Vanguard's Sauter: Avoid Irrational Exuberance with Alternatives

Gus Sauter is Vanguard Group's chief investment officer. He started at the fund giant in October 1987, two weeks before global markets crashed.

In that environment, Sauter took over as head of Vanguard's quantitative equities group, which at the time consisted of only index mutual funds. Since then, the unit has expanded to include a combination of passive and active quantitative strategies. Six years ago, Sauter assumed the company's CIO duties as well.

On Wednesday, IndexUniverse.com's Managing Editor Murray Coleman caught up with the busy Vanguard executive to discuss current market conditions and trends he's watching such as the upcoming launch of the Vanguard FTSE All-World ex-US Small-Cap Index Fund.

IU: Is buy-and-hold investing dead?

Sauter: No, I don't think it is. In fact, it's as prudent today as ever. When investors establish an asset allocation plan, they should realize there's going to be volatility in the market. So they should stick with their plan in a disciplined fashion. Realizing that volatility exists in the market now shouldn't be reason to abandon a long-term investment plan.

IU: How do you view the relative under-performance by fundamental indexes last year?

Sauter: It's not surprising given the fact that a value and mid-cap orientation under-performed the broader market in 2008. That's the tilt you get with a fundamental weighting scheme. That was true in historical backtests and it has proven to be true in real time as well. As mid-cap value goes, so goes fundamental indexing.

IU: Why did it take so long to come out with an international small-cap index fund and corresponding ETF?

Sauter: We love a challenge, and thought it would be a great idea to launch an international small-cap fund in this environment. But seriously, we think there's a long-term investment opportunity for certain investors in international small-cap stocks. In particular, we've been trying to provide financial advisers more tools to build diversified portfolios.

There's definitely a portfolio management challenge in trying to access the small-cap international marketplace. It can be a very illiquid corner of the market. So we have to use sampling techniques, which can lead to some tracking error at times.

The other concern with an international small-cap fund was that we didn't want to offer a product based on fad appeal. We wanted this fund to be viewed as another element in a long-term-oriented portfolio, not just as a short-term timing vehicle.

And finally, we've offered several index mutual funds and ETFs through FTSE lately. It complements our FTSE All-World ex-U.S. ETF (NYSE: VEU). So it was a natural fit with that fund. (See related article here.)

IU: Unlike much of the rest of the industry, didn't Vanguard have strong inflows into ETFs as well as mutual funds in 2008?

Sauter: Yes, across the board inflows were quite positive. (See related story here.) The ETF class probably attracted a bit more assets into the hotter categories. We saw strong money flows into emerging markets. And we saw a lot of money flowing into REITs in the first half of the year before reversing course as the economic climate became more unclear. And we saw broad interest in the Total Stock Market ETF (NYSE: VTI) as well as in the mutual funds share class.

Last year was actually the second-best year in terms of cash flow into the total complex across both classes of shares of ETFs and mutual funds.

IU: Why did you add a long-short mutual fund, the Market Neutral Fund (VMNFX)?

Sauter: We thought it would be a good diversification tool for institutional and high net worth investors. Although it has been a Vanguard fund for a little over a year now, the fund itself has a history going back several years. It started out on the Schwab platform more than 10 years ago. But it didn't receive much in the way of traction, so we decided to adopt it at Vanguard.

IU: Why is that?

Sauter: We wanted to get into the long-short market-neutral space. We think it's a good diversifier for a broad-based portfolio. We'd been working on it internally for several years. But when this fund became available (it was a Laudus fund), we decided that since it had a good track record, it made sense to add it to our lineup. The external adviser is Axa Rosenberg, which remains a manager on the fund. But we've taken over 50% of the fund's management internally here. Both managers apply quantitative techniques to maintain the portfolio and to control the risks of the long and short portfolios.

IU: Where do you see quant funds compared to active funds these days?

Sauter: The distinguishing feature between quantitative methodologies and active management is that we're not using fundamental techniques such as talking to competitors and evaluating corporate management. But in quantitative modeling we're still trying to beat the market, just as with an actively managed mutual fund. We've got 15 different quant funds with a total of around $20 billion in assets. Most of them are internally managed. Over the long term, their track records have been favorable. But over the past 18 months, they've had difficulties.

IU: How so?

Sauter: A lot of hedge funds are quantitative in nature and have been deleveraging. As they've had to sell off positions, they've put pressure on the same sort of stocks many of our quant funds own. And every product has a down cycle. This is definitely one of those times for quantitative managers. We're anxiously waiting for the other side of the cycle.

IU: With stock funds undergoing their worst 10-year period on record, is the case for building portfolios around equities somewhat diminished?

Sauter: We don't think the past decade has done anything to alter the long-term case for equities. We think the reason why there's a risk premium with equities is due to periods like what we're going through these days.

IU: How about international equities, which have been hit even harder lately than domestic equities?

Sauter: Our view on U.S. versus international is one of trying to gain broader diversification. Investors should realize that diversifying into international markets helps smooth overall portfolio returns over the longer term, but only at the margin. Greater diversification can actually be gained by investing in other asset classes such as bonds.

IU: What about alternative asset classes such as commodities?

Sauter: Other diversifiers can be useful in a portfolio. Investors need to have rational expectations, though. A lot of people rushed into commodities a year ago and probably had too-high expectations about their performance. Over the long term, performance expectations for commodities would be in the 6-8% average annualized return range.

But many investors have been projecting short-term return trends—when commodities were soaring to historic levels—into their future asset allocation plans. Those were probably too high. Nevertheless, the advantage of owning commodities and other diversifiers isn't necessarily to increase overall returns. They're useful as a means to smooth return streams.

People need to avoid irrational exuberance over alternative asset classes.

Comments

[Jim Hawthorne:]

'People need to avoid irrational exuberance over alternative asset classes.'

Are you kidding me? Gus Sauter needs to get out more! The only 'irrational exuberance' around these days is that of the Mutual Fund pimps.

Most of this interview could have taken place at any time during the past 20 years! A reality check would be in order! Unbelievable!

Feb 26 06:05 AM

[Roger Schre...:]

Passive investing never made sense, it never will. Only looking backwards can one tell if you SHOULD HAVE. Investing is about going forward.

The facts are: passive investing is investing without an escape plan, which means it is greatly flawed. Active investing, while offering no guarantees, certainly gives you a fighting chance.

Last year Vanguards passive equity strategy suffered market like losses. Our portfolios were up 5% to 30% and we took less risk. We have outperformed the last 1, 3, 5, and 10 year periods, again, with less risk.

Now we only manage .001% of the assets that Vanguard does, but we have investors who are still growing there assets, rather than the losing money as those who made a single bet without a safety net.

I wish Vanguard good luck, because the ONLY way they can win for therei investors is if there is a bull market.

Roger Schreiner, CEO
Schreiner Capital Management, Inc.
scminvest.com

Feb 26 08:37 AM

[Oneslip:]

I'm not saying you should invest with your head in the sand, but a passive, proper allocated portfolio makes a lot of sense. I would say congratulations to Roger Schreiner on his past performance but it is very easy in this volatile market to be on the wrong side of a trade or theory. For the average investor to have a low cost, properly allocated portfolio that they are dollar cost averaging & reinvesting the div-cap gains has one factor not to worry about- an investment manager making a wrong turn in the market and charging excessive fee's. I'm not saying a manager cannot add some value but in all the research I have done finding the right one is the issue especially when the right one can turn into the wrong one. I think a lot depends on what your expectations are and time frames. This is a great short term trading market & yes, if you are a long term investor you are buying the averages at a much lower price and if your time horizon is long enough I'm sure you will benefit even if the market continues to trend down and stay there for a long period. An L shaped recovery is not out of the question.

Feb 26 09:42 AM

[Fund Insider:]

Great unpaid advertisement for both Vanguard and Mr Schreiner.
Fact is Vanguard is for "do it yourself" investors, for the most part,
who want to do their own asset allocation, but not deal with security selection. Park your $ in mmkt or any of their Treasury funds and you made money at Vanguard. Vanguard also serves another purpose.
I don't worry much about being Madoff'd.

Feb 26 02:50 PM

[Stephen Webb:]

Roger,

I believe investors deserve more "than a fighting chance" when it comes to their portfolio. They deserve to get what they pay for and over the long term, a majority of active managers don't offer anything in terms of results for their fees.

Take a look at the most recent S&P 500 scorecard on active managers vs. their respective benchmark. A few stats standout:

Over a 5 Year period:
-68.6% of all LCAP managers failed to beat the S&P 500
-75.9% of all MCAP managers failed to be the S&P Midcap 400
-77.8% of SCAP managers failed to be the S&P Small Cap 600

I think that's great if your firm is able to continue to offer those investment returns for your clients, while taking less risk to get there. But consider yourself in a miscropic minority compared to your peers.

Feb 26 04:28 PM

[Stephen Webb:]

Here's a link to the S&P report from December reporting through mid year 2008.

www2.standardandpoors....

Feb 26 04:33 PM

[AccreditedEYE:]

I am sick and tired of every other idiot ready to carve out the grave stone for buy-and-hold investing. Every time I watch Fast Money and have to watch any one of the "experienced traders" say that buy and hold investing is going the way of the dinosaur I want to scream "Where were you in 1999!!!!!!"

First, if it is such a horrible strategy, why do most major institutions (Private & Muni Pension funds, Endowments, etc.) in the US still rely on a passive buy-and-hold allocation for their portfolios? Heck, we won't even get into the greatest investor in the world making his fortune off of it.

The time to decry buy and hold is NOT when expectations for equities are the lowest they have ever been in 75+ years. It's not when every economist is as eager as a beaver to label this the Great Depression of our time. It's like buying high and selling low. You folks look at the Dow during the Great Crash. Look where the market went over a 5 to 10 year term (in a Depression no less!!!) This is the time to be accumulating equity assets NOT selling them. Buy-and-hold is not dead and now is the precise time to be buying for the long haul....when nobody wants to even think about the strategy...or equities for that matter!

Feb 26 06:32 PM

[donzelion:]

If "buy and hold" died, it's because "buy and hold" never worked quite the way folks thought it did. When you buy shares in a company, you own that company - you have a stake in it, and inject just a touch of effort into reviewing financial statements, reviewing management activities, and determining whether continued participation with that company made sense for you. You "bought and held" a reciprocal set of duties: management earns profits and pass them honorably to the shareholders, shareholders hold management accountable.

However, with ETFs and other purely passive funds, "buying and holding" means buying into a quantitative structure. Want to hold an algorithm responsible? How do you fire bad math? What do you do about creative accounting that can exploit persistent market information flaws (e.g., CDOs and other securitized obligations that stay off the quant charts).

Buy'n'hold IS DEAD - if buying and holding means buying into the S&P 500 instead of buying equities within the S&P 500. The funds, whether passive or active, are not "buying and holding" - rather, you're buying into the wisdom of a computer program.

Index funds fix a major market flaw - transaction costs make broad diversification extremely expensive (buying all 500 companies in the S&P 500 would be prohibitively expensive). Buying them and holding them is not "buying and holding" - it's diversifying. Diversification is no small thing, but one should not mistake one tactic as though it would fulfill another.

Feb 28 01:46 AM

[Ron Rowland:]

AccreditedEYE, I'm confused by your comments. In the first two paragraphs you seem to be in support of B&H, but then in the last paragraph you are telling us it is time to "Buy". How can one be "active" and start "buying" at this time if they are still "holding" everything they bought in 1999?

Feb 28 10:20 AM