Vanguard's Sauter: Avoid Irrational Exuberance with Alternatives

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 |  Includes: VB, VEA, VEU, VT, VTI, VWO
by: IndexUniverse

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.