Invest Like the Best with Patrick O'Shaughnessy - Humble Giants – Vanguard’s Gerry O’Reilly and Jim Rowley - [Invest Like the Best, EP.06]

Episode Date: October 18, 2016

There is a good chance that this week’s guests manage your money. This episode is a rare and fascinating look into the world’s largest asset manager. My first guest is Gerry O’Reilly, who is the portfolio manager for the largest mutual fund in the world, and oversees more than $800 billion for Vanguard. My second guest is Jim Rowley, a Senior Investments Analyst with deep knowledge of indexing and ETF’s.  The two provide incredible insight into some of the particulars that make Vanguard and its funds tick.  Please enjoy!   For comprehensive show notes on this episode go to investorfieldguide.com/vanguard/ For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaunisee is a principal and portfolio manager at O'Shaunicee Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunacy Asset Management. This podcast is informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Ashanti Asset Management may maintain positions in the securities discussed in this podcast.

My guests today are Jerry O'Reilly and Jim Rowley. Jerry oversees roughly $800 billion in assets for Vanguard, including their flagship total market fund. He does so quietly with great humility. Jim is a senior investments analyst with Vanguard with deep knowledge of both indexing and ETS. I've always been impressed with Vanguard as an institution, so it was a blast diving into some of the particulars that make the company and its funds tick. For show notes on this episode, visit investorfieldguide.com forward slash Vanguard. And now, please enjoy my conversation with Jerry O'Reilly and Jim Rowley. All right, well, Jim and Jerry, thank you very much for doing this with me today. This is going to be a really fun conversation. I think some of the interesting minutia that we'll get

into around index investing and Vanguard's actor strategies as well. will be great fodder for the listening audience out there. I'd love to start with something fun, which is that I have recently gotten very into running. Let's see where this is going. And looked up with the last name of O'Shaughnessy, all of the Irishmen who had broken the four-minute mile. I was reading Phil Knight's new book, Shoe Dog, which I really enjoyed and saw, in connection with the interview, that you, Jerry, had, I think, the third fastest time. Certainly a Villanova, but sub four-minute mile. Yeah. So I'd love to hear just tell me a little bit about the first time you did it.

Okay. So I had been knocking on the door of four minute miles for my sophomore year in college. And just for whatever reason, it's 4.001, 4.2 tenths of a second, just just never quite got there. And so at the end of my sophomore year, a little disappointed and then went into my junior year and kind of figured, okay, this year it's going to happen. and trained like I'd never trained before. And when I got the opportunity, I actually went from, instead of running 359 or 358, I actually went from a four-minute miler to a 354-miler. So I took, you know, almost six seconds off my personal best in one race. And that was, I think, just, I think the fact that I didn't have success, my sophomore year in terms of breaking it,

I was maybe even more determined. So that's kind of was the fodder for breaking it. At what stage did you figure out, I'm assuming you started running, relatively young. Yeah. Like at what stage was it, did it become apparent? Like, okay, I've got, I've got something interesting going on here. I think I was probably, you know, you're right.

I did start running at a very, very early age, probably eight or nine. The town that I grew up in Ireland didn't have a whole lot of options available. There was, there was, there was Gaelic football, soccer, and running. And that was kind of it. So a neighbor happened to be into running and invited me to, hey, you should come down and try it out, tried it out, liked it. But I'd say it was probably 15 when I realized, you know, I actually had. I have something going on here where I can, I tend to be able to keep going when other kids start blowing up.

And, you know, I just said, this is, this is maybe something I should stick with. So there's a thread there that I'm interested in the, a quote that I pulled up here from Shudog, which was Bill Bowerman, I think I pronounce his name, the famous Oregon track coach, said that his philosophy for running the mile was to set a fast pace for the first two laps, run the third as hard as you can, and then triple your speed on the fourth, which sounds insane and like crazy, but a lot of people said that actually is kind of what you do. Yeah, I mean, when you're running four minutes, there's no, at no point are you kind of taking it easy.

Right. It's 50 miles an hour on the treadmill. I mean, yeah, it's cranking it. It's keeping it honest. I was probably not gifted with the best closing speed in the world. So I had to ensure that the pace was reasonably respectable. And then hopefully off of that pace then, I could still come home hard, which was my best races were races like that.

If it was a really slow first two laps where it was more of a race probably set up for half-miler, I was probably in trouble. But if it was an honest pace with a strong finish, I was generally in there. I assume, especially since you had the six-second gap down, that this is as much mental, if not more mental, than physical at that point. Yeah, it is. Absolutely. I mean, and overcoming the mental aspect of it, once I think I realized that there's no question I'm going to break it, it became a lot easier. So was your last major running experience in the Olympics in 88? Yeah, I mean, I ran for a few years later. I think it got to a point where, you know,

if you're a professional athlete, which I was for a little while after college, you don't make a whole lot of money, at least not at the level that I was at. And at some point, I started, I was dating my now wife back in the time and I started trying to put it together. Well, let me see what I'm making here

versus what it's going to cost to have a car and a mortgage. The math didn't really add up. And so I was fortunate enough to have a competitor I used to run again. who was working at Vanguard, Jim Norris, and Jim said, I'll drop your resume off. So that was almost 25 years ago. I thought I'd be here for a few years, and here we are 25 years later. And how about you, Jim? How did you get started at Vanguard? Well, I'm a little bit of an oddity, I think, because I've been around the block where, you know, you have a lot of crew members here,

as, you know, everybody's referred to who have been here for very long periods of time. And like you and I discussed before we went on air here was I actually started as a English tutor and a boarding home in Germany. I made me. my way back to the U.S. and reconnected with some college friends. And I've been involved in investment sales at Merrill Lynch. I went to graduate school and I got my investment banking job at Lehman Brothers in the early 2000s, well in advance of any issues because my wife and I wanted to come back to the area, both being Villanova graduates. And I'll put the in for Jerry as well. He is as well, you know, it got us back to this area. And she could start going back to work.

And after a couple of years, it just started making my networking and connections and found my way in Dort Vanguard, and that was 10 years ago. So it's tough to believe, looking back, that I've been here 10 years. I like to say that I've always been a Vanguard investor, but maybe I didn't know how to articulate it, which actually is now my number one job responsibility to help articulate it. But I think it's been very good to me having worked at other places in a sales capacity, in an investment banking capacity, worked in different cultures. When we say a real Wall Street culture coming here, I think it's informed my perspectives and my judgment to a very, very good degree that maybe others don't have. The length of 10 years is something that's on the decline,

right? The average time people spend with a firm is coming down kind of across industries in 25 years and 10 years. And I would say at other really great firms that we work with where there's the same 10 year long tenure tends to be a characteristic. It always comes back to the culture. And I think Vanguard, rightly so, has a reputation for a great culture. Maybe the two things that's gotten most right is the kind of original setup where the funds own the firm and the culture. So I'd love to hear maybe listeners will be asset managers themselves, who are either building businesses or part of one. I'd love to hear from each of you what you think the key cultural components are that drive this reputation that Vanguard has. I'll start only because

I do my fair share of interviewing for HR department. You know, they'll ask us to do recruiting or when students coming off from outside on the campus and they'll say, hey, Jim, you know, what might nobody explained to me that helps somebody's success at Vanguard. And I'll say, look, there are far more successful people than I am here. But two rules that are serving really well is, number one, it is a do the right thing type of place. You might hear that about Vanguard. You might think that's a little bit corny. I can't tell you how many times I've been in a meeting where you discuss a topic and somebody says, hey, wait, how does that affect our shareholders? So that really is the way things work around here. It's a do the right thing place. And you are concerned with

your shareholders and your fellow crew member. And I said, oddly enough, the other thing that gets noticed is you start every sentence with we. We accomplished a goal. We did this as a team. You know, we improved engagement. We improved success ratios. But your successes are determined as a team, as a we. And if you start a sentence with I, I did this, it gets noticed and not in the right way. So I feel very good about saying that we do look out for the interests of our shareholders and it is very much a team environment. Such a simple heuristic, but it's a, something easy to say, but probably hard to do, you know, year after year. What do you think, Jerry? Well, I mean, and this may sound a little corny too, but I have, you know, interns come in and

they talk about what makes Vanguard different. And I was like, well, Sunday evening, I'm actually looking forward to coming to work on a Monday morning. Now, I think I'm in a minority. I work out, you know, I live out in a neighborhood where I talk to other people who are involved in other businesses. And I think that's not, that's not normal. And I think the reason I look forward to come is the people I work with incredibly, you know, team oriented, as Jim mentioned, just great environment. I mean, they're not only colleagues, but they're also good friends away from work. So we, we socialize together. We're, uh, I think the fact that you are involved in, in, um, in an area that can be quite stressful at times. You do, you do tend to bond together. And, um, that I think just is, is great.

If you can work at a place where you enjoy actually coming in here and spending time in here, it's, it's fantastic. And Vanguard's actually managed to create that. And the, the, the, The groups that I interact with, it's a lot of what Jim mentioned. It's not, you know, the I. It's the way and it's, you know, working together. I think I remember when I interviewed for the job on the desk, Gus Sauter was in charge at the time. And Gus said, you know, I like to use the analogy of a high school basketball team where you don't really have these big egos. You've got five people plent together and you can achieve incredible things.

And that type of environment is alive and well here at Vanguard. So, and when people get in here, we tell them, hey, you can have a phenomenal career path, and it doesn't really matter where you went to school. It doesn't matter, you know, who your parents knew. It's what kind of a job are you going to do here, and you'll have opportunities here, which is great. Yeah, so the idea of a mutual is, is pervasive. It is, right?

It really is, yeah. Well, let's dive into investing, which is what I think most people will be very interested to hear both your perspective on. Obviously, the major debate or question, we hear it in every single meeting with advisors, with clients, with institutions, is this act. active passive debate. And what I'm most interested in is not so much who's right, because I think the answer is obviously we need both. And the more interesting question is, what does an equilibrium look like? What does the transition from now until that point look like? And how a firm like Vanguard

who owns, you know, owns, which owns, I think today's six and a half percent of Apple, you know, there's going to be a 13D for conceivably every security in, in the universe. in the not too distant future. I think for passive investors, it's not until 20%, that you have to file it. But that sort of thing starts to be a real consideration,

and there are all sorts of knock on effects. So I'm curious, as this ramp-up has happened, and I guess it's really accelerated post-financial crisis, have you noticed, specifically in the passive side, but maybe the active side, too, things changing in terms of the execution difficulty,

especially, let's say, in the bottom 1500 stocks of the total market fund, our firm trade, some of those names we know what they're like. Have things changed? Are we starting to get towards a point, a saturation point, you know, past which we're either sniffing that equilibrium or tracking errors start to rise in the total market fund versus the reference index? What do you think about this whole, this whole debate in transition period? I mean, I think if you, if you step back a little bit, you know, I've been on the trading desk for about 20 years, and there's no question, there's a lot has changed in the market structure in that 20-year period. You probably

remember yourself back in the days when it was really, you know, you had New York and NASDAQ. It's very different today. We have 13 exchanges. We have about 40, 45 different pools of liquidity. I would say with regard to, you know, small caps have always been difficult to trade. I would say what's different today is the fact that, you know, with even though we've had large assets coming into our funds, you know, one of the great things about indexes is that there tends to be little turnover. So while the assets in the funds themselves are huge, the rebalances or tend to be, you know, a 5% turnover in a year is kind of around the norm. So it tends to be little in the way of turnover.

So even when we have rebalances, they're relative to the size of the fund, they're not huge. Now, having said that, there is still a lot of trading that needs to be done. And I would like to think that the traders on our desk are very much aware of the tradeoff between tracking error versus impact. So obviously there's certain names, and you mentioned, you know, the bottom deciles of the total market, where if you needed to get something done and you have to be done in a day, you're definitely going to have impact. So we tend to be somewhat opportunistic in those names, and we will exhaust all different types of ATSs, dark pools, crossing venues, wherever we feel we can find liquidity. We will take advantage of that. Most of the cash flow that's coming into our funds tends to be benchmark to the close. So when we're running lists that are going to be for that night's closing price, that tends to be traded more towards the close where you tend to get a pickup in liquidity in that last half hour of the day.

So, you know, there's not the issue in there. But there's no question on the bottom desile names. It is a challenge. And, you know, I'd like to think that over the years we've accumulated some expertise with regards to trading those names without signaling out to the market that I'm out here as a bunch. buyer, whether it's using, you know, algos, crossing networks or whatever the case may be. So if I said to you, you know, in the next two years, you're going to quadruple in size in the total market fund. You're going to go to $2 trillion.

What face would you make? Yeah. I mean, you're, we still, obviously there will be, I don't think small caps are going to be that much significantly easier to trade two years from now. But we're just going to have to adjust to it. I think that's maybe a tad optimistic that we're going to get to that size. But there's always going to be those issues. Not if you had been in some of the meetings I've been in.

Yeah. But I would say, you know, there's always going to be a challenge with trading those smaller microcap type names. The good thing, I guess, from the fun point of view, is that they represent a relatively small portion of the overall fund. And so to the extent that, you know, they're difficult. They do are relatively small in the overall context. Patrick was going to say you brought up an interesting point at the outset just that kind of looking at the definition of indexing, right? And the amount of the impact it's had in the marketplace. And the one thing I think it's very interesting for investors to pause and think about, right,

is you say there's X amount of cash flows going to indexing or Y percent of assets or indexed funds. We think about the definition of index fund, right? That includes all these non-market cap weighted index products, right, which are active strategies. And I don't mean that as a four-letter word. That's not a negative. But from the standpoint that they hold securities not in a market-weighted capacity, those

are active decisions. If you look at cash flows that go into products, notably ETFs, because they have the balance of index products, you may find that cash flows are proportionally more going into small cap value funds or mid-cap growth funds. That is not the proportion of the total market. So, in effect, these are all active decisions going on. They may be using index pieces to do it, but when you take it out at a higher industry or higher strategy level, that's not about indexing. anymore. These are all about active management decisions. Yeah, it seems like the only true, probably the total market fund or something close to it, everything, right, is the only true passive approach. And you see this stat now that there's

more large-cap indexes than large-cap stocks, which is, which is, you know, some sorcery, I think, behind a lot of that. I believe that Vanguard uses Crisp now, crisp's indexes, and used to use MSCIs. How do you think about that? And the underlying question would be, why don't you just do it yourself? Why do you need a third-party index provider against which to say benchmark yourself? I think we've probably, we have looked at that in the past, but I think there's a lot to be said. I mean, Crisp has been around, I think, 90-odd years studying indexes and providing that type of information. And there is something to be said for, you know, an arm's length between us, the manager and the index provider. But, you know, having said that,

we're always in touch with index providers in terms of how to better improve their index methodology. So I think back to when I started, there was no such thing as float adjustment. So you potentially could have had a name that had 100 million shares outstanding, but insiders would have owned 70 million shares. So you have all these managers trying to track, you know, go after these 30 million shares. And it led to pretty severe, you know, price movement when if a name like that got added to a benchmark or was deleted from a benchmark, now most of the index providers have adjusted for float. So it's really just the what's available to us the public. That's just one example. But I mean, we are always in terms of whether it's corporate

actions, making sure that, hey, we might want to consider if there's something somewhat complicated, be aware of this, always giving feedback. And if there's a lot of times there's opportunity for us for input when an index provider is considering making a change, whatever the case might be. I know in our emerging markets, you know, there's been discussions about China if it's in or out. We were very much involved in that. Along the way, we do have an opportunity to be involved, albeit, you know, at an arm's length. Very interesting. I think it's one of the next issues that comes to mind is proxy voting, where alongside this

rise in market share for Vanguard specifically, let's even say, but other big index providers too, is that it's almost this passively active idea now where in general, a lot of managers have relied on services like ISS to vote proxies, and they have to follow a formula because they don't have scale to actually evaluate decisions. And so, you know, famously they said that Coca-Cola shareholders should withhold votes from Warren Buffett. And the joke was that, you know, apparently one of their checklist items was, is he the greatest capital allocator of all time? So how does Vanguard think about this big and growing issue where, to use that extreme example again, you know, you're going to own 20% of more, pretty much every stock, publicly traded stock? How do you, how does the, is there a group behind it?

How does that work? Any mechanics there would be really interesting to hear about. The simple way to think about that is, I mean, we do have. have a corporate governance group at Vanguard that is engaged in these matters. And I think depending upon what you see in the press, right, you have almost this litmus test that says, oh, you know, percentage of times a firm votes with or not with management is, is the litmus test in terms of how active or how engaged they are. And I think the way we might look at it is that's not necessarily, you know, the only way a firm or an asset manager can go about corporate governance, right? A lot of that can be at a more personal level, what others might deem to be behind the

scenes, but more in a conversational type of approach to management, not necessarily this binary yes or no vote type of approach. Will it be a group that keeps growing, do you think? Will it kind of grow in linear fashion with Vanguard's own size? Never really thought about that. Both Jerry and I are investment management group people, so don't have too much insight in terms of other business units in the company. Yeah, yeah, fair enough.

I would say, Patrick, though, we will get calls on the desk, you know, when a company an issuer is looking to speak to someone in our proxy area about something that may be coming up down the road. So certainly to that extent, we will put them in touch with that group. If they have an opinion that they would like to make sure that they were aware of, absolutely that happens, not infrequently. What are the skill sets that, you know, let's say I was hiring someone to be an analyst at an active shop who might have skills in quantitative arena or as a fundamental analyst,

you know, pretty specific set of skills I'm looking for, what would be that same skill set for, say, someone you're looking to hire in your group. If you're looking at, you know, minimizing the difference between, you know, after cost, returns versus the index. What is the skill set that you're after? Well, I mean, there's a lot of different. I mean, we've actually done that this year. In fact, we've hired some new traders on the desk.

The first thing I would say is that the traders on the desk, we probably have an average tenure of about 13 years. We have some guys who've been on the desk close to 30. So we've got a good combination there. The things that we look for is a couple of the customers. of things. We look for people who are passionate about the markets that absolutely, you know, they enjoy what they do. We obviously, there's this, when you're tracking a benchmark, I mentioned a little earlier, there's understanding what the importance of tracking error versus impact is.

I mean, as you talked about our growth in assets over the years, that's become a challenge that everyone needs to be aware of. The ability to work with other groups, specifically, you know, I would say if you looked at our desk today and looked at it 20 years ago, transaction cost analysis was something we did very limited, I would say, back then. Now we have a transaction cost analysis group that works very closely with us. So in terms of analyzing our trades and taking that information then and baking it into our trading strategies, also I would say the ability to work with our risk areas. So we have an investment risk group that allows us to trade large rebalances in a very risk controlled fashion, which was something that probably we didn't

have 20 years ago. And now today. So the ability to understand that. So obviously, you know, individuals would need to have pretty useful skills when it comes to, you know, just technology skills. We use a lot of different systems. Understanding market structure, as I mentioned earlier, it's somewhat, it's not exactly. I think if you had a blank sheet of paper, I'm not sure you'd design the current market structure that we have today. But just understanding that and how does that interact with all of the different tools that you have available to you. And so we also have the ability to work in teams and groups and understanding that, you know, you are a contributor, but ultimately it's, it's the desk is what's, it's the desk and it's vanguard, what's ultimately important. You mentioned two,

two terms I want to flesh out a little bit there, risk and market structure. So when I think about risk, or I think what most people think about risk, it's risk relative to you, relative to the total market. Yeah. So what dimensions of risk are you mentioned, are you mentioned? So we would, we would be referring to risk. So if we have, for example, large trade coming up, what type of, we would be looking at that trade relative, you know, what type of tracking error would you be looking at relative to the benchmark? So as you have a rebounds coming up, say, you know, at the end of a month, you know, there's obviously names that are going to be added to the index names that are going to be deleted to the index. So you look at basically, hey, how is this trade looking relative

to the current index? And as you, you know, obviously you can't trade the entire rebounds in the last hour of the day, you could certainly match your benchmark, but you're probably going to have impact that you'd rather not have. So to the extent that you're going to, you're going to start to trade some names early, you need to know what type of risk that is to the portfolio. So we have very, very, very good risk folks that are analyzing that every day, letting us know how we're doing what the tracking is looking at relative to the benchmark. And then the second being market structure. And you said that, you know, if you had a pen and paper, maybe draw it up a little bit differently.

Flesh that out a little bit. What are some aspects that are subpar? Yeah. Well, I mean, it's a very fragmented market. I mean, and anytime it's, you know, you have, as I said, had 13 exchanges right now and understanding, you know, how your orders are getting routed, that whole venue analysis, that is something that is probably not optimal. Now, the benefits are if there is an issue at one of the exchanges, the other end, and it has happened in the past,

where you have the ability to trade and avoid that one index that's having a particular problem, but it does add a whole level of complexity to trading. And, you know, I would say that understanding how your orders are interacting in this maze of pools and exchanges, and being able to take that information and apply it to the way that you trade is really important. So we're fortunate that our TCA group, they live and die by understanding that venue analysis. And so we can look at the end of a month. We have monthly meetings to determine, here are different algos that you're using, and here are the results that we're seeing. And if there's results that we're seeing that are not, but we don't think are optimal, we're going to have a conversation with the broker and say,

we're noticed that on this particular, when we use this, we're seeing quite a bit of adverse selection going on in these names. And can you give us any color as to what's going on? And if we don't feel comfortable with it, we actually won't use it. But to the extent that you take that information and use it as a tool to help enhance your trading, I think it's a win-win for everybody. Yeah, that makes sense. We've talked mostly about passive.

Of course, Vanguard has a trillion dollars of active assets. It seems unassailable that Vanguard's, you know, low cost or cost matters, hypothesis is true just because cost compound and there's no denying that. Assuming that there is a set of principles or values are applied when deciding what active strategies to pursue, whether that's internally or through sub-advisors, could you walk through how Vanguard thinks about other key components other than just low cost on the active side of the equation? I think it's probably three things if you were an investor saying, how would I go about building

my portfolio and three quick things to think about, you know, cost is unavoidable, so I'm going to mention that. But, you know, we would say talent, cost, and patience. Granted, talent is a very qualitative, tough to sort of, yeah, and it's very tough to get your own on how do I judge talent, but you know what? There are a lot of people that have their own metrics or philosophies in terms of how they define who a talented manager is. So maybe that's a bit of the art component here that goes with the science because the science components are cost, right? And this is relevant to whether you're an index fund or an active fund, right? Every basis point of cost is a basis point in return you don't get. So those principles apply not only to active management, but index

management because having a high cost index fund is doing you less of a good job in a relative scale, even on the indexing side. And the third thing I would say is patience, right? Most successful active managers are successful because they have longer track records. And maybe that success is achieved over longer periods of time. And they're most likely going to have speed bumps along the way. They're most likely going to have intermittent periods of, hey, that didn't really go well, or maybe we really underperformed. But to the extent they are successful, and it is over the long term, if you're an investor that doesn't have patience and you jump ship and you switch managers or, you know, you don't have the patience anymore, you don't realize that longer term track record.

So talent, cost, patience, maybe three quick guides that investors can think about when they go through the active manager search. The behavioral side of that that you mentioned at the end of our just human tendency to do the wrong thing at the wrong time with our money, especially in markets. It leads me to the next question, which is I'd love to hear, guessing the answer is what I think it is, but would love to hear what you think about the market efficiency debate, whether or not markets are efficient, to what degree. I mean, obviously, Vanguard has active assets, and that assumes a belief in inefficiency. But I'd love to hear just you two in particular what you think. I think I can start with sort of the more academic how we talk to investors. Maybe Jerry can talk about actually trading securities. Yeah, being in the market itself.

I always sort of jump ahead of the argument a little bit and say, when we get to this and it's an active passive debate, market efficiency is, dare I say, irrelevant for why indexing works. If we believe in Bill Sharp's zero-sum game principles, whether or not a market is efficient or inefficient, only half the dollars can do better than average, no matter what. So indexing works because it's taking the average and having a cost advantage over the average active manager, efficiency isn't the focal point of that discussion. And the natural next question is always, well, okay, Jim, what about in small cap emerging market stocks and, you know, try and make a little bit of a light, hard discussion. say, hey, for every genius who correctly identifies an undervalued stock, there's some not-so-genious person that sold them the undervalued stock, whether that's a corporate bond, an emerging market stock, a mid-cap growth stock, it doesn't matter.

For every dollar that was a relatively winner trade, that same dollar is a relatively loser trade for somebody else. So when we put efficiency into that active, passive context, right, it's the notion that no matter what the market is or what the perceived efficiency or inefficiency, indexing works because of a zero-sum game principle, not because of efficiency or inefficiency. Fair enough. And I would say, Patrick, on the trading side, I mean, a price discovery, I think, has never, I'm always amazed at just how quickly in today's market.

You know, I don't know if you've been back to the trading room, but there's no shortage of TVs there just to see what's going on. And it's amazing to me, a name will get halted. And for whatever reason, and that thing is, once they open, open that up, it's up and running in size and it seems like it's not an issue to get to get these stocks back up and running again. So it's, I'm amazed at the speed of it. You know, there are, I think there are times when it's, you know, somewhat when you're dealing maybe in the when issued market occasionally you've probably seen it yourself where there is issues about price discovery.

But as it gets closer to when it's going to start trading regular way, that tends to beef up a lot. And to the extent even with IPOs, it is amazing how quickly that whole process, you know, can get up and running once you have an IPO price as well. The word speed makes me think of high frequency trading. Yeah. And if you think of HFT as or the opinions on HFT as some sliding scale of pure villainy on one side and something that's actually very healthy and good for markets on the other side, where do you fall on the spectrum? I don't think it's, I agree with you. I don't think it's all or nothing. I think there are aspects of high frequency trading that are absolutely beneficial to the market.

I wouldn't say that everybody involved. But I think there are, you know, the high frequency trading firms that are arming out between futures, ETFs and the cash and keeping markets kind of, at some extent, knit it together is not a bad thing. I think spreads have come in dramatically in the last 15 years. I don't think it's a coincidence that that also is when HFTs have gotten involved. But I do think there are players in the HFTA space that are not. that are looking to take advantage of, whether it's latency ARB issues, if looking to take advantage of potentially sniff out larger orders that may be out there

so that they can jump in front of that. So I'm not naive enough to think that all HFTs are great, but to a great extent, I think they are a huge provider of liquidity in the market right now. And we would say that from a retail perspective, spreads have never been tighter. It's been a net positive. Nonetheless, we feel as traders on the desk, it's our responsibility to protect our order. So we have techniques that we've developed over the years to make sure that we are not signaling out there that, hey, I'm out here, I'm a big buyer, and let people run in front

of our order. We own that process, and it's up to us to make sure that we do that in a way that's not going to be harmful to our shareholders. Anything to add on high frequency, Jim? I'll leave that to him. He's the one that deals with it every day. Sure, sure, fair enough. One of the things that I'm most interested in is the quarterly rebalance versus

daily trading. And obviously there's a lot that goes on in markets and there's corporate action. There's secondary issuances. There's buybacks. I know that a lot gets bundled into the quarterly rebalance. So maybe start by telling me what happens quarterly. And then we can go from there. Yeah. So maybe just a two-second overview of index methodology. So for most index providers, the line is 5%. If a company issue shares of over 5%, that tends to be done. And so, on the following day. So company A is buying company B and is going to issue 6% of their shares outstanding. That change will generally hit the index the following day. If it's less than 5%, they kind of group them all up together. And as you pointed out, they wait until the end of the

quarter to do that trade. So you're right in that, you know, as we own so many names, it's not unusual at 10 after 4 in the afternoon to get multiple calls from syndicate offerings that are going on. And, you know, they may be issuing stock. to pay off debt. They may be acquiring another company, whatever the case may be. So to the extent that our index providers are going to be making a change the next day,

we will participate to some extent in those, assuming that we feel that, you know, they're priced right and that the environment is good. So we have those going on all the time. And the quarterly rebounds is, you know, depending on the index provider, those are trades that are known to everybody out there in the market.

And we put it, you know, we basically will be notified ahead of time from the index provider here are the changes that are going on. Usually it's about a week to two weeks ahead of time that we're going to know what the index, the new index constituents are, what changes are going to be. And then we will set about putting a plan in place. So we have a group within the desk. Actually, that is a rebalance group that basically looks at these. They would have history going back as far, you know, as we've been doing these about how certain names have worked. and we incorporate all of that into our how we handle rebalances.

Now, as I mentioned earlier, it's a lot of dollars, but, you know, we look at it. We work closely with the folks in our transaction cost group as well as in our risk group to make sure that these rebances are done in a kind of a risk-controlled way. So the 5%, I didn't know that threshold specifically was a good rule of thumb. What about the buyback side of the equation? So it's a huge issue. Yeah. Interesting issue these days where there's a lot of these corporate cannibals,

as they call them. And sometimes you'll see a firm buyback 10% of its shares in a month. Yeah. Or something really aggressive like that. But certainly buyback's happening all the time. Sure. So how's the flip side of the coin? The flip side of that basically is, so for example, if you have a company that's doing that, so I mentioned earlier we have this float, this idea of a float adjustment. So obviously when a company is buying back, that's going to have an implication for the

float on the fund that was available to shareholders. And generally, we are, if a company is buying back shares, we are going to be selling, yes, absolutely. And it's the same, you know, same type of rigorous controls are in place, whether it's on the sell side or on the buy side. Yeah, I think that's a really interesting dynamic here with such a rise in these issuance and especially buybacks, right? Yeah.

Where there's big debates about at the market level, if they're good or bad for America or for the companies and the shareholders of the companies, and to have index providers behind them. And then the companies knowing that indexes will act a certain way, whether they're issuing or buying back, it's certainly an interesting kind of game. Yeah, I would hope that the companies that the fact that an index might need to sell because we're buying back our shares, I would hope that's not the primary reason for doing that. In fact, I would be shocked if that was the case. I think they're obviously doing it for other much more meaningful reasons. Yeah, I think I think 90, whatever percent of the time, that's true.

When I talked to a guest on the show, Michael Mobus, in one of the camps that he has for buyback motivations is the impure motive camps, he calls it. And hopefully that's a small minority. But knowing what we know about markets, it's not a zero. It's not a zero percent minority. It is, you know, I will say this, that a lot of the, whether it's on the by side or on the cell side during large rebalances, there are one of the advantages, I think, of having it publicly available,

that information out there is that it tends to become a liquidity event. So whether it's a company that's in buyback mode and knows that indexers are going to be selling, I can't tell you the number of times that you've looked. And if you just look at what your trade is relative to what trades on a normal day, you think, wow, we may have some impact on this name. But the buy side will actually show up to offset that because I think they will be prodded and given a heads up that, hey, indexers have X number of shares that they're going to need to trade and they'll offset the other side of that. So a lot of times I'm surprised that there's actually little movement in these names. Jim, what do you make of the rise of factor investing as sort of the theme of the day where we'll call

pure indexing, let's forget all the different definitions of indexing for a minute. We'll say that indexing is truly total market fund. All of the new, they're called indexes, but as you pointed out earlier, are really active combinations of stocks based on value or momentum or quality or low all or whatever the factor might be. What's your take on the rise of the popularity of these factors and how investors out there should think about allocating or not allocating to a factor exposure within their portfolio? Number one think about is it's it's sort of the next wave of active management. I mean, if we went back and maybe did a bit of a history review of active, there's always seemed to be themes, methods, ways to invest. So a little more attention

on factor-based investing just might be that next new thing. Now that being said, factors themselves aren't necessarily new. Maybe the general broader awareness is new, but factor investing isn't. I mean, if we think about, you know, the CAPM has a 50 some odd year, you know, history. And as small and value and momentum have been developed over time, the groundswell has now come to the place where it's a little more broadly known in the practitioner community. The other way to think about that is how it gets implemented. On one hand, it can be all the things that you just mentioned prior. But if we think about the rise of the ETF industry over the past 15 years or so,

a lot of that has been predicated on factor-based investing. I mentioned earlier, it's this idea of being able to use market cap-weighted index pieces to build an active strategy. Well, if I start with Jerry running total market index fund, but I say, well, I like the idea of a value factor or a small factor. I can be a do it myself investor and I can say, well, let's go get Vanguard Small Cap Value Index Fund and I can add a value tilt as defined by crisp or as defined by Russell or whatever the case may be. Or maybe I choose to go get what we would call an actively managed value factor product.

So there's this broad landscape of factors and then there's the how you implement it. I have the pieces to do it myself based upon certain index providers definition, or maybe I outsource it to somebody who's running a factor fund in an active sense. I find interesting is that if you look at firms that offer a growth and a value offering, more often than not, the value of the assets and the value strategy dwarf the growth. I think on the back of, you know, if I'm a French research in the early 90s and this idea that value outperforms, and of course, markets are much harder than that, you know, as soon as something like that as identified.

If it persists at all, it's probably going to persist in a lumpier fashion or a smaller excess return into the future. I'm curious how you both are personally invested. If you don't mind my asking, we can cut this out if you're not comfortable. And maybe even as granular as total market fund versus ETF. I think when I started at Vanguard, I started off entry-level position at Vanguard, and I have some legacy dollars in funds that I probably, if I was looking today, I was like, why did you ever do that? But I keep it relatively simple. I think all of my investments are maybe in five

different funds. And some of them are the, well, most of them are broad mark, whether it's total stock, total international, total bond. They would be, I think, three of the funds that most, and all of my investments are at Vanguard. I actually do not have any ETF exposure. It's all in long-term mutual funds. Does Vanguard have a total, not just total stock market, but total global market across asset classes, passive portfolio, meaning like just representing, you know, an equal weight of bond, stocks, everything? On the equity side, we have a total market index market. It's interesting why everyone talks about 6040, right, as the perfect portfolio, but there's no such, I can't find one of these things anywhere. And I was curious to see that the derivation of that

balance was that at the time, this was in a William Bernstein paper that someone sent me, at the time, that was the actual total market. The market was 60% stocks, 40% bonds. It's obviously a lot more bonds now with so much issuance from sovereign governments. But maybe an interesting product idea. I think the 60-40 portfolio that costs, you know, five basis points or whatever Vanguard would offer it for. It brings up a very interesting point when you think about how do you construct portfolios. And too many times we end up with conversations where investors might think their biggest risk control metrics are in the sub asset class space or, you know, stock selection. And when it comes to how do you control the risk return parameters of your portfolio?

Far and away your stock bond choice, assuming they are diversified positions, right? You're not picking one bond in one stock. But assuming you have reasonably diversified portfolios, that's the most, I don't want to talk in absolutes, but I'll say that's the most unique decision any investor can make. For me, how much in stock and how much in bond. So for anybody whose risk tolerance is 80, 20, 60, 40, whatever it is, that is the most powerful risk return decision you can make building the portfolio. Then we at Vanguard would say, look, given you've made a stock decision, right, we are, we have a reasonable belief set in how we split domestic and international.

And given you have the fixed income allocation, the same thing applies. And maybe more so in the equity space, because we recognize investors. have home bias in their portfolios, and there are real reasons for that. You know, you think about how much of a domestic allocation I should have because I, as investors, I have to save and pay my bills in U.S. dollars. So, and that goes for investors around the world. They have to save and pay their bills in their domestic home currency. So there are reasons why investors will have levels of home bias.

But again, the bigger picture to tie that back is the stock bond decision is arguably the biggest one an investor can make. Jerry, you said you have no money in the ETFs. From the perspective of an investor out there that says, okay, I want total market fund, and I've got VTI or I don't know, I can't remember the symbol for the fund. I looked at the fund docs and there's something like 112 billion of unrealized gains in the fund. And obviously, the ETFs have this amazing tax advantage. Do you think that that tax advantage is significant enough for prospective investors to choose VTI, the ETF, over the fund? I would say that there are, and certainly the ETF mechanism has advantages in that fund,

but I would also say that in terms of just the fund itself, you know, every week we are fully aware of where we stand in the fund in terms of potential gains, what the losses are in the fund. So there is some, you know, there's definitely an awareness on the portfolio management side is that what we're looking at within the funds. Now, for every stock that we've bought at 20 bucks that's gone to 100, unfortunately, there's those stocks that we've bought at, you know, at 30 or 40 bucks that have gone to bankruptcy.

So to the extent, you know, there is an ability at the fund level to look at tax harvesting when it's prudent to do so in a risk-controlled manner. But, you know, our ETAF is another share class of the fund. So it's the extent that there is ETA activity in there, that can be beneficial to the fund. as well. In a scenario where in the future, let's say, demographically driven, there's outflows because the flow chart has looked like this. So there really hasn't been that term. But let's say there's a bear market and boomers are all, you know, retired in selling down equities.

How in that scenario where there are, let's say, net outflows, very specifically, like, how would taxes be managed? Is it lot by lot? Is there some piece of technology that kind of tells you how to best produce after tax returns in the fund? Yeah. I was going to say, I'm going to hit it first from the many investors probably want to start with the active index thought around this, right? And they hear the glitz and the glamour around tax efficiency and ETFs. And I would argue the tax efficiency comes from the indexing strategy first and foremost, and that the overwhelming benefits are because of indexing, not because of ETF. So just maybe to start at that place, I think is really important for investors to understand.

Sure. And I would say to get to get back to your point, Patrick, as we work very closely with our fund accounting group to determine, you know, where we are in the funds. And then we have tools available to us on the desk that allow us to basically, you know, if potentially we're looking at tax harvesting, what is the most efficient way to do that? What type of tax loss should we be signaling in order to get the biggest bang for the buck?

So you could have potentially a relatively small notional value, that you need to trade that could potentially, you know, generate large tax savings. So we're all the time tweaking that, but we're very much aware of it on the desk. And there are people that kind of specialize in that area too. You have to each pick a favorite component of each of your jobs. What would it be? I get to do lots of different things. I think it was what makes it most fun.

You know, in our investment strategy group, we like to say we're responsible for answering the question. What does Vanguard think about any number of investors? topics. I get to do that in written form. It's been the thrill of the lifetime to be published in the spring 2015 edition of the Journal of Portfolio Management. You know, getting an acceptance letter from Frank Fibosi was better than a college acceptance letter. But if you sit, you know, in one angle, that's, you know, a very formal published piece in a journal. What was the paper? The ins and outs of index tracking. Sort of linking what characteristics help explain how well index funds track their indexes. You know, the other end of the spectrum is I get to

write dopey, witty, sarcastic blogs where three paragraphs in a picture is a really challenging way to get a point across. I get to go out in the road and speak at conferences in front of two or 300 people at a time. So, you know, I have leadership positions where, you know, I work with others around here. So just the idea of I get, I get to have a well-rounded athletes way to do the job and not necessarily a particular position for me is what keeps me really engaged and motivated. I would say, Patrick, on my side, it's on the trading desk, you are, you see. You talked about the cash flows coming in earlier.

So you kind of have a front row seat of what's going on in the business. And just knowing that you have some small part to play in helping people, whether it's for their retirement, getting their kids through college, there's incredible satisfaction out of that. It just makes you feel like if you have it a tough day and you're on the way home, you feel good about the fact that you're helping people, whatever it is, those life, you know, challenges that come along the way that you're involved in that. And the people that I work with on the desk are just second to none. So that's the part that I enjoy.

Tell me about your most memorable day, individual day, I think. My most memorable day is actually not a good day. My most memorable day was 9-11. That was very, very difficult because we lost some brokers that we actually traded with, the guys that we spoke with on a daily basis. And we just had the anniversary just a few weeks ago. And I think it's still raw. It's still raw when I think about, you know, those people that we lost.

We had some very good friends, very good colleagues that we worked with at Kenner Fitzgerald, that I would say there wasn't a day go by that we didn't speak to at least one of them. And so that and just the whole way that that day played out was just something I will never forget. And it's, you know, Eve, I'm not sure I ever will forget it. I know there was, you know, just I think for the next four or five days after that event, I'm not sure I slept the wink. And I know the guys who've been on the desk a while, they'd probably say that that's a day they'll never forget either.

Now, that obviously was a very tough day, but there are so many great days here at Vanguard that are, you know, they're good too, but if you're asking me, what's the day? I'll remember most. I mean, the look on Gus's face when he saw that the towers were coming down, that I will never forget. And just people just realizing the enormity of what was going on. Yeah, I remember, as everyone does, you know, exactly where I was sitting, how I heard.

Yes. First picture. I remember what the TV looked like, right? And the answer, well, of course, was a horrible day, reminds me of an earlier point, which was this idea. of tenure and knowing some of these people for so long. And it's a great example for me, at least, and thanks for the great answer,

of how important it is to work with people that you care about, that you love, maybe, and who you share good and very, very bad experiences with. So certainly an unbelievably bad day, and the 15-year anniversary is tough. Yeah. How about you, Jim? Most memorable day.

I probably have a couple memorable days where I've helped some, you know, crew members get to places here in the company that, you know, have been their dream job or they didn't think they had a shot at it or, you know, you had to work your way around to get them in places where maybe they were too shy to speak up and say they wanted to get to. And I could drop names, but I'll leave that aside. And maybe say it goes to what makes the job so fun is, you know, if I speak at conferences or I meet with our clients,

there's nothing more satisfying or beneficial than when you have a conversation or you have a presentation. They say, Jim, that was great. Thank you so much. That was so beneficial. I didn't understand that before, but I get it now. And if that's my self-representing Vanguard, and that's the impression they get walking away from what Vanguard means or how Vanguard is trying to help them succeed, you know, what Jerry alluded to. That's a great feeling every day to think that you made something click with somebody and they get to go back to their desk and help their clients. or they get to go back to their house in their portfolios,

that's a pretty good feeling. And if you get that once a week, that's a pretty good week. So I've been asking this question, which is an interesting question, I think, because one day is so specific. And I'm amazed at how often another version of the question is, and maybe I'd love to hear your answers, the kindest thing that anyone has ever done for you in your career. So you're talking about a kindness for others,

where very often the answer is one of integration. some sort of like out of the way to integrate someone into something else that you didn't need to. So what do you think about that question? If you had to think about the kindest thing that someone's done for you. Wow. Boy, that's the enormity of that. Honestly, I'm not even sure how I could handle. Too bad.

Yeah. If I said I'm not where I am today without a help from a lot of different people, I'm not sure I could honestly even pick one. Fair enough. Yeah, I think the same, like Patrick, I just think of the, you know, we will sometimes have interns that'll come through and ask for some career guidance. And, you know, I remember one time I was asked the question, like, what do I need to be due to be in your seat in 10 years? And I thought about it. And it's like, there are so many people that did great things for me along the way that I, it's impossible for me to say, if you follow this roadmap, you're going to end up in this seat in 10 years. time. Whether it's coaches that instilled in me certain work ethics, whether it's, you know,

getting, Gus probably taken a little bit of a leap in terms of a belief that I could do the job initially. People along the way, just great mentors, great, great people to work with, Mike Bukoi work with on the desk, there's probably nobody more knowledgeable about market structure and trading and I sit three feet away from him. I don't need to call up anybody. I just say, Mike, look at this situation. What do you think? You know, phenomenal. person mentor to kind of have working with you. So I think Jim and I are both beneficiaries of a lot of people within Vanguard who've been like that. And, you know, one of the one of the competencies that's really valued here, I think, at Vanguard is, you know, how are you when it comes to developing

other people? And so it's something that people really kind of take seriously. And I know we have younger traders on the desk and that's something that every one of them are senior traders is always trying to make sure that these people know everything that you can possibly pass on to them to help them, you know, grow their career. And it's something that it definitely is something that's taken seriously. And we've both been great beneficiaries of it. Yeah, that's great. It definitely seems like a component of the culture, which a lot for a lot of people. I would agree. So my first love is reading. And I ask this question of everyone very selfishly in search of great new books. If you could pick one or two, well,

call them formative books, books that shape the way you think, or that you just, you know, enjoy it and always think back on with, I'll say, extra points for a book that's not obvious. So everyone keeps telling me, read Thinking Fast and Slow by Danny Kenamon, which is a great, great book, but it's on every bestseller list. So any favorite or formative books? You know who I love to follow? And, you know, I've read a couple books and follow his blogs as Dan Ariely, the professor at Duke. So predictably irrational is a wonderful book because obviously as a behavioral economist by trade who delves into psychology.

His writing is not for the books. It's not above anybody's head. He writes in very simple terms, easy to understand, gives you follow-ups and whether or not it's from an investing perspective or I go out to dinner and think, I'm about to order a meal. What did Dan's experiments tell me about what I'm about to do? And you placement and everything, yeah. You know, you get a real sense of I could apply this to a work setting. I mean, maybe there is a takeaway or I just think, what am I doing on a daily basis that what I've read about is subliminally impacting my decisions and how I handle myself. So I do appreciate any reading that gets me outside of investing because I think it kind of spurs the creativity or the other side of your brain that maybe always isn't applied and sometimes an overly numeric fashion.

But, yeah, if I had to pick one, I'll go with predictably irrationals. I've read quite a few of the Malcolm Gladwell books. I think initially someone had put me on to him because, hey, this guy used to be a runner. And that was the initial. He's a good runner. Yeah, he's a good runner. I think he's a master's competitor now. Yeah, he is.

And quite good at it. And he may have actually spoken, I think, at one or two Vanguard events back in the day. But I've also, you know, I like some of the lighthearted stuff on the desk. If somebody has a good experience with a book, I remember back when Freakonomics came out, everyone was like, hey, guess what? And then what do you think what will happen? or whether it's realtor selling their own homes or whatever the case may be. You know, obviously with the whole IEX coming along, we have known Brad and Ronan when they were brokers at RBC.

And so when that book came out and 60 Minutes of Michael Lewis, that was one that we knew a lot about what they were talking about. So that was a book that I think pretty much everybody on the desk has read. Last couple of questions. what is the area that you're most interested in in improving upon or exploring in markets in the future that maybe you haven't maybe you've already gone started to go down the path but haven't haven't mastered or felt that there is room for exploration and discovery or improvement if you want to think about it in those terms well i think in in in broad terms i think uh you know a lot of vanguard's growth has been here in the u.s and on the et f and the mutual fund side but i think as we look the next 10 15 years down the the road, I think it's going to be on the global side. And whether that's, you know, Canada, Europe or Asia PAC, I think there's, I think there's a framework in place now that probably wasn't in place 15 years ago to really grow Vanguard, Vanguard's brand overseas. So I think you're going to see a lot on the global side. I've been amazed how different, even the Canadian market,

let's say we do a lot of work up in Canada, how equities and corporate culture is different, how the level of indexation can be drastically different. For example, in Canada, that's very low. Closet indexing is very high. In Europe, you know, dividends are favored over buybacks, all these different things that affect things. So it would be interesting to see a company that's focused so much on U.S. markets really get its feet wet elsewhere.

Yeah, I think that would you agree, Jim, over the next decade or so? I think that's the, you know, if you said topically speaking and to whom you're reaching out to, outside these borders is where that's headed. Go global. It is go global. Wonderful. This has been a blast. Really appreciate all the time and I think some insight into how things work around here. I think people think index fund and they think, okay, it just works, right? And obviously it's a lot more complicated than that. So really appreciate your time talking about Vanguard and about markets. Thank you, Patrick. Thank you, Patrick. Thank you. Pleasure.

Hey, everyone. Patrick here again. To find more episodes of Invest like the Best, go to Invent. investor field guide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter at Patrick underscore Oshag, OSHAG. If you enjoy the show, please leave a quick review for us on iTunes, which will help

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