Vanguard veterans discuss investment management and issues

June 19, 2013

 

John Ameriks and Joe Brennan, recently named to leadership positions within Vanguard's Equity Investment Group (EIG), are veterans of Vanguard. The EIG index team, now under Brennan's guidance, is responsible for more than 80 U.S. and international equity index funds and ETFs, representing nearly $1 trillion in index assets. Ameriks leads EIG's active team, which manages $14.5 billion in active equity fund assets and serves as investment advisor to Vanguard Strategic Equity Fund and Vanguard Strategic Small-Cap Equity Fund, as well as managing portions of 10 other Vanguard stock funds.

In a recent interview, Ameriks and Brennan discussed their roles, how they measure success for their teams, and the potential risks of alternatively-weighted strategies.

 

Joe Brennan joined Vanguard in 1991. He earned a B.A. in economics from Fairfield University and his M.S. in finance from Drexel University. He is a CFA® charterholder and a member of the CFA Society of Philadelphia.

What can investors expect now that you're at the helm of your respective teams?
Joe Brennan: In essence—more of the same. Clients should expect a continuation of the kind of investment results that Vanguard's equity index funds and ETFs have historically produced for them. John and I will continue the tradition of ensuring that our clients' assets are well-managed.

John Ameriks: The teams that Joe and I oversee are made up of seasoned professionals who know their jobs inside and out. Our role is to help them to continue to do excellent work, to foster and encourage innovation and growth in what the teams do and how they do it, and to ensure the funds get the best management possible.

 

John Ameriks was a senior research fellow at the TIAA-CREF Institute before joining Vanguard in 2003. He received an A.B. from Stanford University and his M.A., M.Phil., and Ph.D. in economics from Columbia University.

John, you most recently oversaw Vanguard Investment Counseling & Research group. How will your 15-year career conducting academic and industry research benefit your new team?
John Ameriks: Most of my prior work has focused on the empirical and theoretical economics of how individuals make financial decisions. That research involves careful quantitative study of investor behavior. I'm not sure my background means I have anything to teach the very experienced quantitative researchers on the active-equity team. But I do speak their language, and I have a very similar, research-oriented mind-set. I'd also like to think that the years I've spent helping clients understand technical issues relevant to the design of target-date funds will be helpful as I and the active team strive to communicate the potential value that our active funds can offer investors.

Joe, you've most recently served as chief investment officer of Vanguard's Asia Pacific region. What insights from that experience do you bring to your current position?
Joe Brennan: The biggest take-away for me is the global perspective that I've gained, which, as Vanguard expands internationally, becomes increasingly important. We operate a global investment team, with centers of portfolio management and trading in the United States, London, and Melbourne, Australia. Having a global perspective when working with teams in various countries is invaluable. I understand what they need and how the operation works.

The other thing I've seen firsthand is that Vanguard's mission—our stand for investors; our focus on low costs, high quality, and diversification; and our approach—resonates with investors everywhere. Vanguard's core tenets are universal principles that transcend cultures, and I expect that they'll become even more appreciated as Vanguard expands globally.

John, can you talk about the strategies you employ in managing the funds?
John Ameriks: Our process relies on quantitative measures of the attractiveness of stocks based on a set of key fundamental factors that are combined in our models. Our strategy and models have been developed and refined over many years through a rigorous and disciplined research process.

In building models, we focus on measuring the fundamental economic prospects of firms and the business foundation for future returns, as opposed to things like purely statistical patterns or short-term trends in returns. We don't rely on very short-term or high-frequency trading opportunities or technical indicators such as "chart patterns." Essentially, we attempt to quantify in our models how we think a skilled, fundamentally-oriented traditional active manager assesses stocks. Then we apply those models at scale, globally, at Vanguard costs. A great merit of the approach is the risk control and discipline that it implies about assessing value.

Anyone who has an active mandate has to believe that there are market inefficiencies and information that could be used to exploit those inefficiencies. We are firmly in that camp. But we're under no illusions about how fleeting the inefficiencies can be and how difficult it is to identify them systematically going forward. We do believe that our techniques can add value over time and through cycles. But they won't add value in every time period and in every set of circumstances. Over time, given the advantage of Vanguard's low costs, we think our process offers investors a disciplined, risk-controlled way to potentially outperform Joe's index funds.

Joe, indexing has enjoyed increasing acceptance, with significant cash inflow over the past few years. Why, and what are the upsides to this trend? Downsides?
Joe Brennan: Much of it has to do with the fact that indexing simply embodies those couple of keys that tend to bring investment success, such as low costs, diversification, and long-term discipline. Increasing numbers of investors are focusing on those types of products, including ETFs.

Investors have the potential, of course, to have the same outcome with an active product. The problem is, not many active products are low-cost. And that eats into returns, often significantly.

John Ameriks: For investors who don't have a preference for index or active funds (or don't know the difference), Vanguard continues to suggest they consider low-cost, broadly diversified index funds first. I still strongly believe that is a good guidance, even though my role at Vanguard is now overseeing a set of active mandates.

But the one thing index funds can't deliver is a significant opportunity to outperform, which is only possible through an active approach. If an investor desires outperformance and understands that to do that some risk of underperforming the index is also necessarily involved, then we'd suggest he consider Vanguard's low-cost active funds.

And, of course, I'm partial to the funds my team manages. To me, if active risk is acceptable, the next question is, "What's the best way to attempt to take that active risk?" That's the problem the EIG active team attempts to solve. The way we approach active management maintains broad diversification relative to an index. Yet it enables modest potential for outperformance, as well as an attempt to control the risks of underperformance.

Joe Brennan: We realize that people have preferences. If their preference is active, we're giving them the best chance at investment success by giving them low-cost active funds. There are all sorts of headwinds in investing, and the key to getting through them is cost. The reason most active managers don't outperform is because the cost of their strategy overwhelms the alpha that they can produce.

John Ameriks: Right—we remind clients of how difficult it is to outperform the market, we try to give them a reasonable strategy, and then we keep the cost to the absolute minimum.

Joe Brennan: The downside to the Vanguard index story is that it gets misconstrued as "index versus active," with indexing the clear winner. And to say that is to miss the point. The Vanguard story is a low-cost, investor-advocacy story, not an indexing versus active-management story.

Speaking of indexing, the concept of alternatively-weighted strategies and so-called "smart beta" is getting a fair amount of press lately. What are these strategies, and how do they differ from indexing?
John Ameriks: Investors' willingness to take risk fluctuates and can be influenced by the memory of recent market events. The financial crisis of 2008 still looms large, and while investors may be starting to consider taking more risk again, many are thinking, "I don't want to make the same mistake twice. I don't want to go through that again. I've got to find something new and different." So it's not a surprise that a number of firms have cranked up their marketing machines and are out there saying in essence, "Look! Here's something new and different! It's alternative beta. It's smart beta." The implication, of course, is that it's not the beta that led to the market decline.
But my view is that if you take the time to do the analysis, you'll likely find out that it's not really new. I believe that a lot of it is repackaged, stripped-down, and simplified versions of quantitative strategies that fell out of favor with many investors after 2007.

Vanguard's investment strategy team has done some research that shows the results have not been particularly encouraging on average for alternatively-weighted equity strategies, and that a lot of the results that are there are attributable to exposure to particular market segments or well-known factors.

Joe Brennan: Unfortunately, with many of these alternatively-weighted strategies, it begins with firms' understanding the dynamic John is talking about, where investors don't have much of an appetite for risk but they do want returns. The firms want to sell something, so they take a concept that's quite simple—indexing—and they tweak it. Now it's enhanced indexing. Well, which one would you want? Don't you want the enhanced one? It's not beta, it's smart beta. And then without any real proof behind this, they go to a few big institutions or consultants and they get a few people onboard and, all of a sudden, it starts to gain some attention as a small subset of investors are drawn to the idea that "it must be different this time."

John Ameriks: Investors should never forget that producing investment products is a business like any other, and large marketing efforts are often a part of it. The question is this: Absent the sales pitch, is what you're being sold right for you? These strategies are not magic. Do you understand what you're being sold?

Our strong conviction is that alternatively-weighted strategies are forms of tilts against the market that emphasize exposures to particular securities, sectors, or segments of the market. If that's what you want, there's not a problem with that. But you should still shop around for it. Don't overpay.

In my view, what sets Vanguard apart is that we've built a reputation for delivering what our investors expect. If that's the S&P 500 Index return minus very low fees, Joe's team delivers that. If that's the potential for adding modest outperformance above an index, subject to a controlled risk of underperformance relative to the index, that's what my team can potentially deliver.

Joe Brennan: In other words, what you see is what you get.

John Ameriks: And you should be able to understand it and not overpay for it.

Some investors find it difficult to see how an active-equity shop can coexist with an index-equity shop at the same firm. Can you talk a little bit about how and why it works at Vanguard?
John Ameriks: Again, Vanguard is not about active versus index. We're about a low-cost, disciplined approach in both active and index, and that's where our clients get value from investing with us.

Joe Brennan: As a firm, we're happy to offer both strategies because we know we're going to offer them at a low cost. That's the key for the investor. Low costs are part of our DNA and a natural outcome of Vanguard's at-cost structure.*

John Ameriks: I will say, though, people do forget Vanguard's history. The firm started as an active-management shop; it grew out of Wellington™ Fund. That Vanguard actually offers both strategies shouldn't be surprising because the Vanguard philosophy has always been about cost, not the superiority of one particular approach.

How do you know when you're doing a good job? Obviously, fund performance is a critical component of success. Are there other measures?
John Ameriks: For EIG's active team, it's not just performance. Yes, our objective is to beat the benchmarks, but we also strive to beat them in a particular way, within particular constraints. We're very intentional about how much risk we take. It's very important to us that we maintain that risk control over time.

Joe Brennan: One of the reasons I love what we do is because we get daily feedback in a performance scorecard and because we get feedback directly from clients.

Other measures that are more behind the scenes but equally important include grooming the next generation of people on our teams. As we mentioned earlier, John and I have very deep and tenured teams, and we want to keep that going long after both of us are gone.

It also includes continuing to invest in a robust risk-management program and a global technology platform.

John Ameriks: When I think about how we're ultimately going to measure success, it's about what's going to happen over longer periods, which means delivering the kinds of results that investors expect from us and growing the organization so that we can bring more of what we do to more investors around the world.

*Vanguard provides its services to the Vanguard funds and ETFs at cost.

Notes:

  • Alpha: A portfolio's risk-adjusted excess return versus its effective benchmark.
  • Beta: A measure of the magnitude of a portfolio's past share-price fluctuations in relation to the ups and downs of the overall market (or appropriate market index).
  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • Diversification does not ensure a profit or protect against a loss.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
 

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