Vanguard’s Reyes on Enduring Investment Merit

Published Sep 10, 2024, 6:54 PM

Since its inception, Vanguard has maintained that active investing — if delivered in a low-cost way — can play a meaningful role in a client’s portfolio, for investors who have the tolerance to take that on, says Dan Reyes, global head of investment product at Vanguard. On this episode of the Inside Active podcast, host David Cohne, mutual fund and active analyst with Bloomberg Intelligence, along with co-host Eric Balchunas, BI senior ETF analyst, speak with Reyes about the process of launching new active products, the trend toward active ETFs and the selection of external managers. They also discuss the evaluation of enduring investment merit of products and how Vanguard’s active lineup has evolved over time.

Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into the processes, challenges, and philosophies and security selection. I'm David Cohne, I lead Mutual fund and active Research at Bloomberg Intelligence. Today my cost is Eric Baltoonis, Senior ETF analyst at Bloomberg Intelligence. Eric, thanks so much for joining me today.

Great to be here, David, Thank you so.

Eric, as most of you know, is author of the Bogel Effect, so it's safe to say you not know a lot about Vanguard. Most Bogel's thoughts on active funds.

He was an anti active. A lot of people think that he definitely was pro index, but if when you read his books, he's got over ten books, he highlights act to funds in all of them, especially the Wellington Fund. He looked at that as his firstborn child, and he saved that fund from near extinction. I won't go into the details, but he loved that fund, and he loves some of the other active funds they started. I will say when you read about how his pride in those funds and why he thinks they were able to beat their benchmarks and have better returns. He does kind of move it back to Vanguard's mutual ownership structure and they would bring the fees down, and so I call it Bobo metrics, you know, like sabermetrics. He didn't necessarily think that any human had such superior skills to predict the future. But he thought, if you can get the fees really low, you can decrease the turnover and diversify some of the active, you stand the best possible chance to outperform. And so he was more anti high cost and high turnover, not necessarily anti acting in his books and his writings show that, but that kind of got drowned out by how much he talked about passive for sure.

Well, we're definitely going to get into more about active at Vanguard. So i'd like to welcome Daniel Reyes, Global head of Product at Vanguard. Dan, thanks for joining the podcast.

David, thank you for having me here.

So I'd like to ask our guests, you know, how they got their start in business. So I'd love to hear how you chose a career in investing in what led you to Vanguard.

Yeah, so, David, I'm at Vanguard. I I've had a pretty non linear career here. I actually started in our human resources team as a compensation analyst at Vanguard, but I studied finance as an undergrad and so Vanguard was always a name that I had heard of, But I didn't fully appreciate the Vanguard's story, the ownership structure, all that's embedded in kind of what's popular and known about Vanguard now until I actually got here. So I got to Vanguard in the HR team, went back to business school, studied finance and investments again, and then came back in an investment centric career.

So I came.

I came through a team that did advisory services for small endowments, foundations, pension funds. I worked on our fixed income trading floor, on our rates desk. For a little bit. I worked in our personal investor business. I've been fortunate to lead our education savings business of the five twenty nine business, but for the last several years really focused on investments per se, first in our investment strategy team here in the US, and then between twenty seventeen and twenty twenty one, I actually was really lucky and got the opportunity to go lead our Asia Pacific Investments team, so moved out to Melbourne, Australia where we've got a sizable crew population out there Cruz what we call employees here at Vanguard, and then at the end of twenty twenty one move back to the States to lead our product team. So very non linear in the sense of how my career has progressed here at Vanguard. I'm sure as you've talked to Vanguard employees over time, you've heard this theme where you know, Vanguard's really really great about giving people the opportunity to rotate throughout the organization and learn different parts of the business.

So I'm no different that in that way.

That's great. So you know, I've actually been covering Vanguard my whole career, so I'm quite familiar with their active funds. Can you explain how active management fits in at Vanguard and you know, how active and passive can work together.

I think from a philosophical perspective, you know, are many of our roots right when Vanguard was first started. Our roots were with Active Product as well to Wellington Fund amongst others, being one of the things that originally started with Vanguard. And so from Vanguard's inception, we've always had this idea that Vanguard Active, if delivered in a low cost way, can play a really really meaningful role in a client's portfolio for investors who have the tolerance to take that on. I think that oftentimes people talk about the notion that active and passive, and it's often framed as passive versus active, But in many instances, David, the way that we think about active at Vanguard is that it's an and decision right for investors who have the tolerance to take on the inevitable ups and downs of outperformance that active will bring, and they've got that risk tolerance, that the two can be really blended together, provided that they're grounded in this common principle of low cost.

Right.

Low cost is one of the things that's inherent to indexing, and in many ways, when you give low cost active strategies access to low cost active strategies, you're lowering the investment manager's hurdle for outperformance to deliver alpha after.

Fees, you know.

Moving on, I do want to touch upon product development. How do you decide when to launch new active products?

I think the the product development process David, for active product is the same as the process for any product here at Vanguard, and when we think about product, we're always grounding it in Vanguard's investment philosophy, right, which really centers around this concept of keeping your costs low, focusing on balance, being really clear about your goals and whatever your strategy is, right, being disciplined about executing it against that. That's the backdrop for all product that we think about at Vanguard, and then when we come to the actual product decision. You know, Vanguard is a big fan of these frameworks that we've got to. We've got a framework that we call our Product design Principles where we effectively ask ourselves for questions, and this is applicable for active in general. The first thing that we ask David is does any product that we're thinking about have an enduring investment merit?

Right?

What we mean by enduring is can we envision that this strategy would be on the shelf and available for investors for decades to come.

Right.

Within that that investment principle, we think about whether or not a strategy has a plausible economic rationale to deliver positive real returns. Right, That's another question that we ask ourselves. Within that, the second question that we ask ourselves is does it fulfill the long term needs of the targeted clients?

Right?

Who are we designing this product for? And does it have a plausible role in a well grounded portfolio instruction framework doesn't necessarily have to be the way that Vanguard builds portfolios, but it could be. Is it a reasonable portfolio construction framework? Then we'll think about offering an active, active strategy. There After we clear those two hurdles, David, then we think, hey, is there a reason that we can deliver a compelling advantage over competitors? Do we feel like Vanguard bringing a product in this space can be a best in class product? And then finally we'll ask ourselves is it feasible to launch the product? What are sort of the barriers? Operational hurdles, regulatory hurdles. Those are the four basic questions that we ask ourselves, and it's important to point out that we ask them in sequential order. Right, So we ask ourselves the investment question first, and if we can't clear the investment question, there's no point in talking about the client the client question or or the you know, the business question about whether or not we can offer a compelling, compelling product in this space. Because it has to be grounded in our thoughts on investment principles and philosophy.

I'd like to jump in here real quick, Dan if I could, so everything said makes sense. There is a market for active, especially low cost active. However, I don't know if you've noticed, but it seems like people won in the ETF format more and more versus the mutual fund format, especially on the equity side. How how are you guys dealing with and planning on adapting to that?

Yeah, Eric, you're you're certainly right in the trend towards active strategies in an ETF rapper, and we've historically had a couple of active strategies in our ETF rapper if you think about our five factor products, and then we had an ultra short product that we launched several years ago in an ATF rapper, And more recently you've seen more active ETFs from us on the fixed income side, right we had Core and a Core Plus launch at the end of twenty twenty three. We're doing the new we just announced the new community products as well too, and we're naturally turning our attention to what does this mean for active equity strategies and so it's a body of ongoing work that we have right now. I think the clients. What we're hearing from clients is they're certainly preferring the ETF rapper. If you just look at flows and where flows have gone, you know, first part of the year, and overmwhelming proportion have gone into the active ETF rapper, and active equity ETFs are certainly a part of that trend. Now, I can tell you Eric that as we think about active equity ETFs, you know, our early thinking is that we don't necessarily think that every single strategy that is active equity would lend itself well to the ETF wrapper. And I'll give you an example of kind of some of the things that we think about when we consider any active strategy. Right first is, you know, we have to think about liquidity in the ETF wrapper. You know, unlike a mutual fund where vanguardt has historically deployed closing a mutual fund. If we think that, you know, there are some flows that are coming in that are going to make it more challenging for an active manager to deliver the alpha. You don't have that lever to pull in an ETF wrapper, right Naturally, are active managers in an ETF where you're you're talking about daily disclosure. They're concerned about IP leakage. What am I revealing about the fund's strategy? What am I revealing about the strategy in the ETF rapper that I wouldn't necessarily be revealing in the in the mutual fund wrapper. And so we think about things like that, liquidity, ip leakage, the tax efficiency of different strategies in in an ETF wrapper, virtus versus a mutual fund are all things that are that are on our mind.

Eric.

I think it's particularly in in the ETF, in the active equity ETF world, our initial thinking is that it not everything's going to be you know, I use the term quote unquote etfable, right, They're going to be things that lend themselves well to the ETF rapper and other things that we would be more cautious about approaching them, you know, if we were to offer a product in that space.

Yeah, I mean, just those are very good reasons.

I get that.

It just seems to me that advisors, especially when it comes to large cap US equities and even mid and small to a degree and a developed market, I get, like you know microcaps and maybe emerging markets where capacity can be an issue. But it does seem like advisors don't really like they get all that, but they now expect managers to show what they hold. Every day on the ETS space has been interesting. The non transparent active ETFs try to protect their ip but like nobody bought them, and so Capital Group and others were got on board with transparency and you can see their ETFs start to sell. So I think they have the same issues. But the marketplace demand is a big variable, and the tax efficiency is also really powerful, and I think I don't empathize with your dilemma here. It's clearly you got two polarizing forces. My guess is you're going to have active equity ETFs come out soon. You probably can't break that news here, but I think you're gonna do it.

I'm on record. It's good to know. It's good to know that's where you think we're eric. I appreciate that.

I mean, to your point, advisors are expressing their preference right, and individual investors are expressing that preference.

I think for us, when we think.

About like an active equity ETF, we're going to be thinking about on an after tax basis, even with all those things that I talked about, does it offer comparable returns to the mutual fund wrapper and if and if the answer to that is yes, which is going to be different strategy by strategy, I think that's something that we would we would strongly consider moving forward.

Actually want to kind of you know, still on the topic of active ETFs, but kind of a different question. You know, you have the newer core bond ETFs, and I know those are managed in house. Is active active fixed income and area where you see Vanguard, you know, continuing to launch products that are managed in the house as opposed to external managers.

David, We've got a long history.

I mean, we work with some talented external fixed income managers on a couple of strategies. You know, I think of our long term investment grade strategy, our Jimmy may fund, our high yield fund where we've got Wellington there. But we've also been simultaneously really investing in our in house fixed income capabilities on the active side as well as on the on the indexing side. Now, Vanguard's had some real success in being able to attract talent because the Vanguard story is a compelling story in the sense that if you're in fixed income and you're given the opportunity to build an active fixed income business, but with Vanguard fees as a lower headwind, right, really gives investors the chance to outperform regardless of market environments, you know, when they've got that smaller headwind with lower fees. It gives them the opportunity to be really judicious about when they deploy their drive power and not have to take on risks in order to stretch, you know, and outperform the fee. So I think that you know, the the product development that you've seen with us, even just with those four products that I mentioned earlier, is gonna is gonna that trend will continue moving into twenty twenty five and beyond.

You know, And you did mention the external managers. Yeah, I guess you know. What I'm most curious about is what is the process of selecting those managers. Is it, you know, kind of typical of a manager search that an asset allocator would do, or is this something more of you have your own process.

It's it's similar, but it's definitely distinct in that way.

David. We we we.

Like to often say that we don't typically date managers. We like to marry them, right. We we tend to have a long dating period and coording period as well too.

That process.

Right, when we're thinking about partnering with external managers, we will think deeply about what does their firm look like, what are the incentives of the investors at the firm, what does their culture look like, what does their leadership team look like, and what does the bench of talent look like? And we'll think about that even before we get into the specifics of like what's their process and their philosophy. Right, if you think about those things at the highest level, performance and the opportunity to outperform should be an output of all those things that I just mentioned, like firm culture, people, process, philosophy. We actually spend the vast majority of our time on those elements, David, before we even get to thinking about, okay, what are the returns look like? You know, for the last three to five years, and you know, we will sit with managers, conduct hundreds of search meetings throughout the year because we're always trying to make sure that we've got managers at the ready for any sort of opportunity that we might be thinking, say we're thinking about a product in you know, a certain space will go on and we'll we'll keep kind of a quote unquote lying in the water when it comes to working with managers and searching for managers on a continual basis.

Okay, And I guess you know a continuation of that question. You know, some of the funds have you know, a bunch of different external managers managing different slices of the portfolio if they come up, you know, on the equity side, if all the managers happen on like one stock, how do you prevent it from you know, going beyond diversity requirements and you know, just making sure that you know, the portfolio stays diversified if there's a lot of you know, stocks that each of the managers all like.

I think we try to get get at that process first, David, by having rigorous monitoring at the portfolio level to look at the you know, the exposures of the portfolio at the overweight and underweight level. But then when it comes to actually selecting managers, say, for instance, if we're talking about a growth fund, right, what we wouldn't do is go out and choose managers that we think have duplicative growth styles. Right, one manager might like high high growth companies and look for those companies that are going to be kind of your true outliers. Another company might approach or another subadvisor might approach growth, you know, with a growth at a reasonable price, more of a Garbie type, you know, growth philosophy. So what we're trying to do is pull together managers that have complimentary and not necessarily duplicative styles. So part of that goes into us thinking about what type of active fund do we want this strategy to be from the outset, and then thinking about the managers that might complement each other when we're pulling that together, and then we back that up with rigorous monitoring at the tail end of the portfolio.

So is there, would you say, an oversight to some of the trades they make.

In terms of actually, you know, like the the output, like when they're making the trades, that's not something that they run by Vanguard at the process beforehand. We'll know that they made trades, right, We'll know that that they made trades, and will part of our oversight duty and responsibility is to ask them why, what were what's their thesis on a particular company, How does it align with our philosophy and their process? Right, so we do it on the back end, but they're not. I wouldn't say that they're running trades by us before they execute.

Them doing Okay.

You know, if we, you know, continue talking about Vanguard's active lineup, how would you say it's evolved over time?

I think I think you know, first and foremost you've seen you know, Vanguard. You think about some of our historical funds. We always think about funds that are been broadly benchmarked relative these big indices, and you know, lately, if you think about some of our active lineup, you know, I think that on the equity side, you've seen us launch things, for instance, like the Bailey Gifford Global Positive Impact Fund back in twenty twenty two, which had a very specific kind of need, It had very specific exposure there was going to or for instance, you know, another example on the equity side is the Global Environmental Opportunity Stock Fund in November of twenty twenty two. I mean, those were definitely catering towards investors who had a preference for ESG and also had a preference for active management. On our fixed income side, what you'll see more of now is, for instance, the core type strategies core bond, core plus that give the portfolio management teams the latitude to make that decision across different subsectors of the fixed income space. Right, they can make it decision to think about what their credit beta would look like. They can lean more into security selection if they feel like that's where they're they have the opportunities, or they can you know, think about moving the dial slightly on rates as well too. Right, So, on the fixed income side, the evolution has been giving the given the portfolio managers and the talented investors a little more latitude. And then on the equity side, given the breadth of the existing product strategy product lineup already giving some exposures, some targeted exposures for investors who have the particular preferences.

So what would the future have in store? You know, you know, we know about what's happening with the ETFs. Do you see more mutual funds being launched as well on the equity On the active side.

I think we'd think about both, right, I think we think about a strategy that we find compelling, and then if we think about the structure for instance, that would be a secondary consideration. So I'll give you an example of a you know, we you know, last year we launched an international dividend growth strategy in a mutual fund format because we were we've got a successful US focused dividend growth strategy and there was an international counter counterpart. We'll continue to do that type of work, and then if we think about the structure as a secondary consideration, that's what we would That's what we would see. Is kind of like the the evolution of our of our active offering.

Okay, you know, I know, you know Eric mentioned you know, possible equity ETFs. Is that something you're thinking about, you know, in addition for you know, to the factor ETFs. Is that something you're always thinking about when you're thinking about, you know, what to launch next.

Yeah, just like any other Just like any other trend that we see, you know, at vand GUARD.

We're monitoring the trend.

Very very closely, continue to evaluate it and think about whether or not the strategies that we offer would lend themselves to that ETF rapper. So it's something that we're evaluating. That doesn't necessarily mean we would or we wouldn't do it. But it is definitely on our radar at this point in time.

Quick one here on just competition, you know, I know, you guys are the third biggest active manager by assets. Capital Group is one, Fidelity is year three, and then there's obviously many others below that. Who do you look to as your competition? How important is that to you when you're thinking about what winning is, because there's beating the benchmark, but there's also ranking high in lists, you know, so for like ten yr returns, your fund might be in the nineties percentile that is amongst those other competitors. I'm just curious how you guys view that.

How do we define winning right in the space? And I think, in true Vanguard fashion, we define winning in the space as delivering good investment outcomes for clients right That in and of itself should be the mechanism that ultimately wants people or drives people to consider Vanguard as an active investor. We're much less concerned about who's number one, who's number two, and who's number three than we are about what value did we create for the investors. And at least in Vanguard's you know, frame of thinking, right, making money for the investors is the is the thing that drives the growth. All the stats that you see in terms of cash flow au M, at least in our view, are an outcome of trying to deliver really great investment results for your end clients.

So I guess I actually have one final question before we go, Dan, if you had you know, if you think back of when you started your career, is there any advice you would give your younger self, you knowing what you know now.

The advice, So I'll tell you the advice that I give.

Vanguard has these programs where we hire you know, really talented employees, crew members off of college campuses, and David, they always ask me a similar similar question. I think that, you know, when I first started at Vanguard, the advice that that someone gave me is, you know, you build a trust with people at Vanguard. And I think this is true of any organization on small things, not necessarily on big things. The big things might be more exciting to work on, right, but if people can't trust you with small things, they certainly won't trust you with big things. And so whenever I'm you know, having a conversation with you know, a brand new crew member who wants to come and work on things that are really exciting. I'm always telling him or her, right like, build that credibility, build a trust with your colleagues by delivering on the little things, and then once you deliver on the little things, they'll start trusting you with bigger things.

That makes sense. Well, I definitely think this is great, you know. Dan, thank you so much for joining me today.

Thank you for having me. I really appreciate it.

And Eric, thank you for being my co host.

Oh man, I had fun.

Thank you well until our next episode. This is David Cohne with Inside Active

Inside Active by Bloomberg Intelligence

Reports of active management's demise have been greatly exaggerated. Active continues to grow and ev 
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