Gus Sauter Interview

October 10, 2003

Vanguard indexing guru discusses switch to new domestic MSCI benchmarks - and why the Russell 2000 reconstitution no longer keeps him up at nights. Also featured is Sauter's previous Journal of Indexes article on benchmark construction.

Gus Sauter is Vanguard's Chief Investment Officer responsible for all in-house stock and fixed income investment management functions. Mr. Sauter joined Vanguard in 1987 and oversees nearly $400 billion in assets, or about 70% of Vanguard's $550 billion in U.S. mutual fund assets.

Note: To read Sauter's article on benchmark construction from the Journal of Indexes, click here.

Do Vanguard index fund managers receive bonuses for benchmark outperformance?

The compensation is largely skewed to track the index, with minor incentives to outperform the index.  In other words, there are slight bonuses for outperformance, but we want to make sure tracking the index is the most important job.

Several Vanguard index funds transitioned to new equity benchmarks from MSCI.  Why?

There's still a lot of questions out there about why we made the change.  The one involving the loss of the S&P lawsuit is easy to dismiss.  First, remember we also transitioned the small-cap index fund [which tracks the Russell 2000].  Also, we did not transition the S&P 500 fund, which was the fund involved in the S&P lawsuit.  So that clearly was not the motivation for the switch. 

We don't hold a grudge against S&P, and I would call our relationship solid.

If you look at the performance differences of the various indexes, they're meaningful over short 1-year and 3-year time frames - but less so over longer 10-year and 15-year periods.  The style integrity issue was the most important factor to us.

For example, in 2001 value fund managers slaughtered growth managers.  However, our [S&P/Barra] value index fund performed in line with our growth index fund.  It seemed like there was something wrong there.  Anyone would tell you it was a value year, and a big one at that. 

Index

2001 return

S&P/Barra Large Cap Growth

-12.72%

S&P/Barra Large Cap Value

-11.72%

Russell 1000 Growth

-20.42%

Russell 1000 Value

-5.59%

Source: Morningstar

So that was really the root of the problem.  Yes, it is true that we can now introduce MSCI ETFs, but that wasn't the real motivation for the switch.

To me, it will be interesting to see who adopts the new U.S. MSCI indexes.

The Vanguard small-cap fund no longer tracks the Russell 2000, which has a chaotic annual reconstitution in June.  Did this take up a lot of your time in past years?

We're glad to sit on the sidelines for the Russell reconstitution this year, since we of course transitioned to the MSCI indexes.  The Russell reconstitution is a huge event for indexers.  It involves a lot of work, and it was an expensive undertaking for the [small-cap index] fund.  John Bogle [Vanguard founder, now retired] thought we were incurring substantial transaction costs, perhaps needlessly. 

Historically the Russell 2000 index takes a hit every year due to index effect.  The Russell index essentially buys high and sells low at rebalance.  There's actually a problem that indexing has created in the Russell 2000. 

The MSCI indexes rebalance quarterly.  Frankly, it's also nice not to have the company of every indexer out there.

Are the MSCI indexes radically different from any other benchmarks?

There are a lot of similarities between the Russell and MSCI indexes, but we think the MSCI benchmarks are slightly superior.  And if we're going to make a change, why not choose the best?

Our customers invest in the index funds for exposure to certain market segments.  We believe they trust us to select the best state-of-the-art indexes. 

 

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