What's Next for Vanguard

Jeff Ptak: Hi, I'm Jeff Ptak, global head of manager research at Morningstar. Coming to you from the 2016 Morningstar Investment Conference being held in Chicago, Ill., and I'm very pleased to be joined today by our guest, Bill McNabb. Bill, of course, is chairman and CEO of the Vanguard Group. Bill, welcome. Thanks so much for joining us today.

Bill McNabb: Thanks for having me, Jeff. It's great to be here.

Ptak: So Vanguard has enjoyed phenomenal success in recent years, and I think what's remarkable about it is the relative simplicity, shareholder-centricity of your at-cost model. And so I think one of the questions that naturally comes up is, what is your next act? What does the next decade look like and does it resemble what's come to this point?

McNabb: So I think there are a couple of things there, Jeff. First, we do think there's some things that we have to just continue doing over the next decade. I think the simplicity is a good way of describing it, so we talk a lot about execution and delivering on the promise of low cost, high quality, really thoughtful work on behalf of our investors. So that has to continue. That's kind of a table stakes at this point if you will. I think what will be different over the next decade or so will be a couple of things. First of all, we will continue to evolve and become a more global firm, and not just in terms of client base but actually in the way we run money and the way we deliver service to people. Second, I think there's going to be a pretty big continued evolution on the technological front. We're seeing this, the move from PCs to smart devices, the phone, in particular, I think is going to change the way we all have to interact with investors going forward. And then finally, I think the last thing that we're going to be really working very hard with our clients over the next decade is probably less good news, is we expect returns actually to be somewhat muted over the next decade versus long-term averages. Now I think investors are going to need a lot of hand-holding, a lot of our advisor clients, in particular, are very interested in the kind of work that we can produce to help them explain this to their clients.

Ptak: OK. If I'm a shareholder, I took a snapshot of the business as it exists today, and then I took another snapshot 10 years from now in 2026, what do you think I would find was different in terms of product service and the experience that I'm having as a Vanguard shareholder?

McNabb: I think in terms of the asset mix and so forth it'll continue to be very similar to what it is. I think cost will be even lower, which sometimes people go, how far can you go? But we still think there's efficiencies to be gained. I think the biggest change though will be there will be much more around the--I'll call it the income solution. I don't know when were going to hit the tipping point here but when I look at the baby boomer generation in particular--and I'm a really good representative of it, I think my birth year is the biggest year--and as people get ready for retirement and are really doing as much saving as they can, but when they make that transition and actually have to begin drawing down, I think how we help them as an industry is going to be really very important. And I don't think we've really hit that yet. And so I think that's going to look very different.

Ptak: And so when you look at your product and service set today I know you have a managed payout fund which is probably the most tangible example of helping somebody with orderly withdrawal. What are other things that you think you might endeavor to do in the future to help people to withdraw in an orderly way?

McNabb: Yeah, so I think our own advice service will certainly be a very important element of this for a number of our direct investors. I think we'll probably have to bring out some new types of funds that help, that are helpful from a portfolio-construction standpoint. A good example of that recently was the [Global Minimum Volatility] fund that we introduced just a couple years ago. Now that's a fund that gives you equitylike returns. We expect actually a little lower than the broad market but that hasn't been the case so far. But at a much lower volatility and again as you know, volatility is really the enemy when you're in a drawdown phase.

Ptak: Right, so Global Min Vol, I believe it figures into your managed payout fund. It's like a 10% to 20% stake in that. And so if you were to place that strategy on the active-passive spectrum, how would you characterize it to an investor? Is this an active strategy? Is it a passive strategy, somewhere in between?

McNabb: It's an active strategy that's implemented mechanically if you will, and that's kind of how I look at a lot of factor investing in general. You're taking an active bet but you're implementing it in a low cost, very disciplined, somewhat mechanical process.

Ptak: When I think back on conferences past here year in Chicago, one of our guests was Gus Sauter, your former CIO, your indexing chief. He was on a panel in which he was debating smart beta, I think at that time it was being referred to as fundamental indexation. Vanguard's position was you can achieve more or less the same thing with traditional market cap-weighted index funds, and so, I was curious, has your view on smart beta, which we call strategic beta, has that evolved any?

McNabb: First of all, I'd say smart beta was one of the great marketing names ever constructed, because it sort of implies there's a better way to index, and we don't believe that at all. We think that fundamental indexing, smart beta, whatever you want to call it, is taking an active bet but it's doing it in a disciplined way. I think when Gus was talking, we've had small, mid-, large, growth, value index funds that were market-cap-weighted for a long time. And they certainly capture most of what people are trying to do in the factor space. Would I say some of evolution there is positive? Yeah, I think there's been some positive tweaks to those concepts, and those are things we have to look at. We have to look at can we improve what we do there so that if somebody if they really do want to express an active view can do so.

Ptak: Speaking of active, with my last question here. You run a lot of active money, though I think your reputation as an indexer tends to precede you. You've got lots of active assets under management. I think that there's an argument that's been posited that we're in an environment where the marginal active investor is leaving the field, and the remnants, the active investors who are there are collectively more skilled, canceling each other out. Some call it the "paradox of skill." Is that a view that you as a firm subscribe to, or do you believe that this is a cyclical sort of malaise for active investors and returns for active management, especially in U.S. equity, will improve going forward?

McNabb: No, I think it's a really big challenge. I'm not sure I would describe it quite that way, but I think some parallel thoughts. What's happened is the market has evolved from a point where there were three big constituents 50 years ago. Actually passive didn't even exist 50 years ago so there were really two. They were active managers and then there were retail shareholders. And retail shareholders held 90% of the equities. There was a lot of opportunity if you will for outperformance for that small group of active managers. Fast forward to today there are really two big holders of equities, there's passive investors and there's active investors. And for each one of them it's a zero-sum game. And so for the active managers even if it's a broad group they're going to cancel each other out in the long run. As the group shrinks, the math doesn't change.

It's still ... for somebody who outperforms there's got to be somebody who underperforms. I think the bigger challenge that we're seeing on the active side is almost from the business perspective because if you look at where some of the sources of their business have come from, traditional defined benefit plans for example are de-risking across all industries. Endowments and foundations have gone to a much more bifurcated strategy where it's a lot of nontraditional coupled with very low cost, passive. The traditional active manager is the one being squeezed. So for us what we're really concentrating on are firms that have phenomenal track records in terms of not just how they manage money but also developing people and developing next generations of investors. I think there will be fewer high-quality firms and access to them is going to be really important.

Ptak: So I think we'll leave it there, Bill. Thanks so much for those great insights, very much appreciated.

McNabb: Thank you, Jeff.

Ptak: From Chicago, the Morningstar Investment Conference, I'm Jeff Ptak signing off. Thanks very much.