The Vanguard Way: Serious Business

Rich Powers has been at Vanguard since the Clinton administration, and like much of the firm’s leadership, he has put his time in at all levels of the organization, from the phone bank to investment analysis. 

With so much focus on indexing, the role of bonds in a low-cost environment, and industry concentration, I sat down with Rich to pick his brain about how Vanguard’s approaching the current landscape. 

Dave Nadig, Director of Research, ETF Trends: Just because I’m curious, give me a little bit of your journey at Vanguard. Because you didn’t start in the ETF business, right? 

Rich Powers: I started at Vanguard 22 years ago, right out of college. It’s the only place I’ve ever worked. And I actually worked in our retail phone area. Clients would be calling up and want to open up an IRA or want to talk about the Wellington Fund (VWELX). I was the guy who picked up the line on the 1-800 number to help those clients out. 

But I knew I wanted to get deeper into the investment side of things. So I moved to our portfolio review group more than 18 years ago, and spent most of my time on our active funds. We have a large active franchise, and I had a responsibility for a lot of the relationships we have with Wellington. 

About six years ago I transitioned to this role, where I took over leading our ETF product team. Just in the last year, I’ve also added responsibility for our index mutual funds, so the whole beta franchise, from a product standpoint, that’s what my team and I are responsible for.

Nadig: You’d mentioned you started in a phone bank, and that’s obviously the apocryphal Vanguard story. Everybody works the phone bank, all that jazz. Vanguard has such a unique culture – do you think it would be possible for a firm like Vanguard to be started in today’s environment? 

Powers: Well, I think the structure is the really unique thing, and perhaps would be the biggest hurdle to overcome. An organization that’s owned by its funds, which is owned by its shareholders—that takes a certain type of a thinker, a selfless person, to do that. I wonder if that type of ethos is present today. And certainly, you have to think about the benefits of scale. For a small firm today to operate that way, given the incumbents and the size and cost at which they operate, I think it becomes a much harder hill to climb.

For us, there were these white spaces that no one cared about, that everyone was doubtful of. They gave us the opportunity to build our brand and our base, to then become the innovator that we are. No one believed in indexing as a concept. The idea of distributing directly to clients was really, really novel at the time. Low cost was thought to be a bad thing, because “you get what you pay for,” right? 

Obviously, Jack Bogle’s strategy was brilliant, especially in terms of the different ways he pulled together the old Wellington relationship to allow Vanguard to get its feet under it, but I think those are things that are going to be harder for a newer firm to go after today.

Nadig: You mentioned that Vanguard, initially, was a bit of a renegade in terms of taking professional investment management directly to investors. First, you did that through mutual funds; then, through the defined contribution business, then eventually into the ETF market—and not without some reservations from Jack. Now you’ve got multiple advice offerings too. 

Powers: We have a long history of working with advisors, and we’ve had some bumps along the road, from an advisor’s standpoint. For example, we had a platform where we did custody for advisors, and it turned out, from our perspective, that advisors could be better-served by someone else. Our capabilities there weren’t aligning to what they needed. So we wound that business down, and instead decided to serve them differently through products and thought leadership. That’s worked out well. Obviously, too, dynamics within the advisor industry around moving toward an AUM-based approach versus a transactional-based approach [has helped us]enjoy some success.

In terms of the different ways in which we offer advice, a consumer who’s already with us can say, “I don’t have the time or inclination to build my own portfolio,” and they’ll for our Personal Advisor Services or our digital advisor offering. We recognize that some advisors might look at that and say, “Well, gosh, Vanguard is potentially trying to attract my clients from me.” But we don’t feel that way at all. We know we have a very specific offering that’s going to appeal to a very specific set of investors. There’s millions and millions of investors out there that could be served across the spectrum of different types of advice. 

Nadig: And Vanguard really values that advice. I remember you did a study trying to quantify the value of having an advisor as a behavioral coach, and it was roughly 3% [added to annual return]. Is the reason because, fundamentally, we’re all dumb with our money, so it’s helpful to have somebody standing over your shoulder saying “maybe you shouldn’t buy that meme stock”?

Powers: Well, as you might expect, the clients on our platform tend not to behave in the way that [has been revealed to occur]on other platforms. [Laughter] They tend to believe in the notion of long-term [investing]; buy and hold; balance; diversification. But that population of investors has always existed. I can vividly remember what was happening in the late 90s and early 2000s, and friends or family coming up to me and saying, “Oh, well, what about this thing in these technology funds?” The thesis was right — the innovation was happening, and it was transformative to the world that we live in — but it didn’t necessarily tie into the investments.  

Investing is not about improving the way in which you get your groceries, or how quickly you can get XYZ product from some online platform. Investing is about much more serious matters, like saving for retirement; or saving for that unforeseen medical expense; or saving for education, so your kids don’t walk out of college with debt. 

There are innovations that directly impact investing: the ETF is certainly one innovation; the idea of a zero-dollar commission platform is another innovation. But some of these really narrow strategies, or even the retail stock trading that’s taking hold, they don’t feel like an innovation to us. Because it’s not going to – probably — improve the outcomes going forward.

Nadig: Yeah, but I remember ten or 12 years ago, one of the last things I saw Jack present was one of his papers on trading, and he was quite negative on ETFs because of the ability for individual investors to get themselves in trouble by overtrading. What he would say about the zero-commission brokerage environment I wonder?

Powers: Certainly, when you remove those speed bumps, you create greater risk for people doing the wrong things. They can create self-harm, from a portfolio standpoint. But the counter[argument]is the professionalization of money management across the entire value chain. Look at who owned stocks back in the 50s and 60s: It was the individual. Now it’s effectively professional money managers, with advisors now helping a disproportionate amount of individual investors in the U.S. Even within the advisory community, you’ve seen more and more of them outsource portfolio management to professionals within the industry through the use of models.

So, yes, there will be a population who will use the lack of a speed bump to make bad decisions. But more and more advisors and individuals are moving towards this much more strategic asset allocation approach. More and more, the money is in the hands of folks who are playing the long game.

Nadig: Vanguard is kind of the ultimate player of the long game. You have trillions of dollars under advisement, and while it’s mostly passive, you still have to be stewards of all those assets. How do you think about the way you interact with the companies you own, on behalf of your shareholders?

Powers: Effectively, we serve a perfect slice of the U.S. population, in terms of wealth, geography, political views, what have you, because we own, effectively, every company in perpetuity. A large portion of our assets are in index funds, and they tend to be permanent holders. 

What that means is when we get the opportunity to vote on different proxies, or engage with company management to focus on long-term strategy and the risks that exist within an organization, we have a good sense for what “good” looks like from a strategy and risk identification standpoint. Our goal there is to create value by having those companies be successful over time. 

Our interests are completely aligned with investors: we take voting and engaging with company management seriously, because our shareholders’ wealth creation is predicated on that.

Nadig: Are environmental, social, or governance concerns (ESG) part of the voting process?

Powers: Recently we signed up for the Net Zero Asset Managers Initiative, and so we clearly look at climate change and emissions as a real source of risk. For certain industries and companies, it’s a far more substantial risk, and as a consequence, the conversations we have at the boards and management teams are different and more focused. 

Our approach to company engagement and how we talk about differs from what our competitors do, however. Our inclination is to actively engage in the background to agitate for the positive change that’s going to create value for our shareholders. That’s always been the case. We’re not ones to be out there actively touting what we’re doing; we think it’s much more effective to do the behind-closed-doors approach.

Nadig: But ESG in general is a relatively new endeavor for Vanguard, right?

Powers: About five years ago, we took a step back and thought about ESG strategically and from a product standpoint. At that point, we only had one product: the Vanguard FTSE Social Index Fund (VFTNX), which had been launched 20 years ago, largely as a product for the defined contribution plan era, where a decent segment of clients were pushing for that as an option within their plans. 

But we had gotten a sense from clients, and certainly from observing the marketplace, that ESG was becoming much more prominent. So we concluded that we should be launching more ESG products, because they would serve our clients well. But we wanted to do it our way.

So we looked at a variety of different approaches. Ultimately, we concluded that the exclusionary approach was the right approach, because we just didn’t feel great about the data that underlies the inclusionary approach. 

We launched our equity product in 2018 and our fixed income product in 2020. The reason it took us longer to get the fixed income product out the door was demand. If you had looked at where our client assets were, and the conversations we were having with clients, there was very little interest in fixed income ESG. I think that had a lot to do with the alignment with voting power that exists on the equity side that doesn’t exist on the fixed income side.

Nadig: It does feel like there’s been heightened focus on fixed income at Vanguard lately.

Powers: A bit! We were looking at flows into bond index mutual funds and bond index ETFs. About $1 trillion dollars has made their way into those two categories over the last five years. That’s 60% of all industry flows. Which, for me, it’s just mind-blowing, especially when you consider the performance of the equity market and the fact that yields — even before the pandemic — were relatively low. 

So I think maybe investors are recognizing the virtue of bonds from a portfolio construction standpoint, not just for generating income. The core reason why you hold a fixed income allocation in a portfolio is because of the diversification it offers.

In the current environment, lots of folks have come to us and asked, “Well, has your thinking changed? Your total bond fund has a yield of 1.3%!” Well, we’ve been through this before. We can look at 2008, 2009. Yields were absurdly low then and people were questioning the virtue of fixed income, and asking if it really would play the same role in a portfolio from a diversification standpoint, as it had in the past. So from our perspective, I don’t think there’s any reason to believe that the role of ballast that fixed income has played in the past is going to change in the future.

Yes, the upside to it is a bit more limited, given where yields are. But tossing out bonds as part of the solution, in our mind, would be pretty shortsighted. This game has been played for a long, long time.

Fixed income does have a role. The math is there—it’s just perhaps not as powerful as it once was. Certainly, from a client behavior standpoint, the idea of looking at fixed income as your income generator in a portfolio drawdown is challenged, but there are other ways to draw down a portfolio than just simply living off the bond coupons. You can (and probably should) take a total return approach.

Nadig:  Maybe let’s wrap by talking a little bit about indexing. There are people out there who still worry about the rise of passive investing, arguing that of course 100% of the world can’t be passively invested because somebody has to set prices. Should we be worried?

Powers: I think I worry more about the narrative that people are developing around it. They’re looking at the numbers and seeing flows that are pretty incredible, and connecting inappropriate lines and saying “this is a problem.” 

But less than 5% of the fixed income world is indexed. It’s hard to make an argument that anything disruptive is happening there. Even within equity, where I forget the numbers but let’s say it’s about 35%, we both know the myriad of ways in which equity indices look nothing like the total market. 

If indexing was this monolith, and there was only one way, and it was all total market funds…then all right, I can start to understand where people are coming from when they say “maybe there’s a problem.” But even that said, at 35% market, that means 65% of the owners are active in some way—whether it’s the individual investor or the professional investor…there’s plenty of room for them to develop opinions on what the value of stocks are and offer price discovery. 

The last thing I’ll say is: while 35% of the market is indexed, Jim Rowley [Vanguard’s head of Investor Research] published a report showing that indexing represents only about 10% of the actual trading in the marketplace. So who’s actually helping inform price discovery? Indexers are one of them, but they’re pretty low relative to the price formation that happens, because of the activity of active managers.

Nadig: There’s passive and then there’s passive. Because we count VOO [the Vanguard S&P 500 ETF] the same way we count your factor funds. 

Powers: You don’t even have to go to that extreme. Look at the top 20 ETFs in the industry. Yes, the top ones are conventional market cap, but then that next layer, it’s your value funds, it’s your dividend-oriented funds. These are funds constructed in really different ways: one is zigging the other one is zagging. So sometimes I get the feeling not everyone has a full appreciation of what’s happening in the indexing world.

For more news, information, and strategy, visit the Fixed Income Channel.