Gus U. Sauter Interview


We think the markets are expensive, which doesn't mean they can't go still further, but we don't think they have the amount of steam left in them that they had during the last five years.

George U. Sauter, managing director of the Vanguard Core Management group, recently sat down with the staff to discuss a number of topics - the current performance of Janus Funds, the placement of record cash inflows into the market, competitive low cost ratios for exchange-traded funds, the worrisome trend toward short-term investing, and the market's general outlook. Are the recent disappointing returns of the Janus Funds a harbinger of things to come?
[/:Author:] GUS: Regarding Janus, I would say there is some competition out there insofar as earnings growth is more difficult because asset growth has been somewhat muted. Janus, of course, has been pulling the lion's share of assets this year. So you would expect that if anybody would be doing well on a year-over-year basis, it would be Janus. It seems when other investors hear Janus is buying a stock, they jump into it, too.[/:Author:]

GUS: That works for a while. It used to be called the "Peter Lynch effect." He created such a big fund that by the time he was done buying a stock he himself had driven the price up. That kind of momentum can last for a period of time. But there are other periods of time when that type of investing does very poorly. Janus has been riding a very strong wave. With the enormous cash inflows during this time of high evaluations, is there any difficulty placing this money?
[/:Author:] GUS: No. No more difficult than any other period in time. In fact, mutual funds have relatively low levels of cash right now - lower than they would on average historically. I think that's because it has been such a handicap to have had cash over the last five years that a lot of mutual funds managers have really focused in on benchmarks. They're trying to remain fully invested to make sure they're performing in line with those benchmarks.

Cash has been a killer over the last five years. It's the fear that the market may take off again. You definitely don't want get burned in that event. Certainly holding cash over the last six months would not have hurt you, but you didn't know six months ago that the market was going to be flat. Are you going to try to match Barclay's lost cost figures for exchange-traded funds (ETFs)?[/:Author:]
GUS: We have not actually priced our exchange-traded shares at this point. We're still a couple of months away from introducing them. We haven't finalized the numbers. We did recently announce an Admiral Class of shares, which will be a second class of shares for higher-worth individuals and loyal clients that will be in the 500 Portfolio at about the 12 basis-point range. We don't make money on this because we operate on a net-cost basis. We're unique in the mutual fund industry in that the people who invest in our funds actually own us. So what we would make as profit we turn back over them in the form of lower expense ratios. We merely operate at cost. Whatever it costs us to operate the funds, including our salaries and everything else, we only charge that amount to the funds themselves - so Vanguard essentially breaks even every year.

Vanguard is actually owned by its mutual funds. So the investors in those mutual funds are making what would be our profit. With the lower rates and increased competition in the indexing world, is there a trend toward short-term investing today?
[/:Author:] GUS: It's difficult to detect what is going on in the exchanged-traded shares world because some of the activity is done by broker-dealers, so it's hard to figure out what the retail investors are doing. But there's a lot of other evidence that over the years investors have been moving their money quickly. We look at turnover rates in the industry, which have gone up about fourfold in the last 25 years. They have gone from 10 percent a year to 40 percent a year. So the average holding period has gone from about 10 years to about 2 and one-half years. It worries us. We do not think this is an appropriate way to try to save for goals. We think that longer time-horizon investing is the best way-certainly to achieve retirement goals. If you're forty years old, I'd say longer term would be 30 or 40 years horizon. Even if you're 60 years old, I'd say it's 20 years. It's certainly not 2 and one-half years. Is it true that there have been times when index funds have not performed so well?
[/:Author:] GUS: If you compare them against the appropriate type of managers, index funds do quite well during all periods. It is not appropriate to compare the S&P 500 against all managers because there are a lot of small cap managers who, when small caps are outperforming, beat the S&P 500. And when small caps are underperforming, they underperform it. You have to factor that out. You have to compare apples to apples, and oranges to oranges. When you do that comparison, you find that indexing works really quite well over most periods, certainly over a longer time frame. There can be an individual year when an anomaly crops up - but go back the last 25, even 50 years, and you'll find indexes performed quite well. Can anyone match Vanguard's low costs?
[/:Author:] GUS: Not unless you subsidize them. Some of our competitors have subsidized their funds through the money they make elsewhere. Their expense ratio is artificially low. For instance, if you had some index funds and also some actively managed funds, they make a tremendous amount of money on the actively managed funds and use the index funds as a loss leader. You just have to have an index fund nowadays. At the same time, there's no guarantee that the active managers will always subsidize their index rates. That's the danger of going with someone who is buying down their expense ratio. They could change the tables on you at any time, and if you've been there a couple of years you have unrealized capital gains and you kind of get locked in. Will the new SEC rulings on fair disclosure have any impact on Vanguard?[/:Author:]
GUS: It will not have an impact on us but I think it's a good ruling. I think it's in the best interest of the markets and for investors overall. I think it's great, and I don't think it will impact us - certainly not in a negative way. Some managed funds today seem to act like venture capitalists by backing companies early on and matching them with complementary companies. Will the Reg FD have an impact here?
[/:Author:] GUS: It makes it more difficult to try to game situations like that. To that extent, it makes the markets somewhat more efficient. For those who were trying to take advantage of slight inefficiencies in the marketplace, it ruins their game. I think any improvement in efficiency is a positive, although it is not absolutely necessary for indexing to have an efficient market.

Indexing is an interesting animal in that it's the only prudent way to invest if you have a perfectly efficient market. This is illustrated in an article written by Charles D. Ellis back in 1975 that appeared in The Financial Analysts Journal. It was called "The Loser's Game." He describes how outperformance is a zero-sum game. It means that if one investor outperforms the market, then another investor has to underperform. In aggregate, all investors have to get the market rate of return. In aggregate, they can't beat the market because they are the market. So that would mean half the investors will beat the market and half the investors will underperform it. However, we have costs of investing, and they're rather high costs. When you impose those upon investment returns it means the average investor no longer gets the market rate of return, he or she gets less than the market rate of return. That argument applies whether it is an efficient market or an inefficient market. How do you view the markets today?
[/:Author:] GUS: We think the markets are expensive, which doesn't mean they can't go still further, but we don't think they have the amount of steam left in them that they had during the last five years. Right now, with interest rates easing, we have a fairly favorable market environment. It's hard to point to any clouds on the horizon.

Gus U. Sauter is Managing Director of The Vanguard Group's Quantitative Equity Group. He oversees the portfolio management of Vanguard's internally managed equity funds, including $250 billion invested in 28 index funds and $4 billion in four actively managed portfolios.

Mr. Sauter joined The Vanguard Group in 1987. Previously, he was a Trust Investment Officer with The First National Bank of Ohio.
Mr. Sauter is a member of the Trading Committees of the Securities Industry Association and the Investment Company Institute, and the Quality of Markets Committee of the NASD.

He received his A.B. in Economics from Dartmouth College and an MBA in Finance from The University of Chicago.