The Long View

Ptak: Our guest this week is Gus Sauter. Gus served in a variety of roles during his 25-year career at the Vanguard Group, most recently as the firm's chief investment officer. Gus oversaw the management and growth of Vanguard's index fund and ETF business. At the time Gus joined Vanguard, that business consisted of two index funds, with around $1.1 billion in assets. By the time Gus retired from Vanguard in 2012, he was running the firm's global investment management group overseeing nearly $2 trillion in assets. In addition to these achievements, Gus has built Vanguard's quantitative-investing capability and devised the novel structure the firm employs in offering ETFs as a separate share class of its funds. Today, Gus is on the dean's council at the University of Chicago, and also serves on a number of investment committees. We're pleased to have him as our guest.

Gus, welcome to The Long View.

Gus Sauter: Thanks, Jeff. It's great to see you again.

Ptak: So, maybe a good place to start: You retired from the Vanguard Group in 2012 and I think some of our listeners are probably curious to know what you've been up to since then. So, can you update us on what you've been doing since you retired from Vanguard in 2012?

Sauter: Sure. When I first retired, I took some advice that a friend gave me to kind of be slow to reengage. So, I slept in for a couple of months and then basically since then, I've pretty much flunked retiring. I'm working on seven different investment committees and really also engaged with the University of Chicago in the dean's council at the business school there. But the investment committees have really challenged me. It's been very interesting for me. I wanted to make sure that I stayed involved with investment committees. As opposed to working for the board of directors, I chose investment committees and it's been interesting. I've created an interesting book of business: a large foundation, a small endowment, Australian superannuation plan, PGA of America, Finra. So, it's an interesting book of business.

Ptak: And what was the appeal of serving on investment committees at that juncture of your career?

Sauter: Well, my passion was always investing. And as my career developed at Vanguard, you know, certainly, I was overseeing the investment group, but I was also being pulled more and more into the business every year. I was on the senior staff the last 15 years of my career. And the senior staff is a group that runs Vanguard. It consists of eight to 10 people. And more and more of my time was actually helping to run Vanguard. And really, my passion was always investing. So, I decided I wanted to get back and really just focus on the investment part.

Ptak: Sure. Did you give any thought to running money after leaving Vanguard? Certainly, you have a very esteemed reputation and I would think that it would attract lots of capital and so, if you decided to do that, you could have and I'm sure you knew that option was available to you. How come you opted against?

Sauter: Yeah. Well, I loved working at Vanguard. It's a great company. And if I really wanted to step back and run money as opposed to managing people and helping to manage Vanguard, I probably would have figured out how to do it at Vanguard. My allegiance is still extremely strong to Vanguard. But I decided it was best for me to move on and try something new.

Benz: Being on these investment committees, have there been any surprises?

Sauter: I'd say just the similarity of them more than anything else. So, I'd say that most of them pursue what would be called an endowment model. So, not surprisingly, investing in a lot of private investments, whether it be private equity, or infrastructure or real estate, investing in the public markets as well—stocks, bonds, cash—but really complementing with the privates or alternative investments, if you will. And I guess I was surprised that all of them do that. I would have thought that some would still have maybe a more traditional type of simple asset allocation of public securities.

Benz: So, have you gotten more comfortable with those types of exposures through your work on the committees?

Sauter: Yes. Well, I think, it's an appropriate investment if you can do it well, or an appropriate way to invest if you can do it well. Investment theory would tell you, you should have broad diversification. So, just using private equity as an example, we should have an investment not only in the public equity markets, but also the private equity markets. The significant portion of U.S. equity is actually in private markets. So, if you believe in financial theory, you probably should have some private investments as well. The difficulty is that private investments are extraordinarily expensive and very difficult to get access to. So, as an individual investor, it's maybe a little bit of a different ball of wax. But as an institutional investor, you have access to some of the best managers and you have a little bit of negotiating power on the fees. The fees make anything in the U.S. mutual fund industry look cheap. Even the most expensive mutual funds are extraordinarily cheap compared to what you might pay in the private markets.

Ptak: So, I think that I've heard you previously say that on one of your investment committee assignments, so to speak, that you sort of assume a role of constructive devil's advocacy, so to speak. And so, I wasn't sure if that's a mindset that you apply across the different investment committees that you're a part of and how that's received on them.

Sauter: Yeah, I think it's a function of the investment committee itself. So, the one I think you're specifically referring to is the client I have in Australia. And they're very sophisticated, a very well-run investment firm. And there, I do feel like my role is to challenge them, and really act as a hair shirt or a devil's advocate to just maybe push them a little further. Other investment committees where there might be an outsourced CIO, there I take on a different role. As opposed to challenging the internal people, I'm helping to oversee the external people. I still do like to challenge the external people just so that we don't get complacent or take anything as rote. Everything has to be proven. But it does vary by investment committee.

Ptak: Have you come to any conclusions about what best practices, so to speak, are for an investment-committee member if they were to discharge their responsibilities at the highest level of professionalism and do the best possible job of diligence and oversight? Like if you come to a view of what that looks like, I'm sure it will vary by committee by committee, depending on the mandate or the circumstances, but there's probably also some common denominators, right?

Sauter: There are common denominators. But you're right, it is customized depending on the committee itself. Some of the committees where we have maybe a broader span of control, you're interested in the regulatory aspects as well as just the investment aspects. In Australia, Australian regulation seems to be much more significant than in the U.S. and there the investment committee is much more involved on the regulatory side. In the U.S., we typically focus really more purely on investments. So there, you do have to kind of think a little bit differently. And quite honestly, I like kind of the advantage in the U.S. of just having to think about investments as opposed to all the various regulatory regimes that we have to meet in Australia.

But yeah, certainly best practices would be to make sure that you're adding value relative to what you could very simply do. And so, most of the committees I've gone into have been existing committees, and I come in as a member with a legacy portfolio. And I think in no situation have I ever seen them compare their performance against a very simple 60-40 or 70-30 benchmark stocks and bonds. And so, I always start with that because we could sit here in this room and do 60-40 or 70-30 in an index portfolio with no mental strain at all. And if you can't beat that, what are you doing?

So, I've asked every single one of the committees I'm on to start putting that down as a simple benchmark. There are more complex benchmarks that we hope to add value to. But if we're not adding value to that very simple thing, then we need to step back and say, well, maybe we ought to just not fool ourselves and think that this more complex portfolio adds anything.

Benz: So, should investors and their advisors, kind of, use that same benchmark for themselves?

Sauter: Oh, absolutely.

Benz: Or a target-date fund?

Sauter: A target-date fund is a great way to implement… The beauty of the target-date fund is it ages with you. So, it might be 70-30 when you're 40 years old and 60-40 when you're 50 years old, and aging with you and becoming a little bit more conservative. But yes, that would be a good benchmark for you throughout your life as you age and that target-date fund ages with you. But I think that's really the starting point. I mean, that requires no skill to do. And then, if you think, oh, well, I can identify a good manager. You better be able to identify somebody who adds value so that your overall portfolio is beating that very, very simple approach, whether it's 70-30 or 60-40. I've always felt that way.

I think a lot of people when they think of Vanguard, they think of just an index shop. And it's kind of interesting to recognize that in the year 1987, when I first started at Vanguard, we were 97% active and 3% indexed. Now, it's not quite the flip, but it's like 70% index and 30% active, but still very significant amount of active assets, you know, over $1 trillion worth of active assets, making it one of the largest active managers in the world. So, I think that active management has a role, but only if you can apply it well. And as an investor in these funds, you better be able to identify the ones that are adding value to your portfolio, again, to that very simple construct of, say, 60-40 index approach.

Ptak: I want to come back to active and market efficiency. But before we do that, you mentioned U of C and it sounds like you're also doing some work over there. So, maybe, can you talk a little bit about the nature of the work that you're doing there and…?

Sauter: Yeah, it's a role on the dean's council there. I've been on it for about 17 years now. And it's really just a sounding board for the dean. The dean comes up with his proposed strategy and just wants to bounce it off of a number of people from the community to see if it makes sense and maybe fine-tune the direction he wants to take the school. So, it's kind of an advisory board/sounding board for the dean of the business school specifically.

Benz: And you've taught a few classes it sounds like.

Sauter: Yes, I had the opportunity to be an Executive in Residence. When I first retired, the dean of the school contacted me and asked me if I'd like to come out and I didn't know what Executive in Residence mean, and I said, “You know, what do you think it means because I don't know.” And he said, “Well, you know, it's whatever you want it to be.” So, I showed up at the school for really only a quarter. My schedule was such that I really couldn't make it work anymore than that. And being there for a limited period of time, I couldn't teach a whole course. But I did do some guest lecturing in classes and I did a lot of mentoring with students. I have some friends who are professors at other schools. And so, I've taught a class at Wharton, which is nearby where I live outside of Philly. Actually, a classmate of mine at the University of Chicago is a professor at Wharton now. So, I teach his class, one class every year. So, I enjoy doing that. I enjoy seeing what the students are thinking about and hopefully, challenging them a little bit to think a little bit harder too.

Ptak: So, maybe we'll shift gears and talk a little bit about market efficiency and active investing. I think that you're often associated just given the integral role you played in building Vanguard's index fund and ETF business with indexing. But I've heard you previously speak very astutely about active investing and sort of the overall state of efficiency of the market. I think that you said that markets are quite efficient, but not perfectly so, meaning that you're not on board with things like the efficient-market hypothesis in its purest form. So, the logical question is, where are the efficiencies and how do you think that's evolved over time?

Sauter: I do think the markets have become more efficient than they were. When I first started out in the investment business in the mid-1980s, I actually was managing money in a traditional trust department at a bank and I was doing it traditionally. So, putting on the green eyeshades, talking to management, doing traditional analysis. I had the opportunity to actually build a quantitative model for the bank to try to run an equity portfolio as well. And that's really what landed me my job with Vanguard. Vanguard was looking for someone to run the quantitative business. At the time, it consisted solely of one index fund, which is passive quant. But I was also hired to develop active quant, which we did starting in 1989. And the two portfolios that I've personally managed at Vanguard were active quant portfolios, although I was, as you indicated, I was building the equity-index team as well throughout my career and developing the active-equity quant as well. So, I have a lot of respect for indexing and what it can do for investors to just get the market rate of return. But at the same time, I think it is potentially possible to add value and enhance your return over what you might get from the marketplace.

I do think that over time the markets have become more efficient. When I first started working on quantitative portfolios in, let's say, the '80s, it was much easier to add value back then. It got more difficult every single decade. And today, it's a very difficult process. I mean, it's never been easy, but it was less difficult 30 years ago than it is today. So, I think that in and of itself is kind of anecdotal evidence that the markets have become much more efficient than they were 30 or 40 years ago. Nevertheless, I do still think that it's possible to add value with active management. It's very difficult. I think it's important to keep costs low, which means both expense ratios and low turnover and low transaction costs. But it's possible that you can add value if you have really highly skilled managers who in essence can take advantage of other investors. In other words, if you identify a stock that's priced too low, you've got to find somebody else willing to sell it. You're taking advantage of somebody selling you a low-price stock. So, it's a tough game, getting tougher. But still, if you can identify good managers, it's worthwhile trying to add a little bit of value to your portfolio above the market.

Ptak: So, if you had a finite active budget that you were working with, and you had to spend it, do you have any thoughts on sort of where one would spend it most fruitfully? Like, are there particular sort of investment styles, or areas that you think that, say, a retail investor who's committed to active investing should be particularly focused on if they want to make hay?

Sauter: Yeah, so a lot of people say, well, you know, the large portion of the U.S. stock market is the most efficient. I think that's probably true. And so, they say, well, you should either focus on small-cap stocks, or perhaps the international markets. And a lot of people point towards emerging markets. Yes, I do believe those markets are less efficient. So, it is possible that you can add value there or more value there. But at the same time, the characteristics of indexing apply in all markets. So, indexing is always a very good foundation regardless of the market or the segment of the market. But as you're indicating, there can be certain less-efficient markets that probably offer more opportunities. In other words, I mean, you might say, there are more dupes to be on the other side of your good trade in those less-efficient markets. And those would probably be the smaller-cap markets and the emerging markets like most people would identify. But don't think it's going to be a slam dunk, that you just beat the markets.

Ptak: And do you think that's the main factor that explains why markets have become more efficient? I mean, obviously, information is even more readily available and pass more freely than perhaps it was a decade, certainly two, three ago—but also it seems like the skill gradient has changed in markets as some of the marginally skilled players have exited, many of them fleeing to index funds as a matter of fact, and so do you think that explains why the game has gotten tougher for active investors?

Sauter: Yes, it is a very Darwinian process. If you're not good at active management, you go out of business. So, who's left? It's the highly skilled people. Whereas the highly skilled people used to have an easy competitor to beat or take advantage of, now, a highly skilled investment professional has to take advantage of other highly skilled investment people. And it just becomes more and more difficult all the time, because only the strong are left standing. And so, it is Darwinian.

Ptak: Do you think that's reversible?

Sauter: Well, let's hope it's not reversible. Efficient markets are a good thing. I think it can probably level off at some point. I think we get to a point where indexing becomes so big that inefficiencies start creeping back into the marketplace. Once those… We’ll find kind of an equilibrium where indexing levels off and the inefficiencies level off as well, so in other words, indexing doesn't take over so much that the market becomes inefficient again; it finds a point where it can be efficient and not start becoming inefficient.

My guess is, we've got a long way to go on indexing. I've talked to Burt Malkiel and Charlie Ellis, both pretty famous authors of investment books, and both actually ex-boards of directors— members of the board of directors at Vanguard, so pretty good friends of mine. And we've kind of debated how much indexing the market could bear. And we've kind of come in at anywhere from 80%, maybe 85% of the market could be indexed, and you wouldn't get to a point where the inefficiencies start to creep in yet.

Benz: So, how did you arrive at that figure, roughly?

Sauter: Purely out of thin air and lots of debate. I mean, I kind of first started off on my own thinking probably 75%. I think Charlie was more like 85%, which was purely coincidence. I mean, at that point, we hadn't discussed it among ourselves and yet, we all came up with pretty high numbers. As long as there are two investors left standing, two active investors, they're always going to be looking for cheap stocks or getting rid of expensive stocks. So, you always have people looking to make the market more efficient. And if there was only one active investor left, and the market started becoming horribly inefficient, well, then other people would step in and say, “Well, I guess, I can go to the active game again now.” So, it's kind of mere coincidence that we were all at such a high number without really any ability to prove it. But clearly, at this point, as indexing has grown, markets are becoming more efficient, not less. So, I think indexing can grow considerably from here without compromising the efficiency of the marketplace.

Ptak: I mean, do you think the best measure for whether price discovery is happening as it should is the level of trading activity that's taking place outside of index funds? I think that that's a statistic that I think Vanguard itself has cited in the past in basically trying to rebut the claim that indexing has grown too large and it's somehow distorting markets. Do you think that that's a good way to look at it?

Sauter: I think… Well, that's an interesting question because Jack Bogle and I debated that. So, Jack cited stats back in the '50s and '60s where the average equity mutual fund turned over about 15% or 20% per year. And today, it's more like 100% per year. And Jack was saying, you know, this is a terrible thing. You're just racking up transaction costs to no advantage to investors. And my counter to that—Jack and I had a lot of debates; we never really agreed on anything other than to disagree—but my counter was, if the markets are becoming more efficient, and Jack granted me that, that the markets were becoming more efficient. Then it means that the mispricings aren't so significant, and it probably means that the closing of the gap of the mispricing happens much faster than it would have otherwise. And if that's the case, the inefficiencies close quickly means that what was a profitable trade for you has now become an average trade and so, you get out of it. So, it's a natural consequence in an efficient market that you should see more trading, not less. And that's kind of anecdotally what I think has been going on that over the years as more trading has happened, it's because the markets are more efficient. And you have to move on to find the next inefficiency.

Ptak: It seems that one of the ways that active managers have tried to adapt to changing conditions is developing quantitative-investing capabilities of their own. So, as someone who has built a capability like that, a robust one at that at Vanguard, what would you recommend investors evaluate when they're trying to take the measure of a firm that maybe is developing a quantitative capability for the first time, or making it an input into what had been a purely discretionary process? Like what are some of the things that they want to consider to make sure that this manager, which hadn't done quant and is now doing quant, knows what it's doing?

Sauter: Yeah, it used to be that there were quants and there were traditional managers, and they really…there was very little overlap between the two. And I think over time we've seen overlap; both ends of the spectrum getting closer to the center to some degree. I mean, they're moving towards each other—where traditional managers are starting to develop some quantitative tools, they may not rely on them as heavily as a quant manager would. And at the same time, you see quant managers using a little bit more discretion or subjectivity than they might have historically. If I'm looking at a manager…and unfortunately, the individual investor doesn't have the same ability to know what the portfolio managers are doing that we would have had because we were hiring managers and know exactly what they're doing, watching them like a hawk all the time. But one thing that we always look for was consistency of process. So, it's fine for a traditional manager to start enhancing what they're doing by bringing in quantitative tools but making sure that it's not changing overall what they're doing, in other words, changing their style. We wanted them to have a highly defined style, one that they could apply consistently over time. And if we saw them deviating from that style, we would fire them. I mean, the easiest way to get fired by Vanguard as a money manager is to change your style. I mean, you're gone instantaneously. Barring that, you've got several years of poor performance that we would be willing to live with as long as you're doing what you said you were going to do, and it made sense.

So, the first thing I would look at is, is it a style that makes sense? Is it replicable? And are they applying it and replicating it? And then, you start looking at other things. If you have the ability to get close to the manager, what are the people like themselves? What have they done to manage the business? Managers retire all the time. Are they building the bench strength? Are they going to have somebody else that can come in, in five years when they're gone and not skip a beat? Because you don't want to have large embedded capital gains, and all of a sudden your manager retires and have to realize those capital gains to move on to the next one. You want to make sure that there's continuity there and good continuity.

And then, finally, cost is extraordinarily important. The only advantage indexing has is that it's low cost. Active managers have high costs. And so, you want to minimize that disadvantage of active managers and make sure that you're investing in low-cost active, not high-cost active.

Benz: Going back to the growth of indexing, can you talk about what you think the implications are for corporate governance? There's been sort of a raging debate about whether that's a good thing that index funds are growing and taking up a bigger share of the market. What's your take on that question?

Sauter: Well, we always used to say that active managers rent stocks, and that we invested to own them as index investors. Because in an index fund, you buy a stock and you own it for eternity, whereas as we just discussed, the active managers are turning them over once a year. So, we felt it was extraordinarily important that the businesses were run well across time. And I guess maybe 20 years ago, Jack Brennan, who was chairman and CEO at the time, wrote a letter to all of the holdings that we had throughout our portfolios and told the management how we expected them to run their business. Obviously, we weren't trying to micromanage the business. But from a corporate governance standpoint, you know, how is their board set up; what are they doing across all lines of the social spectrum; are they pursuing diversity; are they doing things that we think would ultimately add value to the management of the business? And so, we were very aggressive doing that. And I know that other index providers do the same sorts of things as well.

Most of the index providers are pretty large and have the resources to pursue that type of a program. A smaller boutique type of active manager probably doesn't have the same resources to go after big companies and they certainly wouldn't have the same degree of muscle that we would have. But we always felt that it was very important for us to be quite active. And we had a separate department that did nothing but talk with management of the companies that our various portfolios held.

So, I think there's been a little bit of misunderstanding and some belief that index funds don't care about it. In fact, we felt we cared more than an active manager who was just hoping for a little gap to close over some short period of time. So, I think it's actually been a positive thing for corporate governance, that money has gone into index funds and that index-fund providers can really be aggressive with them and help make sure that companies are managed well.

Benz: What about the counter argument that the corporation knows that the index fund can't just walk away though? That's what you sometimes hear about maybe a worry.

Sauter: Well, we always told them, every board member comes up for re-election every so many years and we told them, we're going to vote you out. And that's a pretty big stick. I mean, most of them don't want to be voted out. And so, we found that was very, very effective. And we told them that—we would say, OK, you're in one point of the spectrum where we would want you to be, and we want you on the other end of the spectrum. And we'd say, you know, we'll give you a couple of years when we want to observe over time, over the next couple of years, that you're moving in the right direction. And so, we always had the threat, we're going to vote you out if you don't do that. And so, that was pretty effective, I think.

Ptak: Wanted to shift gears and talk about diversification. One of the things that we've observed in recent years is international investing has slumped relative to U.S. stocks and bonds. And I think we could also say the same thing to perhaps a lesser degree about small cap and value, which had been sort of all reliables for many, they would tilt a little bit towards small and value and pick up some extra return, perhaps with a bit more kick of volatility. But those were thought of as sort of reliable premia that one could go and pick up. And that story hasn't quite held together in recent years. And so, to those who look at this and doubt the value of diversifying into these areas, you'd say what?

Sauter: So, these areas are typically nowadays called factors that you're investing in. It's kind of the hot topic now. And I never liked the concept of factor investing because it has kind of this sine wave running through it, that it has periods of outperformance and periods of underperformance. And investors get very disillusioned after a period of underperformance and frequently just sell it right at the bottom before it starts to take off again. So, the fact that we've seen small cap and value and international underperform for a number of years, there are a lot of people that have become disillusioned with them and probably starting to back out. It's probably the time to be actually going the other direction and starting to go into them instead of out of them. But I think that's the difficulty of that style of investing because it really goes against our behavioral attitudes that it's just very hard to ride those. So, I think investors are better off being really broadly diversified and really not looking under the hood.

So, in one sense, a global portfolio is better than a combination of a domestic and an international. When you've got one domestic fund and one international, you're always comparing them against each other and say, why am I invested in the one that's underperforming? And then, you throw it overboard just before it starts to outperform. If it's global, you don't know where the performance is coming from. I mean, anecdotally, you might hear on TV that, oh well, international is doing poorly. So, I think it's important to really maintain diversification, knowing that you'll own the best and you'll also own the worst, but there will be flip-flopping back and forth.

Ptak: I mean, that's part of the beauty of a target-date fund, right, is that all that stuff gets stuffed into the fund and you don't necessarily get those pangs of envy, right? When you're seeing another asset class run and yours is languishing, correct?

Sauter: Yeah, that's exactly right. I mean, all you know at the end of the day is you got this return whatever it happened to be without knowing how to attribute to where it came from.

Benz: You referenced using a 60-40 portfolio as just kind of a good basic benchmark. But looking at kind of the raw materials, at least for the next decade from the U.S. equity market and the bond market, it's hard to get excited about that, about return prospects. So, what would you say for investors who are looking at that, and especially, maybe I think a lot about new retirees thinking about what the next decade might hold for them, how should people approach whether to make switches at this point, given that the 60-40 portfolio may underwhelm?

Sauter: Yeah, it's actually a significant drawback right now. I mean, expected returns I think are very low. Certainly, they are on the fixed-income side. We know that because we can see what the yields are. But I think because yields are low in the fixed-income markets, we should expect lower returns in the equity markets as well. So, I think if we get 5% to 6% per year out of the equity markets over the next decade, we're doing quite well and, unfortunately, it's probably going to come in spurts, big up and down spurts, which is really scary. And at the same time, it's really hard to say, well, you know, just sell out of your equity portfolio because you're not going to get much return from it. Because that means you're going to get 2% out of your fixed-income portfolio. And can you live on 2%? Now, if you can live on 2%, then maybe you think about that. But if you need more, and most people would need more, you still have to take a longer-term view. And unfortunately, recognize that there will be greater volatility. Now, as you're getting older, you should become more conservative by nature anyways. So, in our target-date funds, which you've been talking about, we had at age 65, an investor was 50-50 in our portfolios and at age 73, they were then down to 30% equities and 70% bonds—it declined gradually over that time period, which is, I think, appropriate to do. But at the same time, I don't think just say, well, stocks are going to be poor returners going forward, so I'm getting rid of them all together. I think you still need a broad diversification on your asset allocation.

Ptak: So, one of the places where people have looked for that diversification and you're no stranger to it given your approach on these investment committees, is alternative investments and they've also had quite a bit of difficulty. It depends a bit on the strategy, but I would say broadly, they've had difficulty keeping up with the broad equity, certainly, and even fixed-income markets. And so, my question for you as somebody who's looking at these and evaluating them as part of investment, do you feel like that's more structural where there's so much capital that's come into the space that it strangled some of the opportunities that were formerly available to these managers? Or do you think as some who defend them suggest it's more cyclical having to do with maybe monetary policy and alike?

Sauter: I think it's more structural. I think if you look back at the '80s and '90s, back then there wasn't much capital really chasing these alternative-type investments. I mean, you heard about hedge funds and they were kind of this esoteric thing that you heard about. You didn't know what they were, but you could argue nobody knows what they are today either. But at that point in time, hedge funds were returning 15% a year. Today, a good hedge fund returns about 2% a year. And I think it's a structural shift because of the amount of capital chasing those types of investments. Right now, depending on whose number you use, there's about $2 trillion worth of dry powder in various private investments. I think it's a combination of real estate, infrastructure, and private equity.

Well, $2 trillion—that's $2 trillion that investors have committed that they're putting a lot of pressure on the managers to get into the market, because, oddly enough in the private markets, even if your money isn't invested, you're still paying fees on it. So, you're paying 2 in 20. So, 2% of your investment you're paying in the way of fees, even though you're getting no return on it, because it's not invested. So, there's a lot of pressure on the managers to get that money invested. What they do is, they drive the prices of the projects higher, which means the future return is going to be lower. So, I think that's where we are now that the future returns on private investments are much less than what they used to be because of all this dry powder sitting there trying to get into the marketplace. So, I think that people are starting to chase these because they're becoming more of a common household name than they were 20 years ago. But I think they're going to be disappointed because they're expecting the high returns of 20 years ago and I don't think they're going to get that going forward. I think it's going to be much closer to the public-market rate of return, with a much higher fee structure. So, that is certainly something that I've been talking about in various investment committees.

Ptak: The other thing that we observed is, and you've already alluded to it several times, is this tidal wave of capital that shifted into privates, which, you know, I suppose it's logical, in one sense, right? People are broadening out their allocations. And I suppose portfolio theory would argue that there's certain wisdom in that it also seems somewhat insane, just given the sheer amount of capital that's moved to privates. And so, again, you've had a really good perspective on that sitting on these investment committees. Do you think that it makes sense to be very skeptical of what's going on in privates right now?

Sauter: I do think it makes sense because of why it's happening. Whereas theory would tell us that you should be diversified, like we were talking earlier and being invested in privates as well as public markets. But at the same time, I don't think that's why most investors are going into privates, even institutional investors. I don't think they're going to privates, because they’re thinking, oh, the theory says, I need to be diversified. I think if they're going into private, because they're chasing past returns. And that's what's scary about it. So, you see this flood of money coming in with really what's becoming irrational expectations. And so, I think a lot of people, including sophisticated institutional investors, are going to be disappointed in the future. Not that it's going to be a collapse in the privates relative to the publics. But if they're expecting some premium over public markets, I think that's where the disappointment will come from.

Benz: Does it make any sense to you that individual investors would participate in the private market?

Sauter: It's very, very difficult for individual investors. If they can somehow identify the great private investors and somehow get access to them. That'd be a fantastic thing. The thing in the private markets is the disparity of performance is extraordinarily wide. We look at the public markets, and you've got good-performing mutual funds and bad ones. And the difference between the two is meaningful, but not astronomical. In the private markets, it's astronomical. So, if you get the bad managers, it's not like you just underperform by a couple of percent, you get slaughtered in the marketplace, you might be down 80%. And that's what you really have to be careful of as an individual investor, and also getting access to the best managers. The great managers have all the money they need. I mean, we actually had a very large client who's asking how they could get into the private markets, how they could identify the best managers. I said, just look for the ones that are closed. And that's the problem. You can't invest with the great managers.

So, yeah, it's a really difficult market for individual investors and you're going to pay individual investor fees. You know, one of the most successful guys in the private markets has been David Swensen, who was the CIO at Yale and he's been doing this for 40 years. And he would tell most individual investors, just stay away from this. I mean, that's what he's written in his books. As an individual investor, you should be index is what he says.

Ptak: Just going to shift to indexing for a minute, maybe take you back to 1987, which is when I believe you joined the Vanguard Group. At that time, I think, what there were two index funds, around a billion and some change across the two of them. What did you see in indexing at that point? Obviously, you know, doubts were being heaped upon you, right, because the market was dominated by active investing and sort of these swashbuckling active managers. And here you were presiding over a complex of two funds with a billion in assets that simply sought the index to market. So, what did you see in that format that so many others didn't at that time?

Sauter: Well, I went to the University of Chicago business school and all of the theory or almost all of the theory behind indexing came from the Chicago gang. And so, you had to pretty much swear allegiance to indexing in order to get your degree from U Chicago back in the late '70s. And so, I believed in indexing for a couple of reasons, a little less so based on an efficient market belief, but more so on what's become known as Bill Sharpe math. Very simply, that just states that in aggregate all investors own the market. If we take all of our holdings together, by definition, it's every share of stock out there, so in aggregate, we're going to get the market rate of return. And maybe some of us outperform, but it means others have to underperform to offset somebody else's outperformance. That's true before costs. After costs, the marginal outperformers become underperformers. So, a majority of investors will underperform. So, I thought that indexing made a lot of sense if not for the academic reason of efficient markets, but for the Bill Sharpe math, it's just a negative-sum game.

And it was a nascent industry at that point in time. I like the quantitative aspects of it. I think of it as passive quant. And as I mentioned, I was also charged with developing Vanguard's active quant business as well. So, I had kind of an interesting challenge of one on the research side, on the active quant side, but then also on the business side helping to build out the index franchise at Vanguard. So, it was really kind of an interesting opportunity for me and that was quantitative in nature. So, it quite definitely appealed to me.

I remember one time, this would have been the early 1990s, and I think we had maybe $2 billion. We had started at $1.1 billion when I first got there. The crash of '87 happened two weeks later. So, we got down to about $800 million in two weeks' time. But then we grew back up to about $2 billion in maybe four or five years. And I remember Jack showing up in my doorway, saying, “Gus, you just wait, someday indexing is going to be really big. We're going to have $10 billion.” And I remember thinking, well, wow, that would be incredible. And of course, by the time I retired, we had about $1.2 trillion in indexed assets and now, it's ridiculously large now.

Benz: You mentioned some of the areas of active debate that you had with Mr. Bogle over the years: the size of indexing, when it would become too large, was one. What were some of the other things that you and he would engage over and have active debates about?<

Sauter: Oh boy. Well, I guess the biggest one would be ETFs. And Jack was really against ETFs. I think all of senior management, most people at Vanguard believed in long-term investing. And Jack viewed ETFs as nothing but short-term investing. And so, he just believed that if you could trade it, you would trade it and I felt that you didn't necessarily have to trade something just because you could. And then, we developed ETFs—actually, when jack was away on vacation. Jack had already retired at this point in time, but he had his research center still at Vanguard, and he always took the month of August off, going back 30, 40 years. And he had a place at Lake Placid and spent the month at Lake Placid. Well, we announced while he was at Lake Placid that we were getting into the ETF business. And I remember, when he got back, I just happened to run into him. The day that he got back at Vanguard, most of the people, actually eat in the same cafeteria that we called a galley, and it had a bottom floor that you could enter in but also an upper level with a balcony overlooking the foyer down below. And I was going in the foyer down below. Jack happened to be standing at the top of the balcony looking down and he saw me, and he yelled out—and Jack had a booming voice. And he yelled out, “Gus, what the heck is going on around here?” And everybody in the place—and there had to be 150 people in there—everybody just kind of froze. I know I did. So, as I said, great to see you again, Jack. How was vacation? So, we really strongly disagreed about ETFs and I just viewed it as a way to distribute an index and not a new product. I'd say that was our biggest disagreement.

Benz: And he softened a bit on that toward the end of his life, I would say?

Sauter: You know, somebody said that, not with me. But somebody else to me, oh, yeah, he's OK with them now.

Benz: I think he said that to me in an interview that he thought that some people were using them wisely.

Sauter: Oh, well, that's great to hear. I wish he would have confided that in me.

Ptak: So, when you look back on the experience that you had, basically building up Vanguard's index and ETF business, why do you think indexing has finally caught on to the extent that it has? There's some obvious reasons that, you know, obviously, it's gotten tougher for active investors, investors who have perhaps become more educated about the choices available to them and have come to really embrace low-cost investing, which obviously index funds are conducive to. But what are some of the other structural reasons you would cite for why indexing has caught on to the extent that it has?

Sauter: I think there were three catalysts that really kind of catapulted indexing to where it is today. And it's been slow going. I mean, it was brick-by-brick back in the 80s and 90s. I mean, we were winning over one investor at a time. But I think the latter part of the 90s, a lot of people associated investing in the S&P 500 as indexing. That's what indexing was to them. Well, it turned out in the last three or four years of the 90s, large cap stocks dramatically outperformed small cap stocks. And so, the S&P 500 was literally beating 90% of all active funds, and it was getting written up an awful lot. And so, that was maybe the first wave of investments going into index funds. As in most times, people chase past performance. And so, we saw this flood of money start into index and that was the very first time we saw a growth spurt. That was driven a lot by the building up of the tech bubble in the latter part of the 90s.

Interestingly, at that same time, a lot of people were focusing on tech investing and chasing that bubble and then it burst at the beginning of the 2000s, you know, from 2000 to 2002, and a lot of investors got burned because they had become overweight in tech investing chasing those prior returns. And so, then the mantra became, you need to have broader diversification, don't just own the tech industry, own a broader market. Well, what's broader than an index fund? I mean, that is the entire marketplace. So, then again, we had another catalyst in 2002-2003, that led to another spurt in the growth of indexing. And I think the next big one was the financial crisis that hit in 2008-2009. At that point in time, most people felt the U.S. economy was going to grow very slowly going forward, which obviously has been correct. Most people also felt actually incorrectly that equity returns would be very low going forward because of slow economic growth. And so, then they said, OK, well, if I'm going to get low equity returns going forward, I need to make sure my costs are extremely low getting those equity returns. And again, that fed right into indexing because indexing is a very, very low-cost investment strategy. So, you saw the third major catalyst that really propelled indexing. And I think cumulatively those have just become kind of a snowball going downhill.

Benz: You referenced that late 90s period where we did see a stampede of inflows into index funds. The large cap stocks were so unassailable during that period. Are you concerned at all that maybe there's a little bit of that phenomenon going on right now that in addition to the long-term case of low costs for index funds, some investors might be performance chasing a little bit?

Sauter: In the large cap portion or you mean just indexing?

Benz: Yeah, just even total market index.

Sauter: Yeah. So, well, the interesting thing a lot of people say, Well, you know, indexing is really setting the market up. If you didn't invest in an index fund, but you wanted to be in an equity fund, you'd be someplace else, you'd be in an active fund. So, to me, it doesn't really matter whether you put your money in a total market index fund, or whether you put your money in three different active funds. It's still money that goes into the marketplace. And if you want to get your money out, you're going to have the same impact whether or not you're taking your money out of three different active funds, or one index fund.

So, I think that issue that people raised that market is riskier today because of this concentration in index funds, which is still not a huge concentration, I mean, it's less than 50% in index funds. But I don't think that's well founded, because it's just a way to get into the market that, you know, people would have gone through a different door to get into the market otherwise. So, I'm not at all concerned about that. And I don't think it really creates any sort of systematic risk that we should be worried about.

Benz: I guess I was thinking in terms of just unrealistic expectations.

Sauter: Well, yeah, I think there are unrealistic expectations. Because we have had really good return over the last 12 years. I mean, that's what bear markets are all about. And the fallacy in 2009 thinking that returns would be low going forward is that there's some belief that economic growth leads to certain equity returns. In fact, we know that equity returns are not correlated with economic growth. In fact, the best predictor of economic returns are what you pay for a dollar's worth of earnings. So, in other words, valuations or P/Es and valuations were extremely low in 2009. When the market goes down 50%, the valuations were half of what they were a year before. And so, the market was set up to provide extraordinarily good returns. And I actually had a debate on a Morningstar podcast back in 2010 about this. It was a 10-year debate. Actually, I think I'm due a sandwich next year. But yeah – so, I do think that people do have a tendency to say, well, returns have been great. I think they will be in the future. Unfortunately, they invest looking in the rearview mirror, not looking forward and we discussed earlier, I think that returns going forward are going to be very disappointing compared to what people have experienced in the past, much like – I think, to your point, much like 1999.

I mean, we knew that those returns that we had gotten previously over the prior three years that they would not be repeated. We just didn't know what the return stream would be. Would it be one really sharp pullback? Or would it be a 1% or 2% return for the next 10 years? Well, you know, turned out to be a series of two sharp pullbacks and some good markets as well. But over a 10-year timeframe, very low if any return.

Ptak: I wanted to widen the aperture a little bit and talk a bit about innovation. But before we did that, since we're talking about indexing ETFs, one of the innovations that you were closely involved with was adding an ETF share class to an existing fund, right? And I think that one of the things that pops up from time to time, particularly on social media is this concern that because the ETF is not a standalone vehicle, it's a separate share class, then in a certain scenario, for instance, where investors pull a lot of money, let's say, out of the mutual fund share class to which the ETF is connected, you could end up having a taxable event in the ETF, which maybe other ETFs aren't vulnerable to. It's sort of like this tax bomb scenario. So, what's your take on that? As the person who helped to develop this structure, do you think that that's just a bunch of malarkey and not a true scenario that could come to pass? Or do you think under certain scenarios that could happen?

Sauter: So, this is an argument I've been fighting for 20 years. Ever since we announced this structure, our competitors picked up on this and talked about this tax time bomb that was ticking on them. And I argued it's not going to happen, that in fact, at any point in time, we have stocks that are at a loss. So, even at a market high, the markets are at a high right now, I don't know what it is, but there's a certain percentage of the stocks in, say, Vanguard's Total Stock Market portfolio that are at a loss. And so, we did what we call stress tests. The market was at an all-time high in 1999, at the end of '99 during the tech bubble, and it had gone straight up. At that point in time, 12% of our portfolio had losses in it. So, we could have a redemption of 12% of our portfolio and realize losses, not gains, because we sold off the highest cost lots. And so, we would actually be realizing losses, not gains if money was pulled out of the portfolio.

And to put that in perspective, during the crash of '87, which is by far and away the largest event ever in the history of the U.S. stock market, 21% decline in the market in one day. We had a total of 7% of our portfolio redeemed over the span of about four weeks. So, you overlay the biggest event ever in the history of the U.S. stock market, we have 7% pullout, so what's the likelihood that 12% of the portfolio would pull out? It would have to be an unheard of an event and likely a massive pullback. Well, if the market pulls back, the percentage of loss is even greater level. I mean, it's no longer 12%; it becomes 40%. So, it hasn't happened. I don't think mathematically – I mean, theoretically, it could happen, but it's just not going to.

There's a misconception that ETFs don't distribute capital gains. ETFs do have to distribute capital gains, and probably a quarter of them do every single year. So, this whole concept that only Vanguard's ETFs would never have to distribute, it's wrong. So, I'm not worried about it.

Ptak: Where do you think the need for innovation is most pressing in the investment and personal finance fields, sort of, an atom that we really need to split at this point?

Sauter: I think it's investing for the long term – and probably the most difficult thing is saving. So, investing is easy. Saving is really, really tough. And people don't seem to understand how much money they're going to need, and how little time they have to save for that. I mean, people think, well, I don't have to save now. I'll worry about that later. Well, later comes sooner than you think. I mean, I'm much older than I would have thought I would be by now. It came up on me really fast and people don't prepare for it. So, just trying to convince people to save is the most important thing. And I think, a lot of people think they'll have safety nets that will take care of them in retirement, they'll have Social Security. Well, even if you're getting the top Social Security, it's $35,000 a year. It's going to be tough to live on $35,000 a year. You have to supplement that yourself. So, you've got to be saving all along. And you can see all types of stats that show if you start saving when you're 22, when you start work and save till you're 40 and invest that, that you'll have more money at the age of 65 than somebody who starts saving at age 40, and invest till they're 65. It's just the compounding of time works in your favor.

So, to me, the biggest innovation has to be somehow convincing people to save. And there have been some strides on that. I mean, a lot of behavioral finance work has been done on that. Rick Thaler's book "Nudge," nudging people in the right direction, you know, the auto enrollment in 401(k) plans, the auto escalation in 401(k) plans after you're enrolled and you're enrolled saving 1%, then it's 2% the next year. So, those are great innovations, not really from an investment standpoint, but from a savings standpoint.

Benz: Do you think we need to do or think about something similar for the deaccumulation period to kind of simplify that process? Because that seems like another thing that's really hard to figure out how to spend down against sort of an unknowable time horizon? You don't know what the market will do. Can we do more there?

Sauter: Yeah, there's been a lot of effort in the last 20 years thinking about deaccumulation, instead of accumulation. I think because most of the people running the money management industry are now baby boomers and they're worried about the deaccumulation phase they're facing. But it is a very difficult problem. The difficulty is volatility. If you didn't have any volatility, it would be a much easier problem. But if you're pulling, let's say, a certain amount of money out, let's say, $50,000 out of your portfolio every year; if your portfolio went up 4% a year, you could survive that. But if your portfolio goes down 20% and then up 15%, you know, up and down, if you're pulling out that same $50,000 when the markets are down 20%, you need a much greater return to get back to what you would have had just two years of 4%.

So, what we need, I think, are products that moderate that volatility. And we did a lot of work on that the last five or six years of my career trying to come up with ways to moderate that volatility and came out with a few funds attempting to do that. It's a very difficult thing of trying to moderate volatility and still get return. And you can moderate volatility by investing in money market funds, but people still need the return. So, I think that we will be more working on that. And it argues for broader diversification – has been one of the arguments for going into private or other alternatives. But there's also something a lot of people misinterpret investing in private investments. They think that private investments are less volatile than public investments. They say, well, private equity went down 25% during the financial crisis when the public markets went down 50%. Well, that's not really correct. The private markets are marked to value. They're not mark to market. In other words, the public markets are marked to market. They go down because people get scared and they just get out. Does anyone really think that the value of the U.S. market really went down 50% over a one-year time period, the value didn't go down, the market went down 50%. The value probably went down 25% which is what private equity was marked down. But there was this illusion that private equity only went down 25%. If you had to sell off your investment in a private equity portfolio, if you could sell off your investment in a private equity portfolio, you would have taken a greater hair cut than down 50%. You would have been down 75% because you really get slaughtered in that market because there's no liquidity. So, there is that illusion in the private markets that isn't a solution for this lower volatility that I think we need to fear a solution to.

Ptak: What do you think of direct indexing? That's a concept, a topic that's become increasingly talked about in recent years. The notion is that instead of investing in an ETF or an index fund, which collects the securities to match the benchmark, instead, basically a personalized portfolio is constructed for the investor. It resembles in all respects an index fund unless it's customized in certain ways. I think some have suggested that that's the next frontier in indexing. Do you agree with that?

Sauter: It's very hard to do for smaller portfolios. I mean, try to imagine a small portfolio investing in 3,000 stocks. That really can't be done at a reasonable cost. But even a larger portfolio, the disadvantage is that your portfolio becomes a little stale over time. So, I know of a very large private investor that actually started doing exactly what you're talking about. They did it probably about 20 years ago. They put their portfolio together. The problem is that they really didn't have any additional money to follow on. You need more money to refresh the portfolio all the time, because the marketplace itself changes. You have mergers, you have companies go out of business, you have new companies being formed. If a new company is coming out, where do you get the money to invest in that? You've got to sell off all the other stocks that you own to raise the cash to do that. And if you have to do that, you're probably going to realize capital gains. A fund has a natural advantage of having positive cash flow and can just redirect that positive cash flow to the areas where you need it. If a company like Google comes out or Facebook, where do you get the money to put into Facebook? Well, if you've got a mutual fund that has constant cash flow, that's your source to buy your Facebook stock with. Whereas this private portfolio, this direct index portfolio you're talking about wouldn't have that.

So, what we found – what I heard from this very large family portfolio was after about 10 or 15 years, they actually were in a very bad situation from a tax standpoint. they didn't have the ability to realize losses. Everything in their portfolio at that point was at an all-time high, because it was all purchased 20 years earlier. So, everything's at a gain. What are they going to sell off that's not at a gain? Whereas, as I mentioned earlier, in our portfolio, since we're buying stocks every single day – I say, our, I mean, what used to be ours back six years ago before I retired – in that portfolio, you've got stocks at every single cost lot it's ever hit. And you're always going to have the ability to realize losses to the extent you need them. So, these direct index portfolios sound fine for the first couple of years. But if you're talking about a 10-year or 15 or 20-year investment, you get kind of boxed into a corner.

Benz: What do you do with your personal investments?

Sauter: I'm about 80% indexed and about 20% active. I have very few private direct investments that I've made, mostly in real estate ventures, but that's really a very small portion of my portfolio. So, it's a pretty straightforward portfolio; 99% in mutual funds. I have a very heavy weight in equities personally. But as I they say, about 80% indexed and 20% active.

Benz: So, those are Vanguard active equity funds?

Sauter: Yes.

Benz: OK. How do you decide which ones to invest in?

Sauter: Well, so, I know most of the vanguard managers and over time I've gained a lot of comfort with the various managers. And I know how they built their business to last going forward. As I mentioned earlier, it's very important that you're building the bench strength for the next generation, and I have a great deal of comfort in the funds that I've selected that they've done that and will continue to do that going forward. So, I had a kind of unique exposure to these managers because I was helping to oversee them.

Benz: Right.

Ptak: Well, Gus, it's been a real treat to have you on The Long View. Thank you so much for your time and insights. We really enjoyed having you as our guest.

Sauter: Well, thank you very much. It's great to be with you again.

Benz: Thanks so much, Gus.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)