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Dan, thanks for your time. Could you give us a brief overview of where Vanguard stands with active management?

At Vanguard, our way of doing active management is our own. It has evolved organically, through ceaseless innovation, since the launch of a fund equivalent to the UK Vanguard Global Balanced in 1975, a year after we were founded.

Vanguard is the world’s third largest active fund manager, with over £1 trillion assets under management in active strategies globally1. We run equity, fixed income, quantitative and multi-asset strategies, with various funds available in the UK, the US, Canada, Germany, France, Italy, the Netherlands and Australia. Due to our scale, we are the world’s largest employer of active fund managers.

Tell us about why we use external managers, what’s the advantage there for investors?

A key difference in our approach is the use of both external and internal managers.

In our view, successful active management depends on three key principles, talent, cost and patience. All three are important. Without talent, cost and patience are not going to matter, but unless costs are low and investors remain patient, the rewards of talent are likely to be reduced or even lost.

There are a lot of managers out there, how do you find the good ones?

In identifying talented managers we look at performance, of course, and we maintain quantitative screens. With modern technology and analytical methods, there is a great deal we can see just by rooting through the data, but we’re aware that analytical tools are relatively commoditised and that we need to be both rigorous and creative in the ways in which we look at quantitative information.

We’re also aware that performance is an outcome of the portfolio, and that the portfolio is determined by the people making the investment decisions. If we’re to understand the performance, we need to ask who are those people and what is the culture and structure of the firm that they work within? What is their investment philosophy? What is the process they use to generate and examine ideas and to make their decisions?

If we can answer those questions, it will be reasonably clear what the portfolio should look like, and how, in different market conditions, it is likely to perform.

If a manager’s philosophical view is that, for example, good companies in unfashionable sectors will be undervalued, and their process is designed to find such companies, the portfolio should not be crammed with high growth buzz sectors such as technology and biotech. Performance in this example might be excellent, but the manager is not doing what they say they are doing, and this would not be consistent with the Vanguard approach.

We find the managers we want through continuous search, and maintain those we have through continuous monitoring. We try to turn over every rock. We’re open-minded. We take calls and we maintain a history of interactions. We recognise that it’s a mature market, but we’re constantly trying to refresh the universe.

Give us a sense of how you and your team operate and how you interact with the managers currently running Vanguard funds

Our approach is team-based. There are 20 professionals in the oversight and manager selection team, including myself and seven further senior investment directors. We have a weekly research meeting where the entire team is encouraged to participate. Each meeting examines a set of external managers. We would typically have around 25 external managers running funds for us at any one time. We track their activity continuously through daily holdings and transaction reports.

Across the team, we try to balance specialist expertise with the need for perspective and breadth of knowledge. Individuals will take a lead on a particular area, an asset class or overseeing the global relationship with one of the larger managers. But there is always flexibility and a team approach to help ensure we are looking at things from different points of view. While we like to give people in the team time to develop deep understanding of an asset class or a firm or methodology, we are also aware of the need for regular rotation.

We would expect to meet each of our current external managers between four and six times in a year. We ask all our managers to present to our Global Investment Committee (GIC) once a year, and also to the Vanguard main board. Both the GIC and the board are chaired by our chief executive, Tim Buckley, we believe this level of engagement is necessary to sustain a long-term, committed relationship.

Could you give us some more insight into how you develop and sustain relationships with external fund managers?

There are roughly 200 firms working in any given style or asset class, of which around 50 will be of interest to us in terms of AUM, stability, depth of talent and background. We would look at that 50 to understand how they align with the interests and ethos of Vanguard. This typically brings our focus down to five to ten firms in each of our search categories (for example, global equities, US equities, global emerging markets).

We partner with both large, global asset management firms like Wellington, Schroders and Lazard, as well as small boutique firms. We evaluate the people and resources of a firm as well as ownership structure. Our approach is holistic but whether we are looking at a niche specialist or a relatively large firm with a wide skillset, we are essentially looking for a distinct, quality-driven culture and investment strategies that are enduring and designed for the institutional market.

Partnering with firms of this type allows us to offer to retail clients a quality of investment management that they would not normally be able to access. It further explains why we look externally. If we were to bring our managers into Vanguard as employees, we have to recognise that this could undermine the very creativity and cognitive differences that we want to nurture.

Another strong difference in the Vanguard approach is that we look to form long-term, high-level relationships. We have worked with Wellington for over four decades and with Baillie Gifford for nearly two. The average tenure is 13 years. It typically takes multiple years from the time that we first identify a firm as a potential partner to making the decision that they are right for us.

Once we are satisfied that a firm aligns with our aims and values, and we think we have a fund which would fit their strategy, we present on them to the GIC, consisting of senior investment staff, including the chief investment officer and the chief executive officer. Should this prove successful, the firm will be invited to present to the GIC directly. The final decision goes to the Vanguard full board.

These deep, lasting relationships mean that we can see into the firm and maintain a meaningful understanding of the people and the processes influencing decisions around our clients’ money. But we are careful to keep the relationships at arm’s length. We want managers who can last, but we have to be vigilant that Vanguard’s interest stays on the side of the client. Analysts in my team are regularly rotated, in part to help ensure that they don’t get too close to the managers they oversee.

One of the most difficult decisions is when to remove a manager and when to wait. Even the greatest managers have down periods and as long as they are doing what we hired them to do, and doing it in a way that is transparent and credible, we will generally stay the course.

There have been times when we’ve moved too soon, and times when we’ve moved too late, but in principle we remove managers for the inverse of the reasons that we hire them, that there is a problem that requires change. Succession issues, dominance of a single individual, mergers or acquisitions that alter the culture of the firm, changes in investment philosophy or strategy are all examples of issues that can influence a decision to terminate.

Combining a small number of managers is an interesting approach. Give us some more colour on that, what it is we’re trying to achieve

We have been combining managers since 1987, so it is a structure with which we have a lot of experience and which we think works extremely well. Combining managers gives us scope to layer in a number of advantages, including balance, diversity of thought and robust risk control, including the mitigation of single-manager risk.

This structure enables each manager to focus on longer-term opportunities in which they have the most conviction. We look to combine high-quality managers employing distinct investment strategies that are complementary to the other managers in the fund. By this we mean that there is limited overlap in their holdings or in their style biases, which in turn means a low correlation in their excess returns. The aim is to deliver a diversified portfolio, focused on actual manager alpha and stock selection, with meaningful potential for long-term outperformance.

Experience shows that the structure can lessen volatility and that ‘smoothing the bumps’ in performance helps to keep investors in the fund, and staying the course can help lead to successful outcomes.

The institutional quality of many of the managers we use is also part of the reason that we frequently combine two or more managers in a single fund. This is what institutions would do and the highly focused specialist strategies of many of the managers are structured to be positioned in this way, as a component in a wider portfolio.

Dan, how would you sum up what Vanguard is trying to achieve with its active investment funds?

What we try never to forget is that the purpose of our funds is to provide a means for our clients to reach their real-life goals. Just as we don’t pursue difference for its own sake, neither do we pursue performance for the sake of it. Our approach to active management is constantly evolving, but it is always shaped by the aim of helping our clients to achieve investment success, because that will help to improve their lives.

1 Source: Vanguard as at 31 March 2020

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