newjerseynewsroom.com

BY WARREN BOROSON

NEWJERSEYNEWSROOM.COM

BOROSON ON MONEY

How does Vanguard justify all its index funds — when most of its actively managed funds have done even better?

Will the Vanguard Group open a physical office in New Jersey, the way Fidelity and T. Rowe Price have?

What worries keep the president, CEO, and chairman of Vanguard, Bill McNabb, up at night?

I asked McNabb these questions during a 45-minute interview recently in his office on the Vanguard campus in Malvern, Pa.

McNabb, 53, is 6 feet 5. And despite his aristocratic name (F. William McNabb III) and aristocratic background (Dartmouth, the Wharton School), turned out to be — besides (obviously) very smart — also courteous and modest.

His predecessor, Jack Brennan, had said about him: "Bill McNabb is a man of great integrity, values, character, talent, experience, and accomplishment." He's been with Vanguard for 24 years.

Here's an abridged interview:

NJN: You became president and CEO at an unfortunate time — in 2008, the very beginning of the nasty recession. And yet you managed to bring in more new accounts...

McNabb: We sometimes joke that my timing was not great. Jack Brennan started just weeks before a great bull market began.

When the recession hit, there was a huge spike in the volume of phone calls and visits to our website, but not many sales — perhaps due to inertia, but we like to feel that our communication helped. Communication was key. We spent a lot of time — on webcasts, TV interviews — urging people to hold on, and we were told that it was helpful. No one really knew what was going on. Even professionals were struggling to say what had happened.

NJN: Would you do anything differently today?

McNabb: We would do more. Some people had said that it was really different this time. And it's always different to some degree. "But do you believe that the U.S. markets and economy are going to go away? You either believe in a collapse, or in some sort of recovery and that we'll work our way through it."

Our perspective was, we weren't going to collapse. We felt that the steps the government took were mostly directionally correct. And we sort of began to see light at the end of the tunnel.

In a bear market, a few smart people realize that the good times are not rolling. In the second stage, everyone acknowledges there's a bear market. And in the third phase, no one sees a way out.

In February and March of 2009, many people didn't see a way out. There was a crescendo of those comments — "This isn't going to end." But we had bottomed out. In every steep correction, there's no sense being an investor if you get out and miss the rebound.

NJN: Any lessons from that awful time?

McNabb: Stay balanced. And people who rebalanced did pretty well. They regained what they had lost, though they're not as far ahead as they hoped they would be. By our calculation, they're 80% back to where they were, or even above.

NJN: Unless they sold.

McNabb: Unless they sold.

It's a great argument for balance and diversification. They're critical. The strong message it gave to people is, there are always crises, but you should follow the fundamental rules of investing, like save more than you spend. We think that the fundamental principles are even more important today.

NJN: What do you think of market-timing — trying to predict bear markets in advance and getting out at the right time?

McNabb: Throughout history, no one has done it very well. Today, it's more complicated, and I'm left scratching my head. If it was difficult before, how is it easier today?

NJN: Do you have any long-term goals? Are there any niches you want Vanguard to fill?

McNabb: You mean, what do I want to leave as a legacy? I don't think that way. Vanguard is owned by its clients. I ask myself: Are we running the best investment firm conceivable? On my tombstone, I'm hoping someone will write, 1. He was part of the best mutual fund organization in the world, and 2. he left it better than found it.

To add greater value, we're trying to find ways to lower the cost of investments — like expanding the lower-cost Admiral shares to cover more investors, as we did recently.

NJN: Are there any plans for target-date exchange-traded funds?

McNabb: There are technical hurdles to overcome, but it's been something to think about.

NJN: What about a municipal bond index fund?

McNabb: There are liquidity issues, although there are a couple of such funds out there. But there have been discrepancies between the underlying value of the bonds and the prices.

NJN: Are you happy or sad that many of Vanguard's actively managed funds do better than your index funds?

McNabb: For many investors, index funds are perfect. They don't need to think about them. They're low cost and high quality.

We think that active management can work, but the hurdles are high. What we do on the active side is lower the cost and give the active funds a better chance of beating the broad benchmarks. This is by no means a guarantee, but we've give them better odds than they had. Morningstar has found that the best predictor of future performance is a fund's expense ratio. And we know that the highest cost funds are generally in the lowest quartile.

We don't run all the active money here — there's almost no active money here except on the bond side. With the equity side, we farm that out to advisers all over the world. Wellington runs 19 of our funds.

We all love working here in Malvern, but not everybody wants to live in suburban Philadelphia. There are good funds in London, Edinburgh, Pasadena, Dallas, and so forth. We hire managers based on who's the most experienced, the best people, the best process, and so forth. I think that our selection process, combined with our cost advantage, explains the pretty compelling data that our funds have done a lot better than their peers.

We know how hard a game it is, and the cost is actually pretty important.

NJN: John Bogle [founder of Vanguard] once said that his worst nightmare was that the American funds, which have fine records, would go no-load. Do you have a worst nightmare?

McNabb: The American Funds are a great firm. But from a competitive standpoint, we worry about everybody.

The biggest thing I worry about right now is just the uncertainty of our regulatory legislation. Tax policy and so forth. I think it's created a little bit of a sense of confusion for the retail investor, and one of the things you see is the individual investor who's struggling to make sense of what the future is going to look like. And you've seen a lot of people put money into cash right now and a lack of flow into the equity markets. So I hope that the next three to six months brings us some clarity. There are capital gains questions, dividend income questions. Some people are just taking a wait-and-see attitude. This whole broad topic is what keeps me awake at night.

Then there's the truth factor out there. The financial system has gone through this immense crisis, and the individual investor may worry, can we trust the system? We should be doing things to make sure that confidence is there that the markets work properly.

NJN: Is there any way for Vanguard to tap into the many people who buy through stockbrokers?

McNabb: It's interesting, there's a huge change occurring among many firms. We're seeing more fee-only and fee-based investments, and less commission-based.

Many of these advisers are using exchange traded funds for their portfolios. They're acting more like advisers. It's a pretty pronounced movement over the past three or four years, moving from commission-based to fee-based. It's one of the most dramatic shifts I've ever seen.

NJN: Do you have any explanation of why so many star managers suddenly come to grief? After years and years of shooting out all the lights, they suddenly get shot down. Like Bill Miller of Legg Mason. One explanation is that so much hot money comes pouring in that their style no longer works.

McNabb: I'm not sure that I have a great answer for you. Larger and larger amounts of money are a great challenge — depending on the style. But it may come back to cost. It's a game of probability and you want to up the odds in your favor. The highest-cost funds have the highest hurdles. They have to outperform by a LOT. It's very helpful for managers like Ed Owens at Vanguard Health Care to have low expenses in achieving long-term out-performance.

Then there's the process of growing and developing teams. We look for the depth of the teams, the depth of research, the plan for generational shifts. The founders of Primecap did a brilliant job of transitioning between the founding generation to the second generation. There's great comfort in that — creating depth, creating a generational transfer of knowledge. I'm not sure that a lot of other firms have devoted as much time and energy on this. But that can explain a falloff — a decline in the depth of the research team.

NJN: In New Jersey, Fidelity and T. Rowe Price have physical offices. Is Vanguard considering this?

McNabb: It's a high-cost way to advertise or to attract new people. We try to spend shareholder money the way we think shareholders want their money spent. Yes, there's a convenience factor, having an office near by. But it's a high-cost activity, and it's not for us.

NJN: Thank you for a most enlightening interview.

McNabb on trust (click here)

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