The Exchanges

Q So a lot of pieces that are so different than what the common perception of Vanguard might be. Let's start with outlooks on markets. How do you use the research that this team generates?

A Joe Davis, who's our chief economist, and he and his team do a great job. Joe and I were peers and worked very close together, 15 years before I took this private equity role. His work and his team work feed into our actively managed fixed income side. So they are an input to the decisions made in our fixed income team. Most of our assets on fixed income are actively managed. And so whether they're positioning something a little short or a little long in duration, what type of credit appetite they may want to have from a credit perspective. So that does feed into that work, but also it helps us reassure clients, keep the stated course message in a lot of cases, and just putting out information about where the market stands, where valuation stands, we see it as an effective tool to keep investors doing well.

AI assessment note: “His work and his team work feed into our actively managed fixed income side.”

Q How do you quantify 300 basis points of behavioral alpha?

A So the 300 is comprehensive. The behavioral coaching part is about two of the 300. We use the technique that some of the audience may be familiar with. Morningstar does the behavioral gap. We have our own that I've been doing since I got to Vanguard. We just measured the IRR, which is the internal rate of return, which that is actually the investor's return. And we compare that to the time-weighted return, right? I try to tell everyone, you cannot eat or spend or live off of time-weighted return. So time-weighted return measures the index. So the S&P 500, Or that's a Vanguard prime cap fund. That is the return the manager would derive if there were no cash flows in or out. But that's not what investors get. Investors, timing of their cash flow, in and out, potentially buying near the peak, selling near the bottom. They have this gap, and it's called the behavioral gap, that has averaged about two percent a year. Now, it's not going to add it in every year. It's very episodic. So you see real destruction or gaps, let's say, run up to the tech bubble. In 1998, 19 99, believe it or not, it's one of the stats I'm most curious about, you had five years of stock market returns above 20%. We had never seen that before, but in 1999, you had negative bond flows. If investors were rebalancing, you would have seen negative flows into stocks, into bonds, And not only that, but about a hund…

AI assessment note: “We just measured the IRR... And we compare that to the time-weighted return”

Q One of the head scratchers when you look at the scale of Vanguard and the notion, as you said, that a lot of the top sponsors have capacity constraints is how do you think about rolling this out in such a way that down the road you could have very, very substantial scale?

A I would say two things that made us very attractive. The first is we are really a believer in stay the course rebalancing. And so if you look at fund flows of private equity, they are cyclical with the market. They are tied to the market. You see what happened in no eight or nine. You even see what happened in the first quarter of 2020. The money may disappear when the sourcing of private equity needs it the most. I think those who know our OCIO business and our retail advice business and our aspirations and the growth of those businesses, we were very attractive to the top private equity because our cash flow will be contrarian and counter cyclical to their traditional cash flow model. So we are actually a stabilizing force for those private equity managers. The second area is when we started with active management at Vanguard way back when, We had one manager, Wellington. We now have close to 30. So HarborVest is where we are going to market with today. They are very, very interested in where their top line capacity is. They study capacity very carefully. Most of the fees, as you know, Ted, and the audience will know is performance or carry fee. So they do not want to give away hot money or take on money that they don't feel they can perform. So we know we have a certain runway with them. It's a pretty long runway, though. They feel very comfortable that they can meet at leas…

AI assessment note: “We had one manager, Wellington. We now have close to 30.”

Q And so if you look out, say, five years and you've gotten there, what do you think the prospects are of extending that component of allocation to the retail base?

A That's been our long run aspiration. If you read the press release that we put out, we're starting in the OCIO. We're starting in the QP on the high net worth side, but our long run aspiration is to democratize this asset class. We're all trying to figure out how to make sure that it does not harm clients, and those are real concerns. But at the end of the day, right now, wealth and income are the qualifying gates to get into private equity. There's been a lot of talk in the regulatory channel. Wouldn't it be more prudent if it is advised by a professional allocator? Who has expertise in portfolio construction and rebalancing would not a school teacher or a nurse or a retail client in a target retirement fund. Let's think about a target retirement fund, 50 year horizon, multi-asset class, single nav, rebalanced with return premiums that could be somewhere two to 400 basis points over public markets. I would argue that those investors are the investors who need private equity the most. The average day investor who is saving for retirement or saving for college with a long duration, if it is indeed packaged with a multi-asset class manager like Vanguard and a wrapper of target retirement or advice, we think that that would be a prudent way for regulatory change.

AI assessment note: “our long run aspiration is to democratize this asset class.”

Q Why don't we start with your entrance to Vanguard, twenty-something years ago. What did Vanguard look like back then?

A Vanguard back then, Ted, in many ways, looked more similar than different. Obviously, its culture and its mission has always been laser-focused on delivering superior investment outcomes, and we really tried to lean into an investor population who often lacked access to To a world-class asset manager. So we were serving the smaller investor who may have not been able to get access to world-class managers, and we had highly aligned incentives. It's so weird. I remember walking onto the campus for the first time like it was yesterday. For me, it was like visiting a national or historic monument. The campus is a beautiful college-like setting, and here I am getting out of my car, Walking in, walking up to the building where my office was going to be on the same floor with investment icons like Jack Bogle, Jack Brennan, Gus Sauter, and Tim Buckley, to name a few. So for me, it was like a career dream come true. The obvious differences, Ted, is the growth of the firm. So in the last 23 years since I arrived, we had 300 plus billion when I got there. Today, we're close to six trillion dollars. So growth has been exponential, but growth was never an objective of the firm. It was really an outcome of serving investors well. We felt if we delivered on investment performance and client service, investors would vote with their feet. It's a pretty smart population, and they're going to go …

AI assessment note: “we had 300 plus billion when I got there. Today, we're close to six trillion”

Q You mentioned the term behavioral coaching. Sounds intriguing. So what have you been doing with that?

A When I joined Vanguard to help start advice, the value proposition was a little tricky because the traditional value proposition of fee for advice is hire me and I'll outperform the portfolio, right? That was the, so at Vanguard, our advice offer was, you know, more around a service model. We weren't going to do tactical asset allocation. We weren't doing market timing. So the question became really quickly, well, if you're going to develop a policy portfolio, You're going to rebalance to it. Why am I paying you? And the real area that we found, Ted, is that most investors, investing is emotional. And so when you have a 35% drawdown like we saw in the spring, or a 55% drawdown like we saw in GFC, it sounds real easy to rebalance a portfolio. It's kind of, you know, real easy to go out and exercise, but we know that if you actually work with an exercise coach or a diet coach, you actually have better performance. It's tricky to take, let's say, a two million dollar portfolio, a million in stocks, a million in bonds. They just lost 500,000 in stocks, and you're asking them to sell 250,000 of their bonds to put it in stocks. And so we created a whole narrative around behavioral coaching known as advisors alpha. And that was really the value advice brings, even if it's not about market timing or security selection, but around this behavioral coaching. And we've quantified that valu…

AI assessment note: “we created a whole narrative around behavioral coaching known as advisors alpha.”

Q So let's circle back to the multi-year research process leading up to the manager search. What kind of research were you doing to get to the point where you felt you were ready to incorporate private equity?

A Yeah, we, we really did an extensive research, not just on the managers, but a couple options you could have would, should we build this on our own, right? You could go direct to the holding companies and take direct interest as opposed to using a general partner. The other is you could go right to a big direct GP as opposed to working with an access fund That themselves source what we would say is the world's greatest GPs, and there's trade-offs all. There's not a, there's not a right or wrong answer to this. Different organizations will do it differently. So the first step was we decided that what really matters here is access to the top GPs. You can clearly see the dispersion of returns in private equity are significant. And a lot of the top GPs are oversubscribed and full and not taking on new clients. So as a new entry, if we were to going to do this on our own, my team is a team of seven folks. So HarborVest is a team of 500 plus folks that have been doing this for close to 40 years. So we would not have the relationships or the ability to do this internally at this time. We could have gone with a direct GP, but then you really lose some of the diversity and the diversification of manager managers. There are a lot of specialties in this area. There's all different flavors of private equity. And so in our due diligence, we were clear that we wanted to work with a world-cla…

AI assessment note: “we really did an extensive research, not just on the managers, but a couple options”

Q about this area has been the costs of doing business and fees, and when someone from the outside looks at Vanguard as synonymous with low fee, and private equity synonymous with high fee, and now you're working with a manager of managers, which is another layer of fees, how did you bring that together in a proposition that was consistent with what you tried to deliver to your client base?

A Yeah, it kind of gets to maybe the misnomer on Vanguard. So Vanguard has been trying to lower fees, but it's not always about the lowest fee, and so we do actually have some public active offers that are 60, 70, 80 basis points. We've always believed in what we've tried to do is create net outcomes for clients, and what that means is I always use the example of taxes because clients kind of get taxes. If, if I were to offer you, Ted, a 1000 dollar bonus, more than you were expecting, but your tax cost Or your cost on that would be the federal government taking 300 dollars and 30% of that. Would you turn it down because it had high cost? Hopefully your answer will be no, I'm net, net, 700 dollars higher. So Vanguard, while it's known in this world of low cost, we've always been about high client outcomes. And so what the costs are, let's say, to run an emerging market active equity fund versus an index fund, there's going to be a cost premium. And so, same thing in private investments and private equity. There is a cost premium over public equity. The question is, should I forego that for our investors if we believe, even though it has higher fees, that net outcomes after all fees are still, let's say, two to four to 500 basis points above public equity, that's a trade-off I would take every time.

AI assessment note: “we've always believed in what we've tried to do is create net outcomes for clients”

Q As you put on your portfolio construction hat, how have you thought about the different aspects of private equity is one aspect you could think about infrastructure investing and venture capital and real estate. What are the other asset classes that you've considered and not yet put into portfolios?

A All those that you mentioned, we have done research on infrastructure, private credit, and right now we, as I mentioned, we will enter a space if we believe there's an enduring investment case, that we believe that it has 5200 year runway of still being an enduring investment case, and that it also has some size to it, right? So in the private space, Private equity is by far the largest relative if you look at private real estate or infrastructure or debt. And so we also think about what is the market cap or what is the opportunity set. So it made a lot of sense for two reasons. Given the size of private equity, its growth relative to public equity, its size relative to the other private investment universe. And then lastly, the returns and diversification that could give our investors.

AI assessment note: “All those that you mentioned, we have done research on infrastructure, private credit”

Q What are your favorite teams and musicians or artists?

A Being in Philadelphia, so I follow most of Philadelphia teams, but I also love seeing stadiums, so I've actually had the opportunity to travel and see a lot of different stadiums, both NBA, NFL, baseball, so that's also fun, just to see the architecture and the stadium and, and getting in with other crowds, which I really love, you know, they're all usually very, very generous and kind to see someone with a different jersey on, And concerts, I, I, I've gone from the big shows all the way down to the little. I like actually discovering new acts, so I saw Adele in one of her first performances in a small little theater. I saw 21 Pilots at a movie theater, like, had under a couple hundred people, so I kind of like emerging artists, and hopefully they kind of turn out to be big. That's kind of like a venture capital musician-type hobby.

AI assessment note: “I follow most of Philadelphia teams... I saw Adele... I saw 21 Pilots”

Q This active management outperformance, let's just start on the public side. How much of it is the notion that there are active manager alpha gross returns, and the fees are lower than, say, other active management fees?

A Yeah, I know one of your questions you ask all your guests is your investment pet peeves, and maybe I'll answer that one now. My investment pet peeves is that really people fail to understand zero sum gain. Bill Sharp came out with zero sum game. It's, it's mathematical proof, and that is that for every buyer, there's a seller, right? So there's a counterparty on every side, but what never gets discussed in that zero sum game, and what is my pet peeve, is that someone is on the right side of the distribution. Just like there are bad active managers, someone, by mathematical fact, is going to be in the top quartile. If you have to believe you have access, You have due diligence, you have selection, and when you put all that together, whether you can do it on your own, if you're an endowment and foundation, or a high net worth family, or you work with a manager, a manager like Vanguard, who has 40 years of experience doing this, we believe it tips your odds, and if you can actually, with confidence and conviction, let's say, get between the 65th and the eighty-th percent of manager talent, Gross. Let's go with gross returns, taking it from, with all due respect, the Robinhood day trader, right? Someone is trading on the other side of every trade, and to think that Wellington and Bailey Gifford and Harbor Vest are not at a competitive advantage to retail investors, people doing th…

AI assessment note: “maybe I'll answer that one now. My investment pet peeves is”

Q What does that pricing ultimately look like to the end investor at Vanguard?

A So as you know, private placements, we really can't disclose all the fees. I have to make sure the client qualified. I have to verify qualification. All I would say is that the majority of the fee is in the carry, meaning that there is alignment of incentives for the audience. Most private equity has a carry threshold, so let's use the number eight percent, meaning that there would be no performance fee or carry Until the total return is above eight percent. We feel that's highly aligned. We feel that that is probably above most episodes of public equity. And so in that arena, clients are not all that caring about paying high fees, because they know they actually hit some kind of bogey. The management fee is not all that penal. Most of the fee is made up in the performance fee.

AI assessment note: “private placements, we really can't disclose all the fees.”