prices, CRSP, which is kind of an affiliate of the University of Chicago. So explain, how do you deal with all this micro-cap? I mean, you had to sell it. Then you turned around, and you had to rebuy it. I mean, micro-cap is a fairly illiquid market.

And I got a lot of questions on the Bogle Heads about, how do you manage the micro-cap side of this? Yeah, so you're right. Micro-caps, if we look at it, those are by far the most difficult. And back when we did that transition, I mean, the thing we did, Rick, was we took our time.

We were opportunistic. Some of these micro-caps, there are days when they don't even trade. Or if they trade, it's for a couple of hundred shares, 1,000 shares. And if we had size and a name, we would certainly-- one of the things about trading is there's a trade-off, right? So if you have a name that is a relatively small weight, which most of these micro-caps tend to be-- you're talking fractions of a basis point-- it doesn't make sense that if you need to sell it, to have huge impact on that name, since it's not really going to cause much in the way of any kind of significant tracking error to the fund.

So the way we thought about that was, let's be smart about how we trade these names. And if it takes time, it takes time. But we will be opportunistic. We're going to be out there. I mean, the US market structure is fairly complex. You've got 16 different exchanges. You've got 45 different pools of liquidity.

You've got dark pools that are available. We've got brokers sending us indications of interest where they can tell us, here are names that we're trafficking in today. So we would take our time and trade those names if we were opportunistic. So I find a buyer in one of the dark pools.

Boom, I may be able to trade five days worth of volume in a minute because the other side showed up. But we certainly weren't going to, if we were selling those names, have a lot of impact, push the prices down, just because on a particular day we were out there, there didn't happen to be any buyers out there.

So we were opportunistic about it, working with our peers in investment risk that let us know, hey, these names, even though they might be a lot, they really represent very little risk to the portfolio. So we really were just opportunistic in terms of how we got into them. And then, you know, CRISP came along.

And I would say CRISP methodology was probably the closest align to what we thought, here's what proper indexing is in terms of how you manage index funds. They had buffers in there so that you didn't have too much in the way of turnover. When we have rebalances now, we're able to do it over an extended period of time, we're able to do it over five days.

So the idea of doing that and, you know, being able to spread that trade over five days rather than doing it in one day was a huge benefit to our shareholders because we were able to minimize the impact you would otherwise have if it was done in one day.

So there were lots of things that we liked about CRISP methodology, how they handled large IPOs, how they handled syndicate. We were able to take advantage of the liquidity available in the market so that they would get added sooner to CRISP maybe than some of the competitors. So there were lots of things we liked about it and we think we're at a good spot today, Rick.

- Another thing we like about it is they're not charging as much money as some of the other index providers for the index. (laughs) You know, saves us a little money. Okay, very good. Rich, I wanna jump to exchange traded funds because in 2001, Vipers were launched and Vipers were the, at the time the code name, the word exchange traded fund didn't really exist back in 2001.

So Vanguard came up with this thing, Vipers, and I forgot what it stood for, but it's an ETF and they eventually dropped the Vipers name and just went with exchange traded fund or ETF. But these were launched in 2001 and they were launched as a share class of an existing fund which was completely unique, a brilliant idea, by the way, which Vanguard patented.

And could you talk about this and then as you talk about it, also talk about the benefit to even the open-end share class holders because of ETFs. - Yeah, Rick, it really was a really seminal moment for Vanguard in terms of entering the ETF category as it allowed us to reach more and more investors that we couldn't access through our index mutual funds because of payment for distribution dynamics, but ETFs allowed us to reach advisors and individuals at a much lower cost through different discount brokerage platforms.

Interestingly, we just celebrated our 20th anniversary in ETFs back in May. The total stock market ETF, ETI, just hit that 20-year anniversary and it's one of the largest ETFs today. We have 1.9 trillion in ETF assets in our US lineup. The benefits of the multi-share class structure were really compelling for our ETF lineup very early on.

So what we were able to do is attach an ETF share class to an existing large fund, like the total stock market fund, and on day one, have that ETF have a very low expense ratio, incredibly broad diversification because it's simply a share class and existing big pool of assets that Jerry now manages today.

And what that means, it allows the fund to track its benchmark really well. And so all that created a nice tailwind for our early ETFs and that they were able to hang it off in the existing fund. They track well, they're inexpensive, and investors were able to access the US market in a really low cost way and get great tracking.

So 70 of our 82 US ETFs have that multi-share class structure. The more recent vintages of our ETFs that we've launched are standalone ETFs. So more conventional, like many of our peers in the industry offer. And that just speaks to the fact that where we had a mutual fund, an index mutual fund, we hung an ETF off of that mutual fund where we could.

And now we're in the midst of launching some new strategies where a mutual fund didn't exist. So launching the ETF is the better answer given where we see client interest aligning. Your point around tax efficiencies is a compelling one in that one of the things that happens with an ETF, there's probably layers of tax efficiency that we can talk about with respect to an ETF.

The first of which is the ETF is based upon an index-based strategy, right? We know by and large, most index-based strategies are lower turnover. So that in and of itself creates tax efficiency for our portfolio. But with respect to the ETF, there's two other really important dimensions to it that give it that extra ability to minimize capital gains distributions.

First, the training of the ETF shares in the secondary market. So we'll stick with total stock market as an example, but if Rich Powers owns VTI and he wants to sell that exposure and I go into my brokerage account and I decide to sell it, there's a market maker on the exchange who's gonna see that order come through and then they're gonna pair that sell order with say a buy order from Jerry O'Reilly who wants to buy that same VTI ETF in the marketplace.

So that training activity amounts to almost a billion dollars a day in our ETFs, which means that activity never makes its way to the portfolio. Jerry doesn't have to lift a finger to trade that activity in the portfolio, buy or sell, because it's just simply exchanging shares on the exchange.

So that really creates part of the compelling nature of ETFs when it comes to tax efficiency. The other component is how ETFs transact. At the point at which maybe there is more buy activity for an ETF on the exchange, a market maker is going to say, "Well, I need to go and acquire more shares from Vanguard "to satisfy this greater buy activity.

"And so I'm going to go out and accumulate "the underlying stocks that represent that index, "hand them to Vanguard, "and Vanguard's gonna give me shares in exchange "to sell to investors out in the marketplace." The same thing happens on the way out. And this is where the power comes in, where if there's a lot more sell activity on the ETF in the secondary market, instead of having to sell the couple thousand stocks in total stock, Jerry's team is gonna hand the market maker those stocks, they're gonna sell them into the marketplace to satisfy that redemption activity that's happening in the market.

So shareholder impact on terms of the tax efficiency and positioning of the portfolio doesn't happen because there is no selling stocks in the portfolio to meet that redemption. We're handing those stocks to the market maker who then sells them outside of the portfolio. - And let me put my two cents with you.

And I call it a double-edged sword here on taxes because, correct me if I'm wrong, Jerry, when you get a cash redemption through the mutual fund side, you could sell shares of stock that are at a high cost basis so that there's very little impact, if any, on the fund.

There might even be a loss to the fund because some of the shares you may have bought at a higher cost. And then when there is a redemption on the ETF side, a creation unit redemption, you can push out stock that's at a low cost basis. So again, pushing out some of the tax liability, unrealized tax liability in the fund.

Is that close to what you do? - Yes, yep. Every day, Rick, we're going to basically net all of our cash flows coming into the fund. Let's say you have a redemption coming in today. I very well might have a corporate action going on where one of the stocks in my portfolio is being acquired by someone else for cash.

Or we could have some other corporate action, and part of it is, hey, you're going to get X number of shares of this stock, the acquirer, and you're also going to get X number of dollars per share. So I kind of net everything together. Around three o'clock, I'm going to know, hey, do I actually have to sell today or am I actually in a buy mode?

And I can tell you through 27 years on the desk, it's been massively skewed towards the buy side where cash flow is coming into Vanguard. The ETF activity that Rich just referred to, I could get a billion coming into total stock today in ETF creates. I actually don't see it at all.

I just know that my assets have increased, but I'm also receiving a basket of stocks, and obviously we're then giving them shares of the ETF. It's going on, I'm aware of it, but it doesn't impact. There's no trading involved whatsoever. If I do need to sell, I need to sell.

And whether that, you know, sell futures or sell a basket of stocks, at three o'clock, it's like, hey, there's 300 million leaving the fund today. I am going to need that fund redemption. Otherwise, I'm going to leave the fund levered tomorrow morning, which would not be good because then you start to introduce tracking error.

But the number of, I would say, sell days are few and far between relative to, I mainly tend to be on the buy side as cash flow is coming in. And ironically, the stronger the market's doing, it tends to be people want to buy even more and more, you know, coming into the fund.

- Let me ask a question about the basket of stocks that comes in as an ETF, because the way that it works is the authorized participant looks at the basket of stocks they have to put together. Now, that basket is not 3,900 stocks. That basket is much smaller than that, maybe half that size.

- Yeah, I think it's actually right around 1,900, yeah. - So they send in a basket of 1,900 stocks, which 1,900 are probably the most liquid stocks, which leaves another thousand stocks in order to make this portfolio balance out. It means if you're getting a lot of money coming in through the ETF side, that you then, your desk, would have to go out and start buying a lot of micro-cap stocks, I would imagine.

- Yeah, well, so the way that we would think about that, Rick, is this, you're right, most of those 1,900, obviously they start off large cap, go down to mid, small, and maybe even a little below that. But you're right that if all you got was ETF activity for months and months and months, you would start to notice like, hey, the tail, the micro-cap, the smaller cap, and you're starting to fall behind a little bit here.

So what we do, you know, what I do as the portfolio manager on the fund is every week, I basically run a trade list Monday morning that focuses on the bottom two deciles of my portfolio, which is kind of that small cap, bottom of small cap, and these are the names that are difficult to buy, they're illiquid, and I split them up between a number of traders on the desk, and we hold them for the week.

We trade them Monday through Friday. And we are totally opportunistic. So if a name happens for whatever reason, you find a natural, so I'm a buyer and, you know, on Wednesday, a huge seller shows up, we'll get done. Now those names, they may not represent a huge weight in the index, but we focus on that tail throughout the week to avoid exactly the point that you're bringing up is if all you're doing is getting your 1900 shares or basket, you know, stocks in every day from the ETF, at some point, you're gonna look a little light on the lower end of small cap and maybe even below that.

And so the way we get around that is we consistently trade them, we break it into small groups, and we have brokers who specialize in micro cap, small cap names, and believe me, on days when they have the other side, we're trading with them. And so we use all of the different tools at our disposal, dark pools, you know, different type of ATSs.

If there happens to be someone who has a big liquidation going on, and we find out about it, we'll see if we can pair off with any of our buys versus a big sell that might be going on in the market. So we do that every week to make sure that we never do fall behind there.

So obviously the tracking error of the fund, that's of paramount importance to managing the fund. And we make sure that that stays as tight as possible. And that's how we get around that issue of making sure that on the smaller names that we're right where we need to be.

- I wanna talk one more time about taxes, because this fund does have a fairly sizable unrealized gain. And I calculate something like a $700 billion capital gain. I looked at the annual report and the fund cost to acquire the stocks was about 550 billion. And the value of the fund is around 1.3 billion.

So call that $750 billion of unrealized gains. And as long as money's coming into the fund, it's not a problem. But at what point, you know, money starts coming out, will you end up having to realize some of these capital gains and distribute them to shareholders? - I'll get us started and Jerry for the job.

Well, if you look at the current position of the fund, also from a realized gain perspective, you would see about a 1% realized loss in the portfolio for this fiscal year. And so, you know, what Jerry's team is able to do there is look selectively at different names where we can maybe harvest some losses along the way to ensure that if we know there's a big corporate action coming down the road that's gonna result in a capital gain, we have a little bit of an offset there that doesn't require us to bear any type of, or minimizes the amount of risk that we're gonna bear in the portfolio.

Now, so there's different levers we can pull there. Obviously, we talked about the in-kind nature of the ETF that allows us to export out different cost slots as shareholders redeem from the portfolio. But I think maybe the place I would kind of finish here and Jerry, please jump in would be, you'd have to think through like what would precipitate investors to begin to redeem in some significant way, right?

And so usually when that happens, and our shareholders are as well-behaved as any, but when that would happen, it would likely be when the markets are going down. And so that would put us in a position where the tax basis of the portfolio and complexion has changed pretty meaningfully so that that unrealized gain you mentioned, Rick, is gonna be meaningfully less and we can be much more selective as we kind of fund those redemption.

And then the last thing I'll say is that we have the ability to in-kind in the mutual fund side. So sometimes plan sponsors will move their 401(k) plan or their pension plan from the Vanguard product to someone else's. And more often than not, we are in-kinding those assets to the new provider rather than Jerry and his team selling those down.

And so I think you look at the unrealized number, you'd say, wow, that's kind of a scary prospect. You have to think about how we got here. We've had an incredible bull market and strong cash flows, but the unwind to that in terms of why investors will walk out the door, we have different levers to pull, be it the market, the tax basis of the fund has changed, and/or we can in-kind on the mutual fund side for those large institutions.

- Yeah, that's a great answer. I would say, Rick, the number one thing, if I'm on the desk today and I find out, hey, someone is looking to redeem substantial size out of one of our portfolios, you try and get some color. And then the first question I'm gonna ask, is this something that is, are they open to doing an in-kind?

And a lot of times it's not on the day. It maybe is two weeks ahead of time. XYZ is looking to move money wherever. The first question that we're gonna ask on the desk, is it open to in-kind? Obviously it's favorable for us from a tax point of view and from a trading point of view.

And a lot of times for the client who's leaving, rather than them receiving cash and then turning around with whoever the new asset manager might be and buying again, it's easier for them as well, as long as they have, we're going from one, the same light benchmark or a benchmark that's very close to it.

And Rich also mentioned tax loss harvesting. We have a great accounting team that notifies us multiple times a week where we stand. And so there are times throughout the year where it may be opportunistic to put on a tax harvest. So if we see, hey, we have a number of names here that we have huge losses on, that we can harvest those names.

You do have to be aware that there's a wash sale period of 30 days. So we work very closely with the risk teams to make sure that you don't have any kind of sector bets where you're selling a huge amount of names in one sector. So we do that in such a way that even if you do have a tax harvest, that in terms of potential tracking error, it is minute.

And so that's something that we have available as well, as well as some of the other tools that Rich spoke about as well. - Let's get into the cost of running this fund. This is news to me when I was doing my research prior to the call, that the cost of running the fund according to the 2020 annual report was around $422 million.

That was the total cost to run the fund. Of that, 176 million was attributed to the investor share class. So this share class is really expensive. It's like 41% of the cost of the fund. And I was actually surprised that there are still people in the investor share class.

I mean, why hasn't everybody moved over to the admiral share class, which is less expensive? - Yeah, a couple of things to inform that, Rick. One, the investor share class is used by target date portfolios that Vanguard offers. And so there's a range of different target date portfolios that we offer for individuals, institutions, and it scales as AUM scales.

And so for a portion of our clients, they're using the, in the target dates, they're using the investor share class. There's a portion of clients who can't access admiral shares on other brokerage platforms. So because there's kind of minimum holding, minimum size requirements to get into admiral shares and some other brokerage platforms aren't able to conform to that, the only available option for them would be to utilize the investor shares with those portfolios.

So those are kind of the two kind of drivers as to where the vast majority of investor AUM would occupy. But certainly I've been here and Jerry's been here long enough to know that that was 100% of the AUM 20 years ago. And then over time, it's slowly whittling down.

And I would expect that trend to continue. If you just look at the organic activity within the portfolio, the preponderance of the assets are coming through the ETF, then through institutional and admiral, secondarily with investor shares, mostly being a function of rebalancing or new plans that decide to use a targeting fund.

- I find it interesting that ETF is so cost efficient at Vanguard. The total cost for a management and administration of the ETF share class was only 36 million. So it was a fraction of what the investor share class or the admiral share class was, clearly very cost efficient to Vanguard to have people in the ETF share class.

And Rich, you could discuss that. - Sure, when you think about who the historical users of ETFs have been, financial advisors have carried the water as it relates to their adoption at Vanguard and elsewhere in the marketplace. And most of those financial advisors will custody their assets at some other discount brokerage platform, or they might be at a broker dealer.

And so when you're thinking about kind of the scale benefits that come from hundreds of millions or billions of dollars being in other platforms, it certainly removes some costs from how Vanguard has to support those products day-to-day administratively. And so the rough number here is about 10% of our ETF AUM is on a Vanguard platform and the balance is held at some other discount brokerage.

And so as you'd expect, the cost that would come with those types of assets would be pretty materially lower than where those kind of directly sold or directly held clients that might be in a Vanguard platform either in a 401k plan or in a direct investor relationship. - And one of the reasons why ETF share classes have a lower expense ratio, although it's only one basis point lower than Admiral shares is because it doesn't cost as much, correct?

- That's exactly right, right? So a couple of years ago, some of our investors would have noticed that historically the Admiral shares and our ETF shares of the same fund would have had the same expense ratio. So I think total stock a number of years ago would have had a five basis point expense ratio for Admiral and ETF.

But now as we sit here today, we've seen the, because of the growth and adoption of ETFs, we've seen the ETF expense ratio, because it's scaled, move down to three basis points and the Admiral shares is at four basis points, both incredibly compelling, but certainly highlights the cost that we bear in managing those portfolios, administering those portfolios is different for the ETF.

- One other thing about cost is that you're able to do security lending. And I noticed again in your annual report that you had about $6 billion out of security lending and you're able to acquire from that about $170 million of income to the fund, which helped to offset the expenses at the fund.

So, Richard, if you could talk about security lending and how that helps to offset the cost. - Yeah, so securities lending is an exercise that we've been involved with for a long time. We only lend securities on our equity portion of our portfolios. We don't lend any fixed income securities.

Our analysis there is that the cost to administer is not worth it relative to the benefit that you got. And so, but there is clearly a benefit for, on the equity side. And so what we'll do is we have a securities lending desk that's operates on behalf of our funds and goes out and lends those securities that are in great demand.

And there could be any number of reasons why those securities could be in demand because of a opportunity from a corporate action that's coming up. Perhaps there's activity from a hedge fund that maybe is interested in acquiring additional shares. And so we'll lend those securities in our portfolio up to a limit where we see that there's value.

We actually approach securities lending from a value-based approach. Some of our peers will basically lend everything they have and try to just maximize the amount of income they generate by lending as much of the portfolios available. We only look for those opportunities that are really ripe, have a big return for minimal lending.

And so we employ this approach where we'll lend those securities out in the marketplace. In return for that lending, we'll effectively get back cash that we'll invest in a money market instrument that will earn a yield. And the return to our shareholders for that special name that we've lent out in the marketplace, there's a premium that was likely paid, but then also there's a capture of the yield that happens for the duration of that lending on that security.

And so that income that is generated is returned to the fund that is lending that security. And so about 95% of the income that's generated goes back into the fund NAV. That five or so percent that doesn't go back into the fund NAV covers the cost of us administering the program.

And so that's a hallmark of the Vanguard program that differentiates us from many of our peers because other firms will lend securities out and they'll do a 50/50 split between the management firm and the lending fund. And so we believe that if you're lending securities and you're bearing some level of risk in the marketplace, you should be compensated with all the rewards after cost.

And so that's the approach that we take in our lending program. Jerry, I know you have a couple things to add there. - Yeah, absolutely, Rich, great summary there. So we work very, very closely, Rick, with our counterparts in SEC lending. And there's certain funds where there's huge demand for the holdings from the sell side who are, and maybe it's someone who's looking to short a stock, right?

And you have to secure the borrow, so they'll call Vanguard, as Rich mentioned. They have to put up collateral. A lot of times, 102% of whatever it is that you're looking to borrow. And then we're gonna invest that with our fixed income teams to make sure that, and the one thing I would point out there, they're very conservative in terms of how they invest that money.

And I know if you go all the way back to '08, some asset managers were trying to swing for the fences in terms of how they invested that money, and it came back to bite them a little bit. So SEC lending is one way, and if you look at some of our small cap, particularly in the small cap growth in value, it's meaningful, the amount of dollars that they receive from SEC lending, to the point where, I've seen it in years where it's north of eight basis points, nine basis points to the fund that's coming in from SEC loan.

And as Rich mentioned, 95% of that is going directly to the funds that loaned it out. So that's one way, you mentioned earlier, Rick, about the four basis points for the expense ratio and total stock. So I would say SEC lending is one way that we try to eat into that in terms of, can we do better than the four basis points that we should underperform the benchmark?

SEC lending is gonna help with that. We've also, we have a very, very experienced desk. I think the average tenure on the desk is about 13 years. So over time, you learn strategies, proprietary strategies about how to work index changes, rebalances, complex corporate actions. And so we've also been heavily involved in syndicate offerings, whether that's just a company that is issuing new shares to maybe pay off debt, or whether it's IPOs that are coming along.

And we have a team that focuses on that. So every day, here around 10 after four, you're gonna get the phones will start lighting up with brokers calling us about syndicate offerings that are happening. And obviously, Vanguard's gonna be a top three holder in almost every name out there.

So we tend to get the call. And as long as it's greater than 5% of the shares outstanding index providers are gonna make the share change. Crisp will make it tomorrow if we get the call tonight. And so we will participate if we think it's going to add incremental value to the fund.

So very, very busy here around 4/15 with calls coming in on syndicate offering. And 2020 was probably one of the busiest years we've ever had on that front. I think we had over 400 between syndicate and IPOs. So very busy. Those are some of the ways that we'll try and eat into that expense ratio.

And so if we can do that in a risk control manner, it's a win-win. - From what I understand from reading the numbers in the annual report, about 170 million of income came in from security lending. The total expenses of the fund were around 420 million. So about 40% of the expenses of the fund were made up with security lending.

Is that fairly accurate? - Yeah, I mean, I would say, Rick, that you're looking at total stock. But depending on the fund, that's not at all surprising because that group, as Rich mentioned earlier, 95% of the revenue that they bring in goes directly to the funds that loaned out those securities.

And in terms of total stock, I've seen that number be a basis point, maybe a one and a half basis points. And when you consider that our expense ratio is four, that's a meaningful contribution to the value add for the fund. - Let's go into just a couple more things because I know we don't have much time left.

I wanna touch on this because it is a little bit of a controversial topic. And I know that you may or may not be involved in this to what extent you are, you could let me know, but it has to do with voting proxies. And Vanguard is a large part of the US market, 10% of the market, if you will.

And how does that all work at Vanguard so that shareholders understand how proxies are voted at Vanguard? - Yeah, so a lot of times, Rick, we will get a call here on the desk from an issuer looking to talk about a proxy issue. And we are fortunate, you can imagine, like say Total Stock where we have 3,800 securities, if every company, if I was to be involved in that, I couldn't do my job, right?

Because a lot of these are not simple issues, they can be complex. So fortunately, we have an investment stewardship group run by John Galloway at Vanguard and his team, and they will analyze all of these proxies. That is a team that's dedicated to everything proxy related. So if a call comes in, immediately we send that call or give them the email address for John's group.

This is the team you wanna get in front of, and they will then obviously reach out, either email conversations about what it is the issue is. And there are certain things that that group, in terms of their principles, if you think about it, we are the ultimate owner, right?

We're gonna own companies potentially forever. So it's in our best interest to make sure that the boards are gonna represent the interests of shareholders. So that group that John runs, they look at things like executive compensation, board composition, oversight of strategy and risk, as well as shareholder rights. So those are some of the key principle things that they would look at.

I know they subscribe to some of the proxy advisors like ISS and Glass Lewis, but that's just one of the tools that they use. And they're gonna make decisions what they feel are in the best interest of our shareholders. And it's not always aligned with the companies. You know, one of the high profile ones that we recently just had was the Exxon proposal, proxy fight.

And, you know, Vanguard voted with the dissidents on this one, where they supported two dissident director nominees. And I would also say it's very transparent. If you wanna see how did Vanguard vote on a particular proxy, you have the ability to go online and see exactly how we voted on it.

And so fortunately from my point of view, Rick, I really just passed those calls onto that investment stewardship team and they do a fantastic job analyzing it. And I know they have folks who specialize in certain regions. I know there's a team in the UK as well that handles same thing for our European counterparts, but it's a robust team that works very closely with the issuers and they'll hear all sides of the argument and then they will make decisions based on what they feel is in the best interest of our shareholders.

- Thank you for that answer, Jerry. I appreciate the thoroughness of it. And there's also always a lot of noise out there about these types of things. So thank you for covering that. I wanna get into one last question and this could be a little bit personal on this.

You've heard the charges of indexing. In fact, the worst one I guess you could say was in the Atlantic Magazine called, "Could index funds be worse than Marxism?" Indexing is ruining the market and indexing is creating corporate slots and shareholder gorillas and so forth. And this is bad and Congress needs to look at this and they need to break up these index funds.

You're there and every day doing this. I mean, is any of this something to worry about? - Sure, Rick. I think there's a couple of things we can look at to kind of disprove this notion that indexing is creating some type of harmful effects in the marketplace. So first one you would look at is the impact on trading, right?

Equity indexing is an example. About 5% of all trading that happens in the marketplace can be tied to an equity index. That in and of itself tells you that while indexing as a strategy has grown remarkably, the nature of indexing as a long-term buy and hold certainly isn't kind of infusing itself into terms of how price discovery is happening in the marketplace.

You can look at dispersion of returns over time over this last 20 or so years. Not a noticeable difference in dispersion of stock returns over that period. - When you're talking about dispersion of returns, you're referring to dispersion between stocks, correct? - That's correct. Rick, if you look at the Russell 3000, for example, and we define dispersion as plus or minus 10% over the index.

If you go back to the early '90s, when indexing was still, if you wanna talk about indexing in terms of what does it represent of mutual funds, that was maybe around the 10% back then. It's now growing to about 50% in terms of ownership of mutual funds. And over that time period, the dispersion, so plus or minus 10% of the Russell 3000, that's remained consistent at 70%.

So the argument you sometimes hear on top of the Marxism argument is that, hey, indexing is lifting all boats, right? As indexing, they're just buying and they don't even care about it. When you have dispersion levels at 70%, that tells me that there's opportunities there for good active managers to outperform.

So the rise of indexing, I don't think is hurting that at all in terms of opportunities available. And on the trading side, as Rich mentioned, if I think about, Rich mentioned the number 5% of daily trading, that's a very, very small portion of the overall pie. If I think about even on our desk, on some of our busiest days, $2 billion is not that unusual that I might trade here on the desk.

If you think about an average trading day, Rick, it's about $450 billion. So my $2 billion that I'm spending total stock, it's less than half a percent of an average daily volume. And it's spread out over 1,200, 1,500 names. And believe me, those names, I'm making sure that whatever I put in the auction, it's not gonna be too impactful.

So price discovery is alive. There are names, if I think about our REIT fund, probably in terms of ownership, it's probably highest among our REIT names, especially if that REIT happens to be in total stock and it's maybe an index 500. There are lots of names that are massively underperforming where we're at today.

And even though the ownership level might be in the high 20s, 30% in terms of passive ownership across the board. So the fact that that name happens to be in an index, there's bad news that's coming out, that fund is gonna get it. I've seen lots of different things out there.

I tend to focus on what are the positives that indexing has brought to the market here? I attended a number of these Boglehead forums when you were on campus. And the number of people who came up to me and said, "Hey, I've been investing in your 500 fund "for 30 odd years.

"It's put my kids through college. "It's helped my retirement." I mean, you wanna talk about walking back on air after that conference when you get a bunch of those stories. That makes you feel pretty good about the fact what indexing has brought to so many people. I just feel really passionate about the fact that indexing absolutely benefits absolutely hugely over any kind of detractors that you might see out there.

And a lot of the stuff that I read out there doesn't hold any water at all. - We all thank you for everything you're doing and your dedication to helping us as investors. I know we've run out of time. I wanna thank you, Jerry and Rich, very much for taking the time today to talk with us about Total Stock Market, Index Fund, and a lot of things having to do with how things work at Vanguard, including the proxy voting, which I appreciate you chiming in on.

On behalf of all the Bogleheads, thank you so much for everything you do and keep up the great work. And thanks for being our guest. - Thank you, Rick. It's been our pleasure. - Thanks, Rick. - This concludes "Bogleheads on Investing," podcast number 37. Join us each month as we have a new guest and talk about a new topic.

In the meantime, visit bogleheads.org and the Boglehead Wiki. Check out the Bogleheads' new YouTube channel, Bogleheads Twitter, Bogleheads Facebook, and find out about your local Bogleheads chapter and tell others about it. Thanks for listening. (upbeat music) (upbeat music fades) (upbeat music)