The Exchanges

Q Irrespective of the benchmark you used, for a long time we've had shrinking number of public companies, particularly in the U.S. How do you think about what that means for the future?

A I'm not sure we know quite yet what it means for the future. The shrinking number of companies from a peak in the U.S., six, 7000 securities, about the time we graduated business school, down to about 4000 U.S. companies is just a fact. When you go and you dig into it, you discover what we lost was a lot of really small companies, a lot of micro cap securities, a lot of small cap companies, and for long-term returns, it's not clear you lost much. We are seeing companies stay private longer, which does mean there may be less return in the public space. It's hard to know. There's SpaceX and others sitting out there waiting to come public. I would love to have had them in my index fund. Back when they were a hundred billion dollar company before whatever trillion is, I still believe the best place for companies to grow their business is the US public markets. There's no place that trades as well. There's no place that has as much liquidity. There's no better place to raise capital. What I don't know is whether this staying private for longer is a permanent phenomenon or not. Let's find a way to get some high quality private assets into retail investors hands over time.

AI assessment note: “which does mean there may be less return in the public space.”

Q With that money that's gone into some of the successful large private companies, should they go public? And there's some noise that some of the bigger ones will this year. How do you think about integrating that into your index products?

A The minute a company comes public, it belongs in an index fund. We've had that belief for a long time. You might need a few days for it to get trading and figure out price discovery. Our best indexes add those securities in day three or day five. That's the best practice. Why should they not be an investor's portfolio from there? They should be float adjusted. Most companies come public, only bring five to 10% of the company public. We only want to buy five to 10% on the day of the IPO. Many years ago, Yahoo came public with a small float. Indexers bought a lot of it, and the price went up. The demand was greater than the supply. Gus Sutter and Mike Buick, people long before me on this desk, pushed really hard for all of our indexes to be floated, just in which they are today. That reflects what's available in the marketplace, and therefore, an indexer doesn't oversize the amount of Shares brought to the market, but get them in there quickly, have it be part of the investment return.

AI assessment note: “The minute a company comes public, it belongs in an index fund.”

Q I'd love to ask you about the business of Vanguard, some of the decisions along the way. You weren't the first mover into the ETF space, now one of the biggest. How did that decision process play out in your organization?

A All of that, Ted, started before I got to the investment side of Vanguard. We did launch ETFs after I was at Vanguard two years. At that point, I was working the four and K operations. It had nothing to do with the original couple of ETFs we brought to the market. The history goes back to Jack Bogle talked to the American Stock Exchange about the spy product, and he said, what are you crazy? Trading intraday is the worst thing for investors. In the early days, Jack Bogle was highly opposed to this. Forward probably a decade or so, Gus Sauter came to Jack Brennan and said, we should offer these. Gus pitched it to Jack Brennan and said, this is an alternative distribution vehicle. Intraday trading is not what we're about. It does open the aperture of getting our products to more people, making indexing better. Jack Brennan threw him out of the office the first time, Gus was tenacious and went back in and said, you really should. This is a way for us to take our business from being just a direct place where we sold mutual funds to putting it out there on a brokerage platform that today advisors can use it. It's widened the use of index funds. Jack Bogle still hated him. He would still talk to him. I got an earful on a number of occasions from Jack as to why would you give someone the ability to trade interday? No one ever needs it. They need to buy it once today, sell it again in …

AI assessment note: “Gus pitched it to Jack Brennan and said, this is an alternative distribution vehicle.”

Q Why don't we start with your background and path to joining Vanguard a quarter century ago?

A It's been a heck of a 25 years since I joined right out of business school. I grew up in a small town in Delaware. My parents didn't go to college. My mom took a job at the University of Delaware as a secretary so that I could get free tuition to the University of Delaware. I got exposed to some folks who were looking at other schools. I was fortunate enough to get into the University of Pennsylvania, but it was a little bit too pricey for my parents. I looked and remembered that I really enjoyed My dad's story's from the Navy. I put the two things together, a chance to go to Penn with a Navy ROTC scholarship, which paid the Penn tuition and got me to go to a great school where I studied engineering, and then I owed the Navy. Five years of service, which I turned into six and a half on a submarine out of Grodden, Connecticut. That was a fantastic experience where I got to see a little bit of the world. I got to see some great leaders and learn about leadership. From there, I went to business school at HBS and Where I met you for the first time. Part of the reason I went to business school because I didn't know what I wanted to do. I tried a summer in consulting, and it turned out that I like doing things a lot more than giving advice on how to do things. I went back to school second year looking for a place to work that had a great mission, a great value set, and was Philadelph…

AI assessment note: “It's been a heck of a 25 years since I joined right out of business school.”

Q As you look at the equity index business today, what's the range of products and asset size across it?

A We have about eight and a half trillion of index fund assets. That would include our fixed income index assets, which a colleague of mine runs on behalf of investors along with the active fixed income space. That's one big business for us. Within equities, we have two teams that run assets today. One is the team that reports to me, the global equity team. We run about five trillion dollars of assets. They range from total stock market broad exposures to global broad exposures to value and growth exposures and country exposures. We're running Australian and UK. There's a wide range of outcomes along with running target date suites. Over on the other side, our SE team, or strategic equity team, they're running size and value growth sector funds for U.S. investors. They're close to what you would see in Morningstar, nine box type things, along with sectors, maybe some unique sectors like dividends, country exposures for non-U.S. investors.

AI assessment note: “We run about five trillion dollars of assets. They range from total stock market”

Q When Andre introduced you to Vanguard, what was it that resonated for you?

A It was the Vanguard case study that resonated, and it's the Vanguard story that resonated. Andre had written a case about Vanguard, and Tim Buckley had actually worked on it, who became our chief investment officer and eventually our CEO here at Vanguard. You read the case and you go, this is an organization that is owned by its shareholders, for its shareholders, and returns its value back when it grows by lowering its fees. That's a really great outcome. You could already see it. We were, in the early days, the choice of the direct investor, those that were interested in saving costs. By the time I got here, we were almost 25 years into the history. We'd already driven expense ratios down. We had democratized investing or the start of it. We were the first place you could really go to direct rather than through an advisor. The fees at the time were probably on average 30 basis points. The industry was probably a hundred basis points. We were still 80% active at the time, 20% passive, but you could see what we were doing. We were the low cost leader with high quality products. Andre introduced me to Tim and to Jack, and I had a chance to come here. Originally, I worked in operations. Four one K operations are part of it. I went to Arizona and ran our 1200 person call center, which I loved. That was the front line of Vanguard. Welcome to Vanguard. How can I help you? Trying to …

AI assessment note: “this is an organization that is owned by its shareholders, for its shareholders”

Q What was your path from starting in operations to where you're sitting today?

A I went to work as far from money management as you could be. We were taking the payroll in for big four one K clients and making sure that that weekly paycheck was getting invested on behalf of the investor with accuracy and trying to make sure operationally it was good. I then went to Arizona to a call center, taught me about frontline customer service, and then I did two years of corporate work running our Six Sigma quality improvement program. A decade into Vanguard, I've done nothing but operations, Including the old days of answering the phones myself as part of our Swiss army to try to serve our investors, but it really made you learn about the retail investor and our foreign investor. And I had an opportunity. Vanguard likes to rotate people. I got a call from my boss. He said, how would you like to go to work for a gentleman named John Hollier, who is head of risk management and is working to globalize risk management? I said, that's near the funds, isn't it? Mike said, yeah, you're going to learn about it. I went to see John Hollier and John said, Roddy, I need some help on my operations and my management. I said, John, how do you do like staff meetings? He goes, what do we need a staff meeting for? I just have a yellow sticky and tell people what to do. So I hope John put in place processes that help scale his business. For that, I get to learn from John, who's one of…

AI assessment note: “A decade into Vanguard, I've done nothing but operations”

Q Once you've picked one that you're going to work with, and for simplicity, you could say S&P, what goes into the implementation that makes it work?

A Number one is there are people in our operations teams that have to make sure the index arrives every day and make sure that the portfolio manager knows what's changing in the index. You got to have an accurate index. The second thing, you have to know much money you have. Every day, my portfolio team, 50 people on a global basis, they're putting people's money to work. If you send us a check for a million dollars, we've got to make sure that we invested at four o'clock at the end of the day, perfectly in line with The index. That's one aspect of it. The other part of it is how we do that. You got to know what the index is. You got to know what you own. You got to know how to put the cash to work. If you're going to execute, you're balancing four things. One, you want as close to tracking as possible. That's how the world judges an index fund. We have to be excellent at that. If the index has five percent apple in it, you look in our portfolio, you're going to see us have 5.0001. We might have a little bit of it. Basic thumb rule of over and underweights. Then we have more sophisticated models using an axioma risk engine that looks at it in an optimizer. Tracking error is one thing. While you're tracking, you're managing three other things. Number one is if you're going to do different than the index you want to outperform. You want to leave money on the table. At times we will…

AI assessment note: “Number one is there are people in our operations teams that have to make sure”

Q wealth management firms moving to Ridgeline gain a decided advantage. That's why customers call it miraculous, game-changing, and an awakening. If that's not how you would describe your investment management tech, request a demo at ridgeline.ai. And now, back to the show. What are some of the subtle ways that you've found that Vanguard's implementation is excellent that maybe some of your competitors or some other people wouldn't necessarily understand?

A Number one is this portfolio manager trader is one person or one team. It's the ability to instantaneously make the trade-off between I could trade something exactly like the index. I think I might be able to add value. I can make that decision because I have the knowledge of what the risk is of doing so. I have the knowledge of, do I think the trade or the Alternative choice is going to be successful and add value. We have the right risk oversight of those choices to make sure that we don't let people do crazy things with their portfolio. We're going to get the outcomes we do. That's the number one thing that differentiates us. This is a career for folks. I have out on my desk a gentleman, Mike Perry, who's been running our emerging market portfolio. He's been in this group, 25 years. Mike Got to Vanguard. He worked in fund accounting. He got to be a portfolio manager and a trader. That's all he wants to do, and we have a career path that goes up through senior portfolio manager and officer. Mike is now showing the next generation how to run a complex emerging market global portfolio. I have roughly 30 people here in the U.S. I have another 20 folks globally. I have a team that reports to me in Australia that cares as much about American investors, as we do, a team in London that cares about American investors as much as we do, and we're completely globally integrated. We do w…

AI assessment note: “Number one is this portfolio manager trader is one person or one team.”

Q What's on the forefront of the newest initiatives in indexing?

A You could go two directions with it. One is something that's not good for investors. That's cutting the index into small pieces, calling it an index fund where it's simply an active exposure. Even worse is if you put leverage to it and triple leverage it and claim you're giving a negative or positive three X return and you are for one day and you're not for the long time series. Unfortunately, a lot of Index innovation is marketing positioning for sales and not good for investors. The second aspect is every day coming in, running the index in a more efficient operational way. We're trying to think about corporate actions and what could AI tell us in large language models rather than 25 years of Mike Perry's history having to be transferred to the next person. Let's look at our history and And pull together what worked and what didn't work for us. Try to put that into an AI model. We're trying to also put efficiencies in. Let's touch the portfolio less. We don't touch it a lot today. You don't trade on average a trillion dollars of execution on an annual basis by going in and touching every stock. We're using algo's technology to do it. We should continue to do that and even more of it.

AI assessment note: “You could go two directions with it. One is something that's not good for investors.”

Q I'd love to dive into some of the mechanics of how you go about indexing. Part of it starts with what index to create into a product. How did you think about launching new products?

A There's the original concept of indexing, which is capture as much of the world's investment universe as possible, and you put it into a total market fund. For those, you're just trying to get from the largest security in the U.S. to the smallest one, That you can invest in. What you're looking for there is all the securities that are equities, and then you're thinking, are they liquid enough and available enough for us to invest in? Then you include them all. That's the simplest version of indexing, and we do that all around the globe. We have a total stock market fund here in the U.S. for American investors. We have an Australian index fund based on the ASX-. For Australians, total bond, total international, total world. Capture the whole equity. Then you start to go, if you're going to cut the index into pieces, what makes sense? One of the challenges in this business are people are slicing the indexes into pieces that don't make sense. There's not an investment thesis for it. We've stayed more pure to it. We've cut the indexes into what I would call logical blocks. We started with size, large, medium, small, value, gross, or the Morningstar nine box. We have dividend strategies. Higher dividend strategy and dividend quality strategy that we believed in. We've given some investors some choices with the ESG indexes, but we're trying to find things that are still capturing, I …

AI assessment note: “We've cut the indexes into what I would call logical blocks.”

Q What are some of the other ways you try to add value to returns?

A We look for places where there's an asynchronous return, where there's more upside than downside. That's our basic role, and we don't do a lot of it. An example would be when a company brings a secondary offering to the market. They're selling new shares and raising money. We would participate in that. Statistically, we've seen that we can buy it from the bank at the time of offer, and by the time it's added to the index, we've usually bought it at a lower price than when it's added. Do we win on every one of those? No. We take a risk-controlled way. We think about that. Corporate actions are another. How we elect to take, when maybe two companies are merging together, how we get through there to the end result. There might be two paths. You might be able to keep the shares you have, and it turns into the new company. You might be able to sell in the market, then use your cash to buy another company. We're always looking for places like that where we might be able to add some value. One of the ways we add some value is with regard to the securities lending program. In securities lending, if someone wants to borrow one of our securities, they're willing to pay for it. Maybe a hedge fund wants to put a short position on. We lend out what we call specials. Specials are ones that have a high rate paid to the person giving the lend out. We will lend those out for a fee. That money f…

AI assessment note: “One of the ways we add some value is with regard to the securities lending”

Q One of the things you hear about a lot are the index rebalancing itself. New components coming in, a couple going out. How do you think about that balance of tracking and value add when there's a change in the constituents?

A We think about it in a risk-adjusted way. For every fund here, we have expectations of tracking error. That's how we're judged. Number one is track the index. Something like a 500 index fund, we're gonna see tracking error be no more than a couple basis points. Typically, less than one. We're not gonna take a lot of risk there. You can imagine if Apple's number of shares in the index are changing because there's a buyback, we're having to sell some Apple. We're going to be largely on the close with that stock. We're not going to be able to take a position. Many investors are trading Apple. We have no ability to know where that's going. On the other side of it, in an international portfolio or global portfolio, maybe there's not the liquidity in the Philippines to help us with the ad. The risk is small. It's a large portfolio. The Filipino ad, it might be a small addition, might take us a week or two to buy the number of shares. On our trading desk, the portfolio manager and the trader, it's one job, one team. When you go to most investment managers, portfolio managers sit in an office, Think great thoughts and what stocks are going to buy. The traders are doing the execution on trading desk. Most of our portfolios are not optimized. They're largely replication. The most important thing we can do is think about that trade execution. How we do those things matters a lot more than…

AI assessment note: “We think about it in a risk-adjusted way. For every fund here, we have expectations”

Q Once you own the portfolio, how do you think about the value creation of the market itself?

A Governance is all about companies that are well run to do well over a long period of time. We have a stewardship team internal to Vanguard, and that stewardship team has always thought about making sure the company's well run. We want a board of directors capable of overseeing the strategy of the company. We want a board of directors who is going to make sure the company gives investors information, make sure that you can see the financial returns, the risks that the company's talking, so investors can make great decisions. We want to make sure that the executive compensation is aligned with long-term shareholder value. We want to make sure that the executives are paid when the company does well. Finally, we want to make sure that the board of directors is thinking about shareholder rights. Our rights are protected as an owner so that we have the ability to have the vote. We stay away from things like telling the company what business to be in or how to operate their business. We're more about making sure we get good governance over a long period of time. We've introduced investor choice. Investor choice is allow the shareholders of our funds to express a point of view. Around how they want the companies in our portfolios to be run. For that, we think about returning the vote to them and they can choose one of five policy portfolios. They could decide to vote with management. T…

AI assessment note: “Governance is all about companies that are well run to do well over a long period”

Q What do you think Vanguard looks like five or 10 years from now?

A We look like we are today, which is the best place for an investor to get an investment product. I suspect, like we have seen in other areas, AI will help to enhance our customer service experience. In a way like the web has. When I first got to Vanguard, people call up every day for a price of the fund and their value. No one does that anymore. They're going to their phone app to do it. You got to imagine it's going to continue to help investors make better decisions through engines that also make it more personalized. Your financial situation is different than mine. The more information we can get with the right Advice engine behind it gives you better bespoke advice that's specific to your family situation, your wealth level, and everything else. We're in the early days of that at Vanguard in the industry. Customization of advice will be one of the big areas.

AI assessment note: “Customization of advice will be one of the big areas.”

Q What's different in how you think about the fixed income markets from the equity markets?

A At a high level of fixed income indexing, you can't own every security. They have to do a lot more with their sampling and with their optimization around it. I would say it's easy if you control your duration, you control your credit quality, you can get the index return. They have choices. Do they own bond A versus bond B? They're always looking and saying, we want a bond that's going to stay in business. They don't want Accredited defaults. They use the credit process to try to identify securities that might have a slightly wrong price or one that might be headed in the wrong direction. They're just as index-centric as we are focused on tracking here. They have different levers to do, and they also have optimization to do there. We've always had active fixed income at Vanguard run in-house. We have continued to increase the size of our team, the depth of our team, We believe we can outperform in the fixed income market in those portfolios because we have the right team at the classic Vanguard low price. We believe we do provide institutional quality active management for investors.

AI assessment note: “fixed income indexing, you can't own every security. They have to do a lot more with their sampling”