Introduction

Patrick: [00:00:46] My guests today are Gerry O'Reilly and Jim Rowley. Gerry 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 investment 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/vanguard. Now, please enjoy my conversation with Gerry O'Reilly and Jim Rowley. Hello Jim and Gerry. 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 minutiae that we'll get into around index investing and Vanguard's active 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, you can see where this is going and looked up with the last name O'Shaughnessy all of the Irishman 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, Gerry had, I think the third fastest time at... certainly at Villanova, but some four-minute mile. I'd love to hear, just tell me a little bit about the first time you did it.

Gerry: [00:02:12] Okay. I had been knocking on the door of four-minute miles for my sophomore year in college. Just for whatever reason, at 4.001, four-point two-tenths of a second just never quite got there. At the end of my sophomore year, a little disappointed and then went into my junior year and figured, okay, this year it's going to happen and trained as I'd never trained before. When I got the opportunity, I actually went from, instead of running 3:59 or 3:58, I actually went from a four-minute miler to a 3:54 miler. I took almost six seconds off my personal best in one race. That was, I think just... I think the fact that I didn't have success in my sophomore year in terms of breaking, made me more determined. That's kind of was the fodder for breaking it.

Patrick: [00:03:04] At what stage did you figure out... I'm assuming you started running relatively young?

Gerry: [00:03:08] Yeah.

Patrick: [00:03:08] At what stage did it become apparent like, oh, okay, I've got something interesting going on here?

Gerry: [00:03:13] I think I was probably... 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 Gaelic football, soccer, and running and that was kind of it. 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, I actually have something going on here where I tend to be able to keep going when other kids start blowing up. I just said, "This is maybe something I should stick with."

Patrick: [00:03:46] There's a thread there that I'm interested in a quote that I pulled up here from Shoe Dog, which was Bill Bowerman, I think they 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 crazy but a lot of people said that actually is what you do.

Gerry: [00:04:09] Yeah. I mean, when you're running four minutes, at no point are you taking it easy. It's 50 miles an hour on the treadmill, I mean. Yeah, it's cranking. 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 were, 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.

Patrick: [00:04:45] 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.

Gerry: [00:04:53] Yeah, it is. Absolutely. I mean, and overcoming that, 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.

Patrick: [00:05:03] Was your last major running experience the Olympics in '88?

Gerry: [00:05:06] Yeah. I mean, I ran for a few years later. I think it got to a point where, if you are 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. At some point, 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. I was fortunate enough to have a competitor I used to run against who was working at Vanguard, Jim Norris and Jim said, "I'll drop your resume off." That was almost 25 years ago. I thought I'd be here for a few years and here we are 25 years later.

Patrick: [00:05:43] How about you, Jim? How did you get started at Vanguard?

Jim: [00:05:45] I'm a little bit of an oddity, I think because I've been around the block where, you have a lot of crew members here as everybody's referred to, who have been here for very long periods of time. Like you and I discussed before we went on air here was, I actually started out as an English tutor in a boarding home in Germany. I made my way back to the US 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. I'll put in for Jerry as well here, as well. I got us back to this area and she could start going back to work. After a couple of years, I just started making my networking and connections and found my way into Vanguard and that was 10 years ago. 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 Vanguard Culture

Patrick: [00:07:04] The length of tenures is something that's on the decline. The average time people spend with a firm is coming down across industries and 25 years and 10 years and I would say at other really great firms that we work with, where there's the same tenure, long tenure tends to be a characteristic. It always comes back to culture. I think Vanguard, rightly so has a reputation for a great culture. Maybe the two things it's gotten most right is the original setup, where the funds own the firm and the culture. 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.

Jim: [00:07:48] I'll start, only because I do my fair share of interviewing for the HR department. They'll ask us to do the recruiting or when students coming off from outside on the campus and they'll say, "Hey Jim, what might nobody explain to me that helps somebody success at Vanguard?" I'll say, "Look, there are far more successful people than I am here." But two rules that will serve you 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?" 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. 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. We improved engagement. We improve success ratios, but your successes are determined as a team, as we. If you start a sentence with I, I did this, it gets noticed and not in the right way. I feel very good about saying that we do look out for the interest of our shareholders and it is very much a team environment.

Patrick: [00:08:55] Such a simple heuristic and something easy to say, but probably hard to do year after year. What do you think Gerry?

Gerry: [00:09:01] Well, I mean, and this may sound a little corny too, but I have interns come in and they talk about what makes Vanguard different. 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 the minority. I live out in a neighborhood where I talk to other people who are involved in other businesses, and I think that's not normal. I think the reason I look forward to coming in is, the people I work with, incredibly team-oriented, as Jim mentioned, just a great environment. I mean, they're not only colleagues, but they're also good friends away from work. We socialize together. I think the fact that you are involved in an area that can be quite stressful and at times you do tend to bond together. That, I think just is great. If you can work at a place where you enjoy actually coming in here and spending time here, it's fantastic and Vanguard has actually managed to create that. The groups that I interact with, it's a lot of what Jim mentioned. It's not the I, it's we, and it's 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, "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 playing together, and you can achieve incredible things." That type of environment is alive and well here at Vanguard. 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 who your parents know. It's, what kind of job are you going to do here and you'll have opportunities here, which is great."

Patrick: [00:10:39] Yes, so the idea of a mutual is pervasive?

Gerry: [00:10:41] Yes. It is. It really is. Yeah.

What Does an Equilibrium Look Like?

Patrick: [00:10:43] 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 in every single meeting with advisors, with clients, with institutions is this active-passive debate. What I'm most interested in is, not so much who's right, because I think the answer is, obviously we need both. The more interesting question is, what does an equilibrium look like? What is the transition from now until that point look like? How a firm like Vanguard, which owns, I think today is six and a half percent of Apple, there's going to be a 13 D for conceivably every security in the universe, in the not too distant future. I think for passive investors it's not the 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. 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, or from 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, past which, we're either sniffing that equilibrium or tracking your restart to rise in the total market fund versus the reference index? What do you think about this whole debate and transition period?

Gerry: [00:12:15] I mean, I think if you step back a little bit, 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 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... Small caps have always been difficult to trade. I would say what's different today is the fact that, even though we've had large assets coming into our funds, one of the great things about indexes is that there tends to be little turnover. While the assets and the funds themselves are huge, the re-balances tend to be... 5% turnover in a year is around the norm, so it tends to be little in the way of turnover. Even when we have re-balances, relative to the size of the firm, they're not huge. Now, having said that, there is still a lot of trading that needs to be done. I would like to think that the traders on our desk are very much aware of the trade-off between tracking error versus impact. Obviously, there are certain names and you mentioned 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 an impact. 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 benchmarked 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 there's not the issue in there. But there's no question on the bottom decile names. It is a challenge. I'd like to think that over the years, we've accumulated some expertise with regards to trading those names without singing out to the market that I'm out here as a buyer, whether it's using algos, crossing networks, or whatever the case may be.

Small caps have always been difficult to trade. I would say what's different today is the fact that, even though we've had large assets coming into our funds, one of the great things about indexes is that there tends to be little turnover. While the assets and the funds themselves are huge, the re-balances tend to be... 5% turnover in a year is around the norm, so it tends to be little in the way of turnover. Even when we have re-balances, relative to the size of the firm, they're not huge

Patrick: [00:14:21] If I said to you, in the next two years you're going to quadruple in size in the total market fund, you're going to go to two trillion, what face would you make?

Gerry: [00:14:30] Yeah, I mean, 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-

Patrick: [00:14:45] Not if you have been in some of the meetings I've been in.

Gerry: [00:14:47] Yeah. But I would say, there's always going to be a challenge with trading those smaller micro-cap type names. The good thing, I guess, from the fund point of view is that they represent a relatively small portion of the overall fund and so they're... to the extent that they're difficult, they do a relatively small in the overall context.

Jim: [00:15:04] Patrick I was going to say, you brought an interesting point at the outset, just looking at the definition of indexing and the amount of the impact it's had on the marketplace. The one thing I think is very interesting for investors to pause and think about is, you say there's X amount of cash flows going to indexing or Y% of assets or an index funds, we think about the definition of an index fund. That includes all these non-market cap-weighted index products, which are active strategies. 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 the cash flows are proportionally more going into small-cap value funds, or mid-cap growth funds that are not the proportion of the total market. 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.

Patrick: [00:16:12] Yeah. It seems like the only true, probably the total market fund or something close to it, everything is the only true passive approach. You see the stat now, that there are more large-cap indexes than large-cap stocks, which is some sorcery, I think behind a lot of that. I believe that Vanguard uses CRSP now, CRSPs 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?

Gerry: [00:16:46] 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, CRSP has been around, I think, 90 odd years studying indexes and providing that type of information. There is something to be said for, an arm's length between us, the manager, and the index provider. But having said that, we're always in touch with index providers in terms of how to better improve their index methodology. I think back to when I started, there was no such thing as float adjustment. You potentially could have had a name that had a hundred million shares outstanding, but insiders would have owned 70 million shares. You have all these managers trying to track, go after these 30 million shares and it led to pretty severe 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. It's really just the, what's available to us in 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 is... A lot of times there is an 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, 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 at an arm's length.

Patrick: [00:18:11] Very interesting. I think one of the next issues that come 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 build proxies and they had to follow a formula because they don't have the scale to actually evaluate decisions. Famously they said that Coca-Cola shareholders should withhold votes from Warren Buffet. The joke was that apparently one of their checklist items was, is he the greatest capital allocator of all time? How does Vanguard think about this big and growing issue where, if they use that extreme example, again, you're going to own 20% or more of pretty much every stock, publicly-traded stock? How does the... Is there a group behind it? How does that work? Any mechanics there would be really interesting to hear about.

Jim: [00:19:04] The simple way to think about that is, I mean, we do have a corporate governance group at Vanguard that is engaged in these matters. I think depending upon what you see in the press, you have almost this litmus test that says, oh, percentage of times firm votes with or not with management is the litmus test in terms of how active or how engaged they are. I think the way we might look at it is, that's not necessarily the only way a firm or an asset manager can go about corporate governance. 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.

Patrick: [00:19:44] Will it be a group that keeps growing, do you think? Will grow in a linear fashion with Vanguard's own size?

Jim: [00:19:50] We thought about that, both Gerry and I are investment management group people, so I don't have too much insight in terms of other business units in the company.

Patrick: [00:19:57] Yeah. Yeah. Fair enough.

Gerry: [00:19:58] I would say Patrick though, we will get calls on the desk 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. 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.

Skill Sets to Look Out For When Hiring an Analyst

Patrick: [00:20:17] What are the skill sets that, let's say I was hiring someone to be an analyst at an active shop who might have skills in the quantitative arena, or as a fundamental analyst, 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 minimizing the difference between after-cost funds versus the index, what is the skillset that you're after?

Gerry: [00:20:41] 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, probably have an average tenure of about 13 years. We have some guys who've been on the desk close to the 30, so we've got a good combination there. The things that we look for are a couple of things. We look for people that are passionate about the markets, that absolutely 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 everybody needs to be aware of. The ability to work with other groups, specifically, I would say if you looked at our desk today and looked at it 20 years ago, a 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 and baking it into our trading strategies. Also, I would say the ability to work with our risk areas. We have an investment risk group that allows us to trade large re-balances 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. Obviously, individuals would need to have pretty useful skills when it comes to just technology skills, use a lot of different systems, understanding market structure. As I mentioned earlier, 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? We also have the ability to work in teams and groups and understanding that, you are a contributor but ultimately, it's the desk and it's Vanguard that's ultimately important.

Patrick: [00:22:35] You mentioned two terms I want to flesh out a little bit there, risk, and market structure. 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.

Gerry: [00:22:45] Yeah.

Patrick: [00:22:46] What dimensions of risk are you mentioning?

Gerry: [00:22:48] We would be referring to risk. If we have, for example, large trade coming up, we would be looking at that trade relative, what type of tracking error would you be looking at relative to the benchmark? As you have rebounds coming up, say at the end of a month, there are obvious names that are going to be added to the index names that are going to be deleted to the index. You look at basically, hey, how has this trade looking relative to the current index? As you, obviously, you can't trade the entire rebalance in the last hour of the day, you could certainly match your benchmark, but you're probably going to have an impact that you'd rather not have. To the extent that you're going to start to trade some names early, you need to know what type of risk that is to the portfolio. 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.

Patrick: [00:23:38] Then the second being market structure. You said that, if you had a pen and paper, maybe you'd draw it up a little bit differently.

Gerry: [00:23:44] Yeah.

Patrick: [00:23:45] Flesh that out a little bit. What are some aspects that are subpar?

Gerry: [00:23:48] Yeah, well, I mean it's a very fragmented market. I mean, and anytime it's a... you have, as I said, 13 exchanges right now, and understanding 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. 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. We're fortunate that our TCA group, live and die by understanding that venue analysis. 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. If there are results that we're seeing that we don't think are optimal, we're going to have a conversation with the broker and say, "We noticed that on this particularly when we use this, we're seeing quite a bit of adverse selection going on in these names. Can you give us any color as to what's going on?" 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.

Patrick: [00:25:08] Yeah, makes sense. We've talked mostly about passive, of course, Vanguard has a trillion dollars of active assets. It seems unassailable that Vanguard's 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?

Jim: [00:25:42] It was probably three things if you were an investor saying, how would I go about building my portfolio? Three quick things to think about, the cost is unavoidable so I'm going to mention that, but we would say talent, costs, and patience. Granted, talent is a very qualitative, tough- Yeah, and it's very tough to get around, 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. Maybe that's a bit of the art component here that goes with the science because the science components are costs and this is relevant to whether you're an index fund or an active fund. Every basis point of cost is a basis point in return you don't get. 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 on a relative scale, even on the indexing side. The third thing I would tell you is patience. Most successful active managers are successful because they have longer track records and maybe that success is achieved over longer periods of time. 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 don't have the patience anymore, you don't realize that long term track record. Talent, cost, patience maybe three quick guides that investors can think about when they go through the active manager search.

Most successful active managers are successful because they have longer track records and maybe that success is achieved over longer periods of time. 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.

Are Markets Efficient?

Patrick: [00:27:19] 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, 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.

Jim: [00:27:49] I think I can start with the more academic, how we talk to investors and maybe Gerry can talk about actually trading securities-

Patrick: [00:27:54] Yeah, being in the market.

Jim: [00:27:55] Yeah, being in the market. I always 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 Sharpe'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. 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?" To try and make a little bit of a lighthearted discussion I'll say, "Hey, for every genius who correctly identifies an undervalued stock, there's some not so the genius 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 relative winner trade, that same dollar is a relative loser trade for somebody else." When we put efficiency into that active-passive context, 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.

Patrick: [00:29:14] Fair enough.

Gerry: [00:29:15] I would say, Patrick, on the trading side, I mean, price discovery, I think has never... I'm always amazed at just how quickly in today's market, 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. It's amazing to me, a name will get halted and for whatever reason, and that thing is, once they open that up, it's up and running in size and it seems like it's not an issue to get these stocks back up and running again. I'm amazed at the speed of it. I think there are times when it's, somewhat when you're dealing may be in the one issued market, occasionally you've probably seen it yourself where there are 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. To the extent even with IPOs, it is amazing how quickly that whole process can get up and running once you have an IPO price as well.

Patrick: [00:30:11] The word speed makes me think of high-frequency trading. If you think of HFT 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?

Gerry: [00:30:26] 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... the high-frequency trading firms that are ebbing out between futures ETFs and the cash they keep in markets to the same 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 HFT space that are looking to take advantage of, whether it's latency arb issues, looking to take advantage of potentially sniff out larger orders that may be out there so that they can jump in front of that. 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. 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 orders. 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.

Patrick: [00:31:47] Anything to add on high-frequency Jim?

Jim: [00:31:49] I'll leave that to him, he's the one that deals with it every day.

Patrick: [00:31:51] Sure, sure. Fair enough. One of the things that I'm most interested in is the quarterly rebalance versus daily trading. Obviously, there's a lot that goes on in markets and there's a corporate action, there are secondary issuances, there are buybacks.

Gerry: [00:32:07] Yes.

Patrick: [00:32:08] I know that a lot gets bundled into the quarterly rebalance. Maybe start by telling me what happens quarterly, and then we can go from there

Gerry: [00:32:15] Yeah. Maybe just a two-second overview of index methodology. For most index providers the line is 5%. If a company issue shares of over 5%, that tends to be done the following day. Company A is buying company B and is going to issue 6% of its shares outstanding. That change will generally hit the index the following day. If it's less than 5%, they group them all up together and as you pointed out, they wait until the end of the quarter to do that trade. You're right in that, as we own so many names, it's not unusual at 10 after 4:00 in the afternoon, to get multiple calls from syndicate offerings that are going on. They may be issuing stock to pay off debt, they may be acquiring another company, whatever the case may be. To the extent that our index providers are going to be making the change the next day, we will participate to some extent in those, assuming that we feel that they're priced right and that the environment is good. We have those going on all the time. The quarterly rebounds are, depending on the index provider, those are trades that are, they're known to everybody out there in the market. 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 new index constituents are, what changes are going to be. Then we will set about putting a plan in place. We have a group within the desk, actually, that is a rebalance group that basically looks at these, they would have a history going back as far as we've been doing these about how certain names have worked. We incorporate all of that into how we handle re-balances. Now, as I mentioned earlier, it's a lot of dollars, but 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 re-balances are done in a risk-controlled way.

Patrick: [00:34:12] The 5%, I didn't know that threshold specifically was a good rule of thumb. What about the buybacks side of the equation? It's a huge issue, interesting issue these days where there's a lot of these corporate cannibals as they call them and sometimes you'll see a firm buy back 10% of its shares in a month or something really aggressive like that, but certainly, buybacks happening all the time.

Gerry: [00:34:33] Sure.

Patrick: [00:34:34] How's the flip side of the coin?

Gerry: [00:34:35] 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. Obviously when a company is buying back, that it's going to have an implication for the float on the fund that was available to shareholders. Generally, we are, if a company is buying back shares, we are going to be selling. Yes, absolutely. It's the same type of rigorous controls that are in place, whether it's on the sell-side or on the buy-side.

Patrick: [00:35:02] Yeah. I think that's a really interesting dynamic here with such a rise in these issuances and especially buybacks, where there are 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. Then the companies knowing that indexes will act a certain way, whether they're issuing or buying back is certainly an interesting kind of game.

Gerry: [00:35:30] 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 mean, I think they are obviously doing it for much more meaningful reasons.

Patrick: [00:35:47] Yeah. I think 90 whatever percent of the time that's true. When I talked to a guest on the show, Michael Mauboussin, one of the camps that he has for buyback motivations is the impure motive camps, he calls it. Hopefully, that's a small minority, but knowing what we know about markets, it's not a zero, it's not a 0% minority.

Gerry: [00:36:08] I will say this, that a lot of the... whether it's on the buy-side or on the sell side, during large re-balances, 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. Whether it's a company that's in buyback mode and knows that indexes are going to be selling, I can't tell you the number of times that you've looked. 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." A lot of times I'm surprised that there's actually little movement in these names.

The Rise of Factor Investing

Patrick: [00:36:50] Jim what do you make of the rise of factor investing as the theme of the day where we'll call pure indexing. Let's forget all the different definitions of indexing for a minute and 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 vol 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?

Jim: [00:37:27] Number one thing about is, it's the next wave of active management. I mean, if we went back and maybe did a bit of a historical review of active, there's always seemed to be themes, methods, ways to invest. 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, the cap M has a ---- 50 some odd year 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 Gerry 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 CRSP 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. There's this broad landscape of factors and then there's the how you implement it, where I have the pieces to do it myself based upon certain next provider's definition, or maybe I outsource it to somebody who's running a factor fund in an active sense.

Patrick: [00:39:17] What I find interesting is that, if you look at firms that offer 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 Fama/French research in the early '90s, and this idea that value outperforms and of course markets are much harder than that. As soon as something like that is identified, if it persists at all, it's probably going to persist in a lumpier fashion or a smaller excess return in the future. I'm curious how you both are personally invested. If you don't mind my asking and we can cut this out if you're not comfortable, but and maybe even as granular as total market fund versus ETF.

Gerry: [00:39:57] 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... All of my investments are at Vanguard. I actually do not have any ETF exposure. It's all in long-term mutual funds.

Patrick: [00:40:31] Does Vanguard have a... not just total stock market, but total global market across asset classes, passive portfolio? Meaning like just representing an equal weight of bond, stocks, everything.

Jim: [00:40:44] On the equity side, we have a total market, total everything global.

Gerry: [00:40:48] Yeah.

Patrick: [00:40:48] It's interesting why everyone talks about 60, 40 as the perfect portfolio, but there's no such... I can't find one of these things anywhere. 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 five basis points or whatever Vanguard would offer it for.

Jim: [00:41:23] It brings up a very interesting point when you think about how do you construct portfolios? 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 stock selection. When it comes to, how do you control the risk-return parameters of your portfolio? Far and away from your stock-bond choice, assuming they are diversified positions, not picking one bond and 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 bonds. 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, 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." Maybe more so in the equity space, because we recognize investors have a home bias in their portfolios and there are real reasons for that. You think about how much of a domestic allocation I should have, because I as investors, have to save and pay my bills in US dollars, and that goes for investors around the world, they have to save and pay their bills and their domestic home currency. The 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.

Patrick: [00:42:57] Gerry you said you have no money in 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. 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?

Gerry: [00:43:27] 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, 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. There's definitely an awareness on the portfolio management side as to what we're looking at within the funds. Now, for every stock that we've bought at 20 bucks, that's gone to a hundred, unfortunately, there are those stocks that we've bought at 30 or 40 bucks that have gone to bankruptcy, so it's the extent, 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 our ETF is another share class of the fund. To the extent that there is ETF activity in there, that can be beneficial to the fund as well.

Patrick: [00:44:22] In a scenario where in the future, let's say demographically driven there are 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 retired and selling down equities. How in that scenario, where there, let's say net outflows, very specifically, how would taxes be managed? Is it a lot by lot? Is there some piece of technology that tells you how to best produce the after-tax returns in the fund?

Jim: [00:44:54] I was going to say, I'm going to hit it first from the many investors, probably going to start with the active index thought around this. They hear the glitz and the glamor on 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. Just maybe to start at that place, I think is really important for investors to understand.

Gerry: [00:45:20] Sure. I would say, to get back to your point, Patrick is, we work very closely with our fund accounting group to determine where we are in the funds. Then we have tools available to us on the desk that allow us to basically 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? You could have potentially a relatively small notional value that you need to trade that could potentially generate large tax savings. We're all the time tweaking that, but we're very much aware of it on the desk and there are people that specialize in that area too.

Favorite Component of the Job

Patrick: [00:46:02] You have to each pick a favorite component of each of your jobs, what would it be?

Jim: [00:46:07] I get to do lots of different things, I think is what makes it most fun. In our investment strategy group, we like to say we're responsible for answering the question, what does Vanguard think about any number of investment topics? I get to do that in a written form. It's been a thrill of a lifetime to be published in the spring 2015 edition of the Journal of Portfolio Management, getting an acceptance letter from Frank Fabozzi was better than a college acceptance letter. But if you sit... On one angle, that's a very formal published piece in a journal.

Patrick: [00:46:37] What was the paper?

Jim: [00:46:39] The Ins and Outs of Index Tracking, linking what characteristics help explain how well index funds track their indexes. The other end of the spectrum is, I get to write dopey, witty, sarcastic blogs, where three paragraphs and a picture is a really challenging way to get a point across. I get to go out on the road and speak at conferences in front of two or 300 people at a time. I have leadership positions where I work with others around here, so just the idea of, I get to have a well-rounded athlete's way to do the job and not necessarily a particular position, for me is what keeps me really engaged and motivated.

Gerry: [00:47:13] I would say, Patrick, on my side, it's on the trading desk. You see what you talked about, the cash flows coming in earlier. You 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 the retirement, getting their kids through college, there's incredible satisfaction out of that. It just, makes you feel like, if you're having 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 challenges that come along the way that you're involved in that. The people that I work with on the desk are just second to none. That's the part that I enjoy.

Patrick: [00:47:49] Tell me about your most memorable day, an individual day at Vanguard.

Gerry: [00:47:53] 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. 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 those people that we lost. We had some very good friends, very good colleagues that we worked with at Cantor Fitzgerald, that I would say there wasn't a day go by that we didn't speak to at least one of them. That and just the whole way that that day played out was something I will never forget. I'm not sure I ever will forget it. I know there was, just, I think for the next four or five days after that event, I'm not sure I slept a wink. I know the guys who've been on the desk a while, they'd probably say that that's the day they'll never forget either. Now, that obviously was a very tough day, but there were so many great days here at Vanguard that are... 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.

Patrick: [00:49:24] I remember as everyone does, exactly where I was sitting, how I heard, the first picture, first... I remember what the TV looked like. The answer, well, of course, it 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. 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. Certainly, an unbelievably bad day, and the 15 year anniversary was tough.

Gerry: [00:50:08] Yeah.

Patrick: [00:50:08] Yeah. How about you Jim, a most memorable day?

Jim: [00:50:12] I probably have a couple of memorable days where I've helped some crew members get to places here in the company that has been their dream job, or they didn't think they had a shot at it, or 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. I could drop names, but I'll leave that aside and maybe say, it goes to what makes the job so fun is 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 and 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." If that's myself representing Vanguard, and that's the impression they get walking away from what Vanguard means or how Vanguard is trying to help them succeed, what Gerry 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 and their portfolios, that's a pretty good feeling. If you get that once a week, that's a pretty good week.

Patrick: [00:51:15] 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 has been, maybe I would love to hear your answers, the kindest thing that anyone has ever done for you in your career. You're talking about kindness for others, where very often the answer is one of integration, some sort of out of the way to integrate someone into something else that you didn't need to. What do you think about that question? If you had to think about the kindest thing that someone has done for you?

Jim: [00:51:48] Wow. Boy. That's the enormity of that... I honestly, I'm not even sure how I could handle that. Yeah. If I said I'm not where I am today without the help from a lot of different people, I'm not sure I can honestly even pick one. That's-

Patrick: [00:52:06] Fair enough.

Gerry: [00:52:07] Yeah. I think the same. Patrick, I just think of the, we will sometimes have interns that'll come through and ask for some career guidance. I remember one time I was asked a question like, "What do I need to do to be in your seat in 10 years?" I thought about it and it's like, there are so many people that did great things for me along the way that it's impossible for me to say, if you follow this roadmap, you're going to end up in the seat in 10 years time. Whether it's coaches that instilled in me certain work ethics, whether it's Gus probably taking 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 people to work with. Mike Bucoy, I work with on the desk, there is probably nobody knows 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?" Phenomenal person, a mentor that you have working with you. I think Jim and I are both beneficiaries of a lot of people within Vanguard who've been like that. One of the competencies that are really valued here, I think at Vanguard is, how are you when it comes to developing other people? It's something that people really take seriously. I know we have younger traders on the desk and that's something that every one of the more senior traders is always trying to make sure that these people know everything that you can possibly pass on to them to help them grow their career. It's something that, it definitely is something that's taken seriously and we've both been great beneficiaries of it.

One of the competencies that is really valued here, I think at Vanguard is, how are you when it comes to developing other people? It's something that people really take seriously. I know we have younger traders on the desk and that's something that every one of the more senior traders is always trying to make sure that these people know everything that you can possibly pass on to them to help them grow their career.

Patrick: [00:53:47] Yeah. That's great. It definitely seems like a component of the culture, which we were talking about earlier.

Gerry: [00:53:51] I would agree. Yeah.

Patrick: [00:53:54] 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, we'll call them formative books, books that shape the way you think or that you just enjoyed and always think back on with, I'll say extra points for a book that's not obvious. Everyone keeps telling me to read Thinking Fast and Slow by Dan Kahneman, which is a great, great book, but it's on every bestseller list. Any favorite or formative books?

Jim: [00:54:24] You know who I love to follow and I've read a couple of books and follow his blogs is Dan Ariely.

Patrick: [00:54:30] Yeah, he's great.

Jim: [00:54:30] The professor at Duke. 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 do Dan's experiments tell me about what I'm about to do-

Patrick: [00:54:59] Like menu placement and everything? Yeah.

Jim: [00:55:01] You get a real sense of, I could apply this to a work setting. I mean, maybe there is a takeaway or 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? I do appreciate any reading that gets me outside of investing because I think it spurs the creativity or the other side of your brain that may be always isn't applied and sometimes in an overly numeric fashion. But yeah, if I had to pick one, I'll go with Predictably Irrational.

Gerry: [00:55:30] 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-

Patrick: [00:55:39] Yeah , he's a good runner.

Gerry: [00:55:40] Yeah. He's a good runner. I think he's a masters competitor now.

Patrick: [00:55:43] Yeah, he is. Yeah.

Gerry: [00:55:44] And quite good at it. He may have actually spoken, I think, at one or two Vanguard events back in the day, but I've also... I like some of the lighthearted stuff we'll... 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?" Then, "What do you think will happen here?" Whether it's realtor selling their own homes or whatever the case may be. 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. That was a book that I think pretty much everybody on the desk has read

Exploration of Markets in the Future

Patrick: [00:56:26] Last couple of questions. What is the area that you're most interested in improving upon or exploring in markets in the future that maybe you haven't? Maybe you've already started to go down the path, but 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.

Gerry: [00:56:46] Well, I think in broad terms, I think a lot of Vanguard's growth has been here in the US and on the ETF, the mutual fund side. But I think as we look at the next 10, 15 years down the road, I think it's going to be on the global side. Whether that's Canada, Europe, or Asia-Pac, I think there's a framework in place now that probably wasn't in place 15 years ago to really grow Vanguard's brand overseas. I think you're going to see a lot on the global side.

Patrick: [00:57:14] 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 are 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, dividends are favorite over buybacks, all these different things that affect things. It would be interesting to see a company that's focused so much on US markets really get its feet wet elsewhere.

Gerry: [00:57:42] Yeah, I think that... Would you agree Jim, over the next decade or so?

Jim: [00:57:46] I think that's... If you said, topically speaking and to whom you're reaching out to outside these borders is where that's headed.

Patrick: [00:57:55] Go global.

Jim: [00:57:56] Let's go global.

Patrick: [00:57:56] 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 funds and they think, "Okay, it just works," and obviously it's a lot more complicated than that. Really appreciate your time talking about Vanguard and about markets.

Jim: [00:58:13] Thank you, Patrick.

Gerry: [00:58:14] Thank you, Patrick.

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