Outgoing chief investment officer for Vanguard reflects on 25 years and peers over the 'fiscal cliff.'
The arc of Gus Sauter’s career at Vanguard is the story of the rise of indexing in modern financial markets. Sauter first arrived at Vanguard in October 1987, just two weeks before the “Black Monday” stock market crash. At that time, the firm had just $1.4 billion in assets in two index mutual funds, including the world’s first retail index, the Vanguard Index Trust/ 500 Portfolio.
By the time Sauter became Vanguard’s chief investment officer in 2003, the Valley Forge, Pa.-based firm’s fortunes were clearly beginning to change, and investors were waking up to the allure of low-cost indexing strategies. The company’s total assets had grown to $615 billion including $79 billion in that original fund John Bogle launched in 1976.
Now, with his retirement just days away, Sauter can boast of presiding over one of the most profound transformations in the history of finance. For one, Vanguard is now the biggest mutual fund company in the world, with $2.3 trillion in assets under management. More to the point, the ETF—the ultimate indexing vehicle—is the fastest-growing piece of Vanguard’s business, and to hear the mild-mannered Sauter tell the tale to IndexUniverse’s U.S. Editor-in-Chief Drew Voros and Managing Editor Olly Ludwig, his role in fostering the growth of Vanguard’s ETFs stands among his proudest achievements.
IndexUniverse: The big question staring at all of us right now is the fiscal cliff. Tell us what you think investors should be, one, thinking about; and two, should investors be thinking about making changes in their portfolios?
Gus Sauter: We don’t know when and what the resolution will be, but we do think that it’s important for investors to think longer-term. The big question would be, if you have some exposure to equities, do you think, for that portion of your portfolio, you can get better than equity-like returns over the extended period of time? Let’s say you’ve got a 10-year time horizon. Are you satisfied getting, let’s say, a 7, 8, 9 or 10 percent return in equities? Or do you think you can do better?
Our experience has been that investors really don’t do much better or any better than the market itself. Trying to time events, such as the impact of the fiscal cliff, invariably works against investors. By the time something happens, typically the market will have moved sufficiently to negate any potential gain. Waiting on the sidelines and then jumping onboard is going to cause you to miss the boat. We know that the market moves in spurts. And if you don’t capture those spurts, you don’t capture the market rate of return.
IU: How does an investor react to this environment of higher taxes?
Sauter: There are some tactical considerations. You certainly have to ask the questions and answer them, as opposed to ignore them. Should you realize capital gains, at this point in time in anticipation perhaps of higher capital gains taxes next year? There isn't a correct answer for all individuals. It’s a very personal thing. It depends on the nature of your portfolio, your age, the amount of your capital gains.
So certainly, investors should be considering all of these possibilities. But again, the response could be very different for two different investors. Obviously, if tax rates are higher on capital gains and/or dividends, the after-tax return is likely to be impacted in equities. I don’t think it would dramatically change how a portfolio should be put together. Over the immediate to longer term, equities will be the higher performing asset class and will likely deserve a spot in a portfolio.
IU: Can you comment on Vanguard’s recent switch to FTSE and CRSP indexes? And as a follow-up to that, there's been a pretty discernible pattern in investment flows since Oct. 2, back toward EEM notwithstanding its large expense ratio relative to Vanguard’s VWO. Do those flows concern you at all?
Sauter: So why did we make this change? Certainly, it wasn’t to benefit Vanguard. It was to benefit the investors in our funds. Because of our at-cost structure, all of the value created by cost savings falls through to the bottom line for investors. One of the fastest growing line items in our budget over the last five or 10 years is index-licensing fees. We’re always looking for ways to provide value to investors, whether that’s providing new services, whether it’s making improvements in our own processes here to gain greater efficiencies, or whether it’s identifying other ways to cut costs.
We did identify a way to really cut the costs of index licensing and provide long-term certainty of cost for index licensing. It amounts to literally hundreds of millions of dollars over time. We felt that that was certainly value-added to investors. Of course, we considered that it would raise a number of questions. The first of which is, are you sacrificing anything in quality? It wouldn’t increase value just to save money, but impact high quality.
We have worked with FTSE and with CRSP for a number of years now and are very, very satisfied that they are top-quality providers of indexes, and that they even have a couple of nuances in their construction methodology that others have not included that we liked. In the case of FTSE, South Korea is the big question. We do think it’s appropriate that South Korea is classified as a developed market. We think that FTSE has that right. It does mean that we’re going to have to transition the portfolio since the emerging-markets has South Korea in it at this point in time.
On the CRSP side, they have their packeting methodology, which slows down turnover when stocks are migrating from one style index to another. The lower turnover results in savings of transaction costs. So we feel that we’ve found an opportunity, to both significantly cut costs, and at the same time, maintain high quality indexes and even add a few whistles and bells.
IU: Looking at the fiscal cliff, but in a broader frame of reference, does it preoccupy you at all that you are leaving at what appears to be somewhat of a precarious time?
Sauter: I guess you have to leave sometimes. You can look back over the last 15 years, and you’ve had about five or six of these events: the Asian contagion, the Russian debt crisis, the bursting of the tech bubble, the financial crisis, etc. Now we’ve got the fiscal cliff. I don’t plan to work for the rest of my life. And I don’t really know that I want to sit around and wait until everything is clearly resolved. In fact, you know, it’s just never been quite obvious to me that everything is taken care of.
IU: How about telling us what you consider your legacy at Vanguard to be.
Sauter: There are several things that I point to. The first one was growing our equity group. I was hired 25 years ago as head of the equity group. And, at the time, we had one index fund. Our goal was to increase our capabilities to develop active equity quant funds, and also further our index capabilities. We started with $1.2 billion the day I was hired. And, of course, two weeks later, the crash of 1987 hit and then we had $800 million. Fortunately, that turned around. Actually later today, we are celebrating our $1 trillion mark in the quantitative equity group.
Sauter: Thank you. It’s been really an awful lot of fun along the way. I would say also our foray into ETFs was something that I had an opportunity to play a part in. We were a little late to the game, but I think we found our niche. It’s a very meaningful part of our business.
The two other things I would point to is being appointed chief investment officer nine and a half years ago, and being given the responsibility for the fixed-income group. We’ve modified the way we manage portfolios to more of a specialist structure rather than a generalist structure and that’s going to serve us extremely well over time. And finally, we used to manage our regions around the world in silos. When I had responsibility for portfolio management in the U.S., I had oversight over the investment group in Europe, but we had independent management in Australia. We decided several years ago to go truly global. My division was among the first to really go fully global, which was an interesting challenge in its own, and rewarding as well.
IU: Do you feel like your mission has been accomplished in terms of what your plan was when you came on Vanguard?
Sauter: I’ve had just phenomenal opportunities, both in my department and contributing on our senior staff as well. But I do think all of us have certain capabilities. And I think, quite honestly, I've done what I can do. My capabilities were probably more suited towards growing a group rather than managing a mature group. And now, we are a mature organization. I certainly believe that [incoming CIO] Tim Buckley’s capabilities are better for managing a mature organization than my personal capabilities. Tim will take it to the next level.
There are some personal reasons as well. My parents are both elderly, and I want to try to spend more time with them. I still have time to do some other things that hopefully will be meaningful. I don’t really think of it as retiring. I think I'm moving on to some new challenges.
IU: You just segued beautifully into the next question. You began to speak about Tim. You are the consummate number cruncher in a strict portfolio management kind of way. And, for his part, Tim is a number cruncher, but perhaps more in that sort of MBA organizational enterprisewide kind of way. Is that a fair assessment?
Sauter: Yeah, I think that’s roughly a fair characterization. Tim has tremendous management skills. He has managed two other divisions of Vanguard. In fact, I’d note he’s probably the first person in the history of the investment management industry to be CIO twice. He was originally our chief information officer. Now he’ll be our chief investment officer. And, in between times, he ran our retail investment group.
So Tim has been on senior staff for, I want to say, at least 12 years and managing several different organizations. He was extremely good running and developing our retail and information technology groups. We’re at a stage of maturity where he’ll come in and do great things in the investment management group. I certainly do not want to make light of his investment acumen. He’s been working in our portfolio review group, which is a group that oversees all of our portfolio managers, internal and external. He has great investment knowledge. He just didn’t grow up on this side of the business.
IU: Give us a sense of the arc of the history and how your tenure and Tim’s will be stitched together in the grand sweep of things.
Sauter: When I started, indexing was only 3 percent of Vanguard’s book of business. And it wasn’t anywhere near close to 1 percent of the industry. So really, we had to go about building an index industry. Until a decade ago, we were 65 percent of the index mutual fund industry year in and year out.
So it was really very different, at that point in time trying to build our capabilities, but, at the same time, contributing to promoting the concept of indexing and helping to build that industry. Indexing has a tremendous amount of momentum behind it. It’s going to be a matter of making sure you're absolutely the best at indexing to compete. You will have to have tight tracking and you're going to have to have a low cost.
That will certainly play into Tim’s capabilities. I think we have an extremely strong group of people here. And I should have said this earlier that Tim will be supported by very, very strong leaders running the different departments within our division. We have tremendous portfolio managers who know their responsibilities. The next phase is just making sure that we’re extremely efficient in what we do, that we are managing all of the risks, whether they’re investment risks or operational risks. And that we are finding ways to create additional efficiencies and pass on cost savings to investors.
IU: Gus, why do you think index investing has been embraced so warmly by retail investors?
Sauter: There were three events that were the catalysts to the growth of indexing. The first one was the tremendous out-performance of large-cap stocks in the bull market in the latter part of the ‘90s.
Interestingly, at that point in time, investors were really focused on large-cap indexing, primarily either total market indexing or S&P 500 indexing. That’s really what people thought of when they thought of indexing, or maybe in 1999, they were thinking of the Nasdaq 100. It was a market that was so dominated by large-cap performance. All of those indexes were dramatically out-performing active managers, because they had a larger cap orientation than active managers had. That was like the first real shot in the arm that indexing got, and the first spurt in growth.
The second spurt was coming out of the bursting of the tech bubble. A lot of people had loaded up on tech stocks in the latter part of the ‘90s and really had a severe ride down throughout the bursting of the bubble. They realized they needed broader diversification. The whole discussion in 2003 was, “Maintain broad diversification.” Well, indexing is diversification extraordinaire. The second shot was not only retail investors, but also many advisors, financial advisors, who recognized they needed broad diversification. They didn’t want to target smaller, more volatile segments of the market. And indexing was a great way to gain that diversification.
I think the third shot was coming out of the global-financial crisis. We had had a decade of time where the return in the equity market was zero. And I think, quite honestly, incorrectly, investors projected the past into the future. They were expecting low rates of return going forward from the equity markets, which is not what we believe. But investors, many investors have adopted that notion, so they sought low-cost exposure to the market.
The recognition of the advantage of low cost came to the front when we had a low return environment previously. Low cost is certainly a strong characteristic of indexing. So again, that pointed to yet another advantage of indexing. Each one of them promoted a different advantage of indexing: low cost, broad diversification and relatively predictable performance.
IU: Shifting gears just a bit here, Gus, can you kind of give us your core investment philosophy?
Sauter: There are three cornerstones to my beliefs, and I think Vanguard’s beliefs as well. The first is to think long-term, to establish a strategic plan and then stick with it. And particularly stick with it when it’s most difficult to do so, because that’s when it matters most. In 1999 people had a tendency to become overly aggressive, to abandon a long-term plan and throw caution to the wind, just at the point in time where you shouldn’t be throwing caution to the wind.
And then, again, in 2009, too many people abandoned their long-term plan and reduced their exposure to risky assets. And, just at a point in time where you wanted that exposure. So what we’ve observed is that investors that don’t stick with their plan invariably hurt themselves. They get out of the market just at or near the bottom and they get in at or near the peak. You have to break that cycle of behavioral mistake. The way to do that is just ignore the noise, think long-term, and establish your plan based on long-term expectations.
The second principle is to maintain broad diversification. Too frequently, investors try to focus on the segment of the market that they think will outperform. But the attempt to outperform also provides ways to underperform. That’s a difficult game. If you're on the right side, you can outperform, but most investors are on the wrong side, and therefore underperform.
The third principle is maintaining exposure to low cost investments. That may sound a little self-serving coming from Vanguard. But, you know, quite obviously, all else being equal; the lower cost investment will outperform the higher cost investment.
IU: Where do you stand regarding John Bogle’s vehement views about promiscuous and deleterious trading that ETFs will tempt people into?
Sauter: Well, Jack and I have opposing views on this. And I think we’ve agreed to disagree. Our investment strategy group has done some research on our investors that by ETFs through our brokerage service to determine if they are higher turnover investors. We’ve found that essentially, they're not, and that they're still predominantly long-term investors. I will confess that all of my recent investments over the last probably five or six years have gone into our ETF share class. I don’t think that makes me a market timer just because I've gone into that share class. It’s just an easy way for me to invest in our funds.