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Nerds in Malvern: A Look at Vanguard's New Chief Quant

The new head of its quantitative equity group will focus on trading cost and improving performance.

A version of this story appeared in the July Vanguard Fund Family Report.

One of Vanguard's most pivotal moves so far this year may have been its least noticed.

At the start of 2009, Vanguard quietly hired a new leader for its Quantitative Equity Group, which runs the family's index funds, actively managed quant funds, and slices of several of its active multimanager funds. Sandip Bhagat, formerly of Morgan Stanley, took over the group, which long had been under the guidance of Vanguard CIO Gus Sauter, in January. Here's what the new position means for Vanguard investors.

Quaking Quants
The equity index funds run by QEG have been firing on all cylinders, but Vanguard's active quant funds, like many strategies that rely on computer models, have sputtered in recent years. Most of the dozen actively managed open-end funds that QEG runs all or part of were trailing their respective category peers over the trailing one- and three-year periods as of the end of July 2009.

It's hard to fault only QEG for the performance of funds on which it shares duties with other firms, such as  Vanguard U.S. Value . But the recent performance of Vanguard's stand-alone quant funds, such as  Vanguard Strategic Equity (VSEQX), hasn't been pretty either. Not only have they trailed their peers in the past one- to five-year periods, but their category rankings also look worse once you back out expenses. For example, Strategic Equity's 10-year return net of expenses as of the end of July 2009 lands just ahead of the middle of the mid-cap blend category. When you add fees back in, the fund's 10-year rank falls behind more than 70% of its peers. That means the fund hasn't added much value beyond its low expenses. Newer funds that were supposed to showcase QEG's talents, such as Vanguard Market Neutral (VMNFX) and the managed payout funds, also have struggled.

No Quick Fixes
Bhagat and Sauter are aware of the performance issues, but they have ruled out any radical fixes. Just as successful human-driven long-term investment processes can fall in and out of favor over shorter periods, the effectiveness of quant models can wax and wane from time to time. Just buying stocks that looked cheap according to valuation metrics like price/book would have gotten you in trouble in 2008; over time, though, the market should restore the effectiveness of such factors. That's why if QEG considers any new factors, they will be evolutionary rather than revolutionary.

Currently, QEG's models compare and rank stocks based on about 15 factors that fall into three groups: valuation, momentum, and earnings. It's a straightforward approach that holds the relative influence of the factors constant and keeps the sector and industry allocations of the portfolios close to the funds' benchmarks. There are a lot of other quant approaches out there that Vanguard could try, including dynamic weighting, or shifting the emphasis of the factors that a model considers as macroeconomic conditions change.

That's not in the cards for Vanguard, though. Sauter and Bhagat believe that buying companies with decent growth prospects and reasonable valuations, which is QEG's goal, still makes long-term sense. Yet QEG is looking at some new factors, including balance-sheet accruals, inventory levels, stock buybacks, and share offerings. Other new factors could spring from behavioral-finance concepts, short interest levels, and signals from the options market. But these aren't new ideas.

Dueling Quants
That's why I think it's what I didn't hear from Bhagat and Sauter that will matter most. Quant investing can be a cloak and dagger affair. Even if Bhagat had some new performance-boosting factor in his arsenal, he, like most quants, wouldn't tell me. There are legions of quants out there armed to the teeth with computers crunching numbers looking for the perfect combination of factors. When they think they've found it, they guard it zealously because, just as too many cooks in the kitchen can spoil the broth, too many quants in a trade can smother the alpha, or degree of superior performance. So, I bet Bhagat and Sauter aren't talking publicly about their most-promising factors.

An important area that Bhagat and Sauter did talk about was trading costs. As one of the world's largest managers of index funds, Vanguard has always worked hard to drive down transaction costs because it's about the only area in which passive investors can gain an advantage. The fund family was an early client of the pioneering trading costs consultant Plexus Group (now part of Investment Technology Group) and currently pays a very low 0.2 cents in commissions per trade. Vanguard, however, wants to bring that trading analysis function in-house this year. That should allow it to slice and dice its trading data in customized ways that could help the firm discern other ways to cut transaction costs, Bhagat says.

Focusing on trading costs may not be as glamorous as discovering a new data point that will propel market- and peer-beating performance for years to come, but it can add a lot of incremental value over the long term. In the end, Vanguard's quant funds may not be cutting-edge, but they are solid state and should be competitive thanks to their low expense ratios. Whether Bhagat can help them be more than that remains to be seen.

 

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