Wednesday, March 21, 2018

A conversation with Vanguard's new CEO.

With the arrival of the new year, Vanguard welcomed a new CEO. Tim Buckley succeeds Bill McNabb (who remains chairman) as Vanguard's chief executiveonly the fourth in the company's 42-year history. Mr. Buckley has spent his entire 26-year career at Vanguard; he has led the company's information technology function and its individual investor business and, more recently, served as chief investment officer and president.

In this Q&A, Mr. Buckley reflects on his early years at Vanguard and talks about what's ahead for the company and the asset management industry amid demographic shifts, innovation, and potential regulatory changes.

You've spent your whole career at Vanguard. What are some of your earliest memories?
My first job was as an assistant to Vanguard founder Jack Bogle. It was 1991 and I was fresh out of college. I had the opportunity to work with him on his first bookresearching, editing, and proofing the manuscript.

It seems archaic now, but we did everything by hand back then. There was no Morningstar software that enabled you to run data queries. I spent grueling hours thumbing through thousands of documents, entering return numbers into Excel, and running regressions to figure out how to predict outperformance.

The results of that analysis are as true today as 26 years ago. Few managers are able to outperform their benchmarks over longer time frames, and the best predictor is cost. The lower the cost, the more likely a brilliant manager might outperform. Intellectual firepower alone wasn't enough back then, and it isn't today.

You've held a variety of positions at Vanguard. What did you learn from those roles that prepared you for becoming CEO?
From our IT leaders, I learned how to separate hype from reality and truly leverage technology for our investors. The crew in our individual investor division taught me the essential elements of client service and how to create promoters. Finally, our investment professionals demonstrated to me that the low-cost, low-risk Vanguard approach to investing could be scaled across the globe.

Vanguard is approaching $5 trillion in assets under management. How do you plan to manage that growth?
Part of the Vanguard culture is an awareness that cash flow isn't a goalit's an outcome of doing the right thing for our clients. Every dollar that comes into our firm is a vote of confidence from our clients that we'll continue to do right by them. It's an awesome and humbling responsibility.

So yes, growth has been tremendous, but overall, Vanguard has done a very good job managing it responsibly. Given our mutual structure, we must ensure that growth benefits our existing clients. Size allows us to fund new services for clients, share economies of scale, et cetera. If growth doesn't benefit our existing base of clients, we'll take action as we have in the past by closing funds.

Will Vanguard be able to continue lowering costs? What else does it need to do to remain competitive?
For Vanguard to be successful, our clients must have the best chance of investment success. There are many keys to a client's achieving that success. Keeping costs low is one of them, so we will continue to drive costs lower. Saving more, sticking to a diversified plan, and being tax-efficient are some of the others. We have made and will continue to make investments in advice, behavioral coaching, and education to ensure that clients follow these best practices.

Where do you see Vanguard's individual investor business headed over the next decade in terms of changing technologies and services?
When I first entered the asset management business, the majority of clients interacted with their advisors face to face. There might have been some do-it-yourselfers or some decisions that were made over the phone. But for the most part, clients would sit across the table from an advisor and discuss their financial goals.

That's obviously changed. Those face-to-face meetings can now take place by videoconference. Some investors are comfortable with a retirement plan accessed on their smartphone and generated by an algorithm. In many ways, clients are engaged now more than everit's just that the interactions aren't happening in a physical office.

But what hasn't changed is the actual advice. Clients still crave information about how to plan for retirement or other life goals. They're just getting that advice in a different manner.
Our individual investor business has done an excellent job adapting to this changing environment. We are heavily investing in technology and constantly improving how we interact and communicate with our clients. I think we have a huge opening there to combine our service, products, technology, and culture to improve client experiences. Vanguard Personal Advisor Services® is the latest example of doing just that.

Speaking of investing in technology, we've seen a lot of headlines about cybersecurity. How does Vanguard approach this issue?
Cybersecurity is at the top of my list. Safeguarding our clients' assets and personal information is something we take very seriously, and we know that it's top of mind for clients, too. Not many financial services companies went into business thinking they would have to defend against hostile foreign intelligence services or organized crime. But that's essentially what's happened, and not just in the financial services industry, of course.

The attackers are very serious about what they do, and they're at it 24 hours a day, seven days a week. They're sophisticated and well-funded. So is Vanguard. We invest in people and technology to protect client assets and privacy. Protecting our clients' data is our single largest investment every year. We have a cybersecurity operations center that works 24/7 to investigate and respond to threats, and that uses National Security Agency-level tools.

What's your response to critics who say indexing is too big?
To me, that assertion is more of a knee-jerk reaction than a well-reasoned argument based on facts. Yes, indexing has enjoyed tremendous growth over the past 20 years, because investors of all stripesindividuals, institutions, and financial advisorshave embraced the low-cost, diversified approach. But there is scant evidence that indexing's growth has hurt the capital markets. Less than 5% of annual U.S. stock market trading volume can be attributed to open-ended U.S. equity index funds and ETFs, so there is still sufficient active trading for price discovery and liquidity.*

You could actually argue that indexing isn't big enough, especially when considering the global investment landscape. There are still so many clients around the world who would be better served by indexing. In terms of total dollar market value, registered index funds account for only about 15% of the value of all global investable equity securities and about 5% of the value of fixed income global investable securities. That means that the wide majority of the global equity and bond markets are invested in some form of active management, whether it be through ownership of individual securities, mutual funds, separate accounts, or hedge funds.*

Could you talk about the importance of Vanguard's in-house research for making investment decisions and advising clients?
We produce world-class research. Investors are familiar with our products and servicesand our research differentiates those products and shows clients how they can be better investors.

A perfect example is our Investment Strategy Group. ISG has done an excellent job studying the economy and the markets and broader topics, such as the impact of technology on global inflation. Our analysts' economic outlook is regularly consumed by our active fixed income managers. They have helped our fixed income team produce consistently strong results. ISG also pioneered research on where advisors truly add value.
Our Center for Investor Research has done great work around U.S. retirement savings and benefits systems. It has helped design plans that make 401(k) participants better investors through autoinvestment features and our Vanguard Target Retirement Funds.

Our research efforts also influence what funds we offer. For example, our Portfolio Review Group conducts extensive research on Vanguard's existing internal and external fund managers and potential candidates. It also researches the competitive landscape and the broader industry and, in conjunction with other teams, builds investment cases for new fund ideas. We have a high bar for product launches, so you won't see us offering the latest fad funds. We won't experiment with clients' money.

In addition, our Investment Stewardship team is researching such topics as climate change, compensation, and board composition in an effort to ensure we are living up to our governance responsibilities and maximizing value for our clients.

Has the Vanguard way of investing resonated overseas?
We've found ready acceptance for what we stand for as we've brought the Vanguard way of investing to investors in Australia, the U.K., Canada, and southeast Asia, among other markets. Every place we've entered quickly understands and appreciates our investment principles and client-aligned approach.

Our value proposition knows no geographic boundaries. So we'll continue to enter select markets and pursue opportunities to serve individuals, institutions, financial advisors and other intermediaries, and retirement plans.

And as we grow outside the United States, we think ETFs will be an important product to our international clients. We're strong believers in ETFs. They provide a low-cost, broadly diversified way for individuals to gain access to a wide variety of markets.

Vanguard has been so successful in investment management—might it venture into other financial services, such as banking or insurance?
Have you read the book Good to Great? Jim Collins wrote about what he called the Hedgehog Concept. It forces us to ask questions such as: What do we think we could be the best in the world at? Where do we think we could be great? That discipline keeps us focused on investment management.

I would never say never, but we don't really have the hubris to think that we could be the best at insurance or banking. We stick to our knitting and stay focused on the things that have brought our clients success over the past four decades.

Finally, let's talk about your life outside the office. You were board chair of the Children's Hospital of Philadelphia. Could you talk about that experience, especially in the context of the emphasis we at Vanguard place on giving back to the community?
Children's HospitalCHOPis a phenomenal organization. It is a Philadelphia institution that has been around for more than 150 years. It's regularly ranked the best children's hospital in the country. And it is responsible for countless medical breakthroughs.

When you meet the people who are on the front lines of giving hope to terribly sick kids, not only from our area but across the country and around the worldwell, it is hard not to be in awe of them. They have a noble mission to give children back their youth. They are a mission-driven organization, just like Vanguard. Similar to the crew at Vanguard, the CHOP doctors and nurses dedicate themselves to making other peoples' lives better. It was easy to give back at CHOP, and the parallels with Vanguard run deep.

* Data are as of September 30, 2017. Global registered fund assets are represented by Morningstar, excluding funds of funds, feeder funds, and money market funds. Global equity fund market share is represented by Morningstar global broad category group equity mutual funds and ETFs. Global equity market capitalization is represented by the FTSE Global All Cap index. Global fixed income market cap is represented by the Bloomberg Barclays Multiverse Index. Global fixed income fund market share is represented by Morningstar global broad category group fixed income mutual funds and ETFs. Ownership share of outstanding securities are best estimates based on available data.

Trading data include domestic equity open-end funds and ETFs. A fund's trading activity is estimated by its cash-flow-adjusted turnover, defined as the sum of (i) portfolio turnover multiplied by average net assets and (ii) one-half the absolute value of annual net cash flow. Examples of other market participants include individual investors, hedge funds, pension funds, separately managed accounts, and high-frequency traders and could include index-based strategies that are not 1940 Act funds.

Source: Vanguard calculations, based on data from Morningstar, Inc., ArcaVision, and FactSet.