Bogleheads on Investing- Episode 037 transcript

Gerry O’Reilly is the manager of the $1.3 trillion Vanguard Total Stock Market Index Fund and ETF, and Rich Powers is the Head of ETF and Index Product Management at Vanguard. In this fascinating interview, we go behind the scenes to learn how the largest mutual fund in the world operates. Our discussion covers trading the mammoth fund – including tricky microcap stocks, fund fees and expenses, security lending, proxy voting, tax efficiency, cash management, in-kind additions and distributions, and a lot more! 

Episode 037- guests Gerry O’Reilly and Rich Powers

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Rick Ferri, September 2, 2021

Rick Ferri: Welcome to Bogleheads on Investing, podcast number 37. Today we have two special guests, the Vanguard Total Stock Market Index Fund lead manager Gerry O’Reilly and the head of ETF and index product management Rich Powers. And today we’re going to get a behind the scenes look at how the largest index fund in the world operates.

Hi everyone my name is Rick Ferri, and I’m the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C Bogle Center for Financial Literacy, a 501(c)3 non-profit organization that can be found at Bogelcenter.net. Your tax deductible contributions keep programs like this going.

I’m very pleased to have Gerry O’Reilly and Rich Powers from Vanguard. When you listen to this podcast, you will be amazed at the candor these two people provide to us about behind the scenes operations, of how the largest index fund in the world, the 1.3 trillion dollar Vanguard Total Stock Market Index Fund operates and is managed. We’ll be covering a lot of ground today.  We’re going to be talking about daily operations and how money flows in and out of the fund, how securities flow in and out of the fund in-kind through ETFs and through large institutions. We’ll talk about how microcap stocks are traded in the fund, which is a difficult part of the market.  We’ll talk about proxy voting. We’ll talk about fees and how security lending helps reduce the cost to investors. We’ll talk about several tax saving strategies used to manage the fund. We’ll talk about the history of this fund and the three different indexes that it tracked during its history, now tracking the CRSP Total Stock Market Index.

We’ve got a lot to talk about today, so let’s get to it. With no further ado I am extremely pleased to have Gerry O’Reilly and Rich Powers from Vanguard. Gerry is the portfolio manager for the Vanguard Total Stock Market Fund and ETF and Rich is the head of ETF and index product management at Vanguard. So welcome Gerry and Rich to Bogleheads on Investing.

Gerry O’Reilly: Thanks Rick. Great to be here.

Rick Ferri: Well before we get into this fund, which is the largest fund when you look at all share classes, of any mutual fund in the world. I just wanted to find out a little bit about your background, Gerry, and a little bit about your background Rich. So Gerry, I understand that you’re an Olympic athlete. 

Gerry O’Reilly: Yeah, that was a few years ago, Rick. Back in 1988 I represented Ireland in the Seoul Olympics in the 1500 meters. Grew up in Ireland and came over to the US, went to school at Villanova on a track scholarship and after I graduated in 1987 my job was a full-time track athlete. So, for a few years I would go to Europe in the summers, and my goal was–you know  I always had this desire from a young kid to someday hopefully try and make an Olympic team. So fortunate enough that in 1988 I ran fast enough that qualified for the Olympics and made it to Seoul. 

A year or so after that it became evident that I might want to think about another job if I was going to be able to afford a mortgage and a car payment and insurance and things like that. So fortunately, a very good friend, Jim Norris, was working at Vanguard at the time and he said, “Hey, I’ll drop your resume off.” So I thought I’d be here maybe three or four years and find something else. Little did I think that I’d be here– I’ll be here thirty years next March– and it’s been a great place to work. And started off entry level at Vanguard and within a couple of years made my way over to be an assistant trader and have been on the desk for twenty seven odd years.

Rick Ferri: Now yeah, that’s a fantastic story. What about you, Rich? I mean you’ve really made your way up, been there a long time as well.

Rich Powers: Yeah I can’t compete with Gerry as it relates to kind of a pre-Vanguard story, but our paths have some similarities in that we both started on entry level positions in our retail phone area. And so I made my way from our phone group over to our portfolio review department. Really think of that as kind of our product group, and for most of my 22-year career I’ve spent focus on our active lineup. So we work with firms like Wellington and Primecap and have them run active equity portfolios for us, and we have internal active capabilities in our Fixed Income Group. And so I was part of a team that looked after those managers, chose managers to deliver active mutual funds to our clients.

And then about six years ago I moved into this role where my team and I are leading the ETF and index product management function. And really that has three dimensions to it. We work with some of our larger and sophisticated clients to help them understand our product relative to the marketplace. Two, we do surveillance of the marketplace as Rick, as you know really well, the indexing landscape has changed pretty dramatically over the last decade or so, and so we’re the eyes and ears for the organization as it relates to that. And then the last part of our job is designing new products and improving existing products.

Rick Ferri: You know it’s really a testament to Vanguard that they retain people for so long. I mean you’ve both been there more than twenty years. Gerry, you’ll be there thirty years soon. That’s really fantastic. I’ve heard it’s a great place to work. I want to get into the Vanguard Total Stock Market Index Fund, and by that I mean everything: the institutional shares, the admiral shares, the ETF class shares. All together it’s the same portfolio, am I not mistaken? This is the same portfolio, just different share classes, correct?

Gerry O’Reilly: Correct, yes. On the actual managing of the fund, Rick, if you think about it this way, to me it’s one pool of assets and so whether cash flow is coming in in the form of if it’s institutional, if it’s admiral, whatever the class might be it’s just cash flow coming into the fund. So I, in terms of managing the fund, I don’t need to concern myself like which channel is this coming through, because it’s just cash flow into the fund. So obviously my goal as the manager is to make sure that the fund is really keeping tight tracking with the benchmark.

And so you know that sounds pretty easy, but there’s a lot of moving parts in there. So there’s cash flow like I mentioned, there’s – we work with a data team that gets in here at seven o’clock in the morning to make sure that the data, the indexes that we’re actually looking at, that all of the corporate actions that might have happened the previous night, that they’re all accounted for, so that when I get in, that I make sure that the index I’m tracking is the exact index and we’re talking like a spot on, like no discrepancies whatsoever. Then throughout the course of the day you have all these different index changes, right, that we get notified that are going to be effective at the end of the day and so we need to position the portfolio so that at four o’clock our fund replicates the index spot on, and so any index changes we need to factor that in, and usually that’s going to mean that I need to buy, so I’m going to have to sell something to fund that buy. And so multiple, I mean we could have a dozen of those that happen on any given day, and it could be syndicate offerings, it could be Dutch auctions, it could be numerous different corporate actions that you need to incorporate into it.

And then you get to the point around three o’clock, Rick, where you actually generate your trade list. So if I have 600 million coming into the fund, some of it’s institutional money, some of it’s admiral, some of it is cash tenders that might be going on in the portfolio. I sum it all up. I have my trade list, let’s say it’s 600 million dollars, and now it’s up to me to trade that. I know my benchmark is the close. I then, because you know at Vanguard we kind of wear two hats, you’re both the trader and the portfolio manager. So I know exactly what the strategy needs to be.

I know that it’s a cash flow trade so most of that trading I want to be able to participate in the auction because that’s how our funds price. You can- whatever the closing price is in the particular, whatever exchange that a stock happens to be in, the primary listing, that’s the benchmark for us, so I know that that’s what I need to be able to buy at that price, or maybe even better. And so we put a portion of it into the auction. And you need to have your orders down there by a certain cut-off time, depending whether a stock is a New York listed stock or Nasdaq, and any residual names. 

Then it’s up to me to put a strategy together on how I plan to trade these names. So there’s lots of moving parts, and the great thing is we have a fantastic team. We have about twenty five traders on the desk, roughly split half and half–well maybe a couple more on the domestic side– and so that if my plate gets too full, Rick, I know that I have two or three traders that I can count on to help me with the workload, to make sure that at the end of the day we’re 100 percent invested and that’s really ideally what you want to be in an index fund. You don’t want to have any kind of a cash drag, you want to make sure that you’re 100 percent invested.

And then at the end of the day we basically can run reports. We have multiple eyes that sign off. I sign off. We have a desk supervisor that signs off. Then we have someone from our risk area that signs off to make sure that the fund is where it needs to be. So lots of moving parts.

Rick Ferri: And just to circle back to the fund itself, based on what’s on the Vanguard website, at this time the fund value is 1.3 trillion dollars. That’s all different share classes, but in aggregate this pool of assets is 1.3 trillion. Now I went to the indexer’s website and calculated that the value of the index, the total US stock index, which is a float adjusted, and we’ll get to what that is in a minute, right now is about 45 trillion dollars, 45 trillion. So this fund, the way I calculate it, this fund – the Total Stock Market Index Fund at Vanguard – is about three percent of the US market float-adjusted. By float-adjusted it’s the shares that are outstanding and available, right? Is that fairly accurate?

Gerry O’Reilly: You’re in the ballpark.

Rick Ferri: You are in charge of three percent of the entire US stock market with just this one fund, which is incredible. Quite frankly it’s a lot of responsibility. Now Vanguard in aggregate has about eight trillion dollars. How much of that is in US equity, of the eight trillion?

Gerry O’Reilly: Well on our desk, Rick, which is the indexing desk, we’re four and a half trillion roughly. Now I think we also have plenty of external managers and we have our internal QEG, which is the quantitative group, they would be on top of that. I don’t know what the total equity would be. I don’t know, Rich, if you would know what the bond portion is that we could subtract that out of the eight.

Rich Powers: Yeah I would ballpark it that US equity investments are probably in that four to four and a half trillion dollar level when you sum up what the equity indexing group runs across the funds and ETFs, as well as the active equity strategies that Wellington or Primecap or the like run for us.

Rick Ferri: So it’s fair to say that about 10 percent of the investable US market is owned in some way, form or fashion by Vanguard investors, is that accurate?

Rich Powers: I would say you’re in the in the right zip code. Yeah okay, okay.

Rick Ferri: Well I just want to get it all down, that’s a phenomenal amount and a lot of responsibility. There are a lot of people’s retirements at stake, if you will, based on what you guys are doing. So we all greatly appreciate–including myself by the way–you know, full disclosure I own a couple of the Vanguard funds, including the Total Stock Market Index Fund. So you’re my portfolio manager. Let’s get into the index itself, because it really has a kind of a history and I’ve been involved a little bit of this because I followed the indexing industry for over twenty-five years and especially this particular fund. It started in 1992, which Gerry, that was the year that you joined Vanguard if I’m not mistaken.

Gerry O’Reilly: That’s right.

Rick Ferri: 1992, and the original index that it tracked was called at that time the Wilshire 5000. Now there weren’t five thousand stocks, but the company Wilshire, called it 5000. There was actually more than that at the time. Now that index is the Dow Jones US Total Stock Market Index. But so this was the original index and Gerry when you came on board to start working with this fund it was 1994, so you were there kind of at the beginning of it when assets started to flow in because it did take a little bit of time before people realized what it was. But it was the first total US stock market index fund to be created. And I was excited about it at the time I recall, but there was- I had a conversation with Gus Sauter after this fund changed indexes and I asked why you left the Wilshire 5000 back in 2005 and you went to something called the MSCI Broad Market. And he said that you at Vanguard were the ones who had to make a lot of  changes to the index because there were some real problems with the index. Is that fairly accurate?

Gerry O’Reilly: It is. I mean I would say back then your memory is correct, Rick. You know back then the Wilshire 5000 there were a couple of things I would point out. So number one, in terms of managing money towards it, one of the big issues that we had is that it was not float-adjusted. So you could have a name that was getting added to the index, and let’s just use round numbers Rick, let’s say there’s 100 million shares outstanding and insiders owned 70 percent, so really the float was 30 million shares available to the public.The way that was managed back then is that we would be forced to buy it as if 100 million shares was outstanding, and obviously that would be problematic as assets grew. You know you’re trying to buy this name as if 100 million shares are outstanding, 70 million shares are held by insiders or some private equity firms, whatever the case might be and we had a massive impact on names when they were getting added to the index. So Gus I know at the time was very much in favor of “Hey, we need to to be in a position where we need to talk about float-adjusting the indexes.” And so once we went to float-adjusted indexes it became much more manageable to trade names when they got added to the index.

And I would say the other big change, Rick, and you mentioned it already, was that there were far more constituents back then, and there were well over 5000 names in the benchmark. And so I would say from managing it there was probably more of an optimization tilt to managing the fund where [it’s] difficult to own every single name, when you have that many, and if you look at today, you know the CRSP Index, it’s 3800 odd names in there. And so you know that has been a problem with this US market structure in general, that just the number of names going public. Private equity was relatively small back then so if you needed capital you became a publicly listed company. Whereas there’s lots and lots of companies that are very very large today that are private, they’re not trading publicly. And I think the exchanges are aware of that and trying to come up with ways to entice more people to go public sooner. I would expect that number in the CRSP index to rise over time as well.

Rick Ferri: Before we went from the Wilshire 5000 to CRSP there was an index in the middle, and that index was the MSCI Broad Market. And this change created a problem. I’d written a book called All About Index Funds and I realized right away that there was a whole bunch of micro-cap stocks in the Wilshire 5000 that you had to sell to get to the MSCI Broad Market because the MSCI Broad Market was 3,000 names. It was fairly close to the Russell 3000.

So you had a thousand or 1500 whatever microcap stocks that needed to be sold and I remember that whole process going on where it took you, I don’t know, what two years or it took you quite a long time to liquidate all of those micro-cap positions. Only to turn around and buy them back again in 2013 when you switched indexes again and went to the CRSP, and CRSP is the Center for Research and Security Prices. CRSP, which is kind of an affiliate of the University of Chicago. So explain, how do you deal with all this micro?  I mean you had to sell it then you turned around and you had to rebuy it. I mean microcap is a fairly illiquid market and I got a lot of questions on the Bogleheads about how do you manage the micro cap side of this?

Gerry O’Reilly: Yeah, so you’re right. Micro caps if we look at it, those are by far the most difficult, and back when we did that transition, I mean the thing we did, Rick, was we took our time, we’re opportunistic a lot. Some of these micro caps– there are days when they don’t even trade, or if they trade it’s for a couple of hundred shares, thousand shares–and if we had size in a name we would certainly–you know one of the things about trading is there’s a trade-off, right– so if you have a name that is a relatively small weight, which most of these micro caps tend to be, you’re talking fractions of a basis point, it doesn’t make sense that if you need to sell it you know to have huge impact on that name since it’s not really going to cause much in the way of any kind of significant tracking error to the fund. So the way we thought about that was let’s be smart about how we trade these names, and if it takes time, it takes time, but we will be opportunistic, we’re going to be out there. I mean the US market structure is fairly complex. You’ve got sixteen different exchanges. You’ve got forty-five different pools of liquidity. You’ve got dark pools that are available. We’ve got brokers sending us indications of interest where they can tell us kind of here are names that we’re trafficking in today.

So we would take our time and trade those names if we were opportunistic. So I find a buyer in one of the dark pools– boom I may be able to trade five days worth of volume in a minute because the other side showed up. But we certainly weren’t going to- if we were selling those names that have a lot of impact, push the prices down just because they’re on a particular day we were out there, there didn’t happen to be any buyers out there. So we were opportunistic about working with our peers in investment risk that let us know “hey these names even though they might be a lot they really represent very little risk to the portfolio” so we really were just opportunistic in terms of how we got into them.

And then you know CRSP came along and I would say CRSP methodology was probably the closest aligned to what we thought here’s what proper indexing is in terms of how you manage index funds. They had buffers in there so that you didn’t have too much in the way of turnover. When we have rebalances now we’re able to do it over an extended period of time. We’re able to do it over five days. So the idea of doing that and you know being able to spread that trade over five days rather than doing it in one day was a huge benefit to our shareholders because we were able to minimize the impact you would otherwise have if it was done in one day.

So there were lots of things that we liked about CRSP methodology. How they handled large IPOs, how they handled syndicate. We were able to take advantage of the liquidity available in the market so that they would get added sooner to CRSP maybe than some of the competitors. So there were lots of things we liked about it and we think we’re at a good spot today Rick.

Rick Ferri: Another thing we like about it is they’re not charging as much money as some of the other index providers for the index. Saves us a little money.

Okay, very good. Rich, I want to jump to exchange traded funds because in 2001 Vipers were launched and Vipers were at the time the code name. The word “exchange-traded fund” didn’t really exist back in 2001 so Vanguard came up with this thing Vipers and I forgot what it stood for but it’s an ETF and they eventually dropped the Viper’s name and just went with exchange traded fund or ETF but these were launched in 2001 and they were launched as a share class of an existing fund which was completely, a brilliant idea by the way, which Vanguard patented, and could you talk about this and and then as you talk about it also talk about the benefit to even the open-end share class holders because of ETFs?

Rich Powers: Rick it really was a really seminal moment for Vanguard in terms of entering the ETF category, as it allowed us to reach more and more investors that we couldn’t access through our index mutual funds because of payment for distribution dynamics. But ETFs allowed us to reach advisors and individuals at a much lower cost through different discount brokerage platforms. Interestingly, we just celebrated our 20th anniversary in ETFs back in May. The Total Stock Market ETF (VTI) just hit that 20-year anniversary and it’s one of the largest ETFs today. We’ve 1.9 trillion in ETF assets in our US lineup.

The benefits of the multi-share class structure were really compelling for our ETF lineup very early on. So what we were able to do is attach an ETF share class to an existing large fund like the Total Stock Market Fund and on day one have that ETF have a very low expense ratio, incredibly broad diversification because it’s simply a share class in an existing big pool of assets that Gerry now manages today. And what that means, it allows the fund to track its benchmark really well. And so all that created a nice tailwind for our early ETFs and that they were able to hang it off an existing fund they track well they’re inexpensive and investors are able to access the US market in a really low cost way and get great tracking.

So seventy of our eighty-two US ETFs have that multi-share class structure– the more recent vintages of our ETFs that we’ve launched are standalone ETFs–so more conventional like  many of our peers in the industry offer, and that just speaks to the fact that where we had a mutual fund, an index mutual fund, we hung an ETF off of that mutual fund where we could, and now we’re in the midst of launching some new strategies where a mutual fund didn’t exist. So launching the ETF is the better answer, given where we see client interest aligning.

Your point around tax efficiencies is a compelling one in that one of the things that happens with an ETF is – there’s probably layers of tax efficiency that we can talk about with respect to an ETF. The first of which, the ETF is based upon an index based strategy, right. We know by and large most index-based  strategies are lower turnovers so that in and of itself creates tax efficiency for a portfolio.

But with respect to the ETF there’s two other really important dimensions to it that give it that extra ability to minimize capital gains distributions. First the trading of the ETF shares in the secondary market, so we’ll stick with the Total Stock Market as an example. But if Rich Powers owns VTI and he wants to sell that exposure and I go into my brokerage account I decide to sell it, there’s a market maker on the exchange who’s going to see that order come through and then they’re going to pair that sell order, let’s say a buy order from Gerry O’Reilly who wants to buy that same VTI ETF in the marketplace. So that trading activity amounts to almost a billion dollars a day in our ETFs which means that activity never makes its way to the portfolio. Gerry doesn’t have to lift a finger to trade that activity in the portfolio – buy or sell – because it’s just simply exchanging shares on the exchange. So that really creates part of the compelling nature of ETFs when it comes to tax efficiency.

The other component is how ETFs transact. At the point at which maybe there is more buy activity for an ETF on the exchange, a market maker is going to say, “Well I need to go and acquire more shares from Vanguard to satisfy this greater buy activity and so I’m going to go out and accumulate the underlying stocks that represent that index, hand them to Vanguard and Vanguard is going to give me shares in exchange to sell to investors out in the marketplace.” The same thing happens on the way out. This is where the power comes in, where if there’s a lot more sell activity on the ETF in the secondary market instead of having to sell the couple thousand stocks in Total Stock, Gerry’s team is going to hand the market maker those stocks. They’re going to sell them into the marketplace to satisfy that redemption activity that’s happening in the market so shareholder impact in terms of the tax efficiency and positioning the portfolio doesn’t happen because there is no selling stocks in the portfolio to meet  that redemption. It’s we’re handing those stocks to the market maker who then sells them outside of the portfolio.

Rick Ferri: And let me put in my two cents. But then I call it a double-edged sword here on taxes, because correct me if I’m wrong, Gerry, when you get a cash redemption through the mutual fund side you could sell shares of stock that are at a high cost basis so that there’s very little impact if any on the fund. It might even be a loss to the fund because some of the shares you may have bought at a higher cost. And then when there is a redemption on the ETF side – creation unit redemption – you can push out stock that’s at a low cost basis so again pushing out some of the tax liability, unrealized tax liability in the fund. Is that close to what you do?

Gerry O’Reilly: Yes, yeah. Every day, Rick, we’re going to basically net all of our cash flows coming into the fund. Let’s say you have a redemption coming in today. I  very well might have a corporate action going on where one of the stocks in my portfolio is being acquired by someone else for cash. Or we could have some other corporate action and part of it is hey you’re going to get X number of shares of this stock – the acquirer – and you’re also going to get X number of dollars per share. So I kind of net everything together around three o’clock. I’m going to know “Hey, do I actually have to sell today or am I actually in a buy mode?” And I can tell you through twenty seven years on the desk it’s been massively skewed towards the buy side, where cash flow is coming into Vanguard.

The ETF activity that Rich just referred to, I could get a billion coming into Total Stock today in ETF creates [sic] I actually don’t see it at. I just know that my assets have increased, but I’m also receiving a basket of stocks and obviously we’re then giving them shares of the ETF. It’s going on, I’m aware of it but it doesn’t impact. There’s no trading involved whatsoever. If I do need to sell, I need to sell and whether that is sell futures or sell a basket of stocks, at three o’clock it’s like, “Hey there’s 300 million leaving the fund today.” I am going to need that fund redemption, otherwise I’m going to leave the fund levered tomorrow morning which would not be good because then you start to introduce tracking error. But the number of I would say sell days are few and far between, relative to–I mainly tend to be on the buy side as cash flow is coming in– and ironically the stronger the market’s doing it it tends to be people want to buy even more and more coming into the fund.

Rick Ferri: Let me ask a question about the basket of stocks that comes in as an ETF. Because the way that it works is the authorized participant looks at this basket of stocks they have to put together. Now that basket is not 3900 stocks. That basket is much smaller than that, maybe half that size.

Gerry O’Reilly: I think, yeah, I think  it’s actually right around 1900.

Rick Ferri: So they send in a basket of 1900 stocks, which are 1900 probably the most liquid stocks, which leaves another thousand stocks in order to make this portfolio balance out. It means if you’re getting a lot of money coming in through the ETF side that you then your desk would have to go out and start buying a lot of micro cap stocks, I would imagine.

Gerry O’Reilly: Yeah. Well, so the way that we would think about that, Rick, is this. You’re right, most of those 1900, obviously they start off large cap go down to mid, small, and maybe even a little below that, but you’re right that if all you got was ETF activity for months and months and months you would start to notice that hey, the tail–the micro cap, the smaller cap- and you’re starting to fall behind a little bit here. So what we do, what I do is as the portfolio manager on the fund is every week I basically run a trade list Monday morning that focuses on the bottom two deciles of my portfolio, which is kind of that small cap, bottom of small cap. And these are the names that are difficult to buy, they’re illiquid and I split them up between a number of traders on the desk, and we hold them for the week we trade them, Monday through Friday and we are totally opportunistic.

So if a name happens for whatever reason, you find a natural- so I’m a buyer and on Wednesday a huge seller shows up we’ll get done. Now those names, they may not represent a huge weight in the index, but we focus on that tail throughout the week to avoid exactly the point that you’re bringing up. Is if all you’re doing is getting your 1900 shares or basket stocks in every day from the ETF at some point you’re going to look a little light on the lower end of small cap, and maybe even below that and so the way we get around that is we consistently trade them. We break it into small groups and we have brokers who specialize in micro cap, small cap names and believe me on days when they have the other side we’re trading with them, and so we use all of the different tools at our disposal, dark pools, different type of ATS’s [Alternative Trading Systems] if there happens to be someone who has a big liquidation going on and we find out about it, we’ll see if we can pair off with any of our buys versus a big sell that might be going on in the market. So we do that every week to make sure that we never do fall behind there. So obviously the tracking error of the fund, that’s of paramount importance to managing the fund and we make sure that that stays as tight as possible. And that’s how we get around that issue of making sure that on the smaller names that we’re right where we need to be.

Rick Ferri: I want to talk one more time about taxes because this fund does have a fairly sizable unrealized gain in it. I calculate something like a 700 billion dollar capital gain. I looked at the annual report and the fund cost to acquire the stocks was about 550 billion and the value of the fund is around 1.3 billion, so call that 750 billion dollars of unrealized gains, and as long as money is coming into the fund is not a problem. But at what point money starts coming out would you end up having to realize some of these capital gains and distribute them to shareholders?

Rich Powers: I’ll get it started, and Gerry feel free to jump in. Well if you look at the current position of the fund also from a realized gain perspective you would see about a one percent realized loss in the portfolio for this fiscal year and so you know what Gerry’s team is able to do there is look selectively at different names where we can maybe harvest some losses along the way to ensure that if we know there’s a big corporate action coming down the road that’s going to result in a capital gain we have a little bit of an offset there that doesn’t require us to bear any type of- or minimizes the amount of risk that we’re going to bear in the portfolio.

Now so there’s different levers we can pull there obviously we talked about the in-kind nature of the ETF that allows us to export out different cost slots as shareholders redeem from the portfolio, but I think maybe the place I would kind of finish here, and Gerry please jump in, would be you’d have to think through like what would precipitate investors to begin to redeem in some significant way, right.

And so usually what when that happens, and our shareholders are as well behaved as any, but when that would happen would likely be when the markets are going down and so that would put us in a position where the tax basis of the portfolio and complexion has changed pretty meaningfully, so that that realized, unrealized gain you mentioned, Rick, is going to be meaningfully less and we can be much more selective as we kind of fund those redemptions. 

And then the last thing is that we have the ability to in-kind in the mutual fund side. So sometimes plan sponsors will move their 401k plan or their pension plan from the Vanguard product to someone else’s and you know more often than not we are in-kinding those assets to the new provider rather than Gerry and his team selling those down and so I think you look at the unrealized number and say, “Wow, that’s kind of a scary prospect!” You have to think about how we got here. We’ve had an incredible bull market and strong cash flows, but to the unwind to that, in terms of why investors walk out the door, we have different levers to pull be it the market, the tax basis of the fund has changed and/ or we can in-kind on the mutual fund side for those large institutions.

Gerry O’Reilly: Yeah, that’s a great answer. I would say, Rick, the number one thing if I’m on the desk today and I find out, “Hey, someone is looking to redeem substantial size out of one of our portfolios you try and get some color and then the first question I’m going to ask is this something that is are they open to doing an in-kind and a lot of times it’s not on the day. It maybe is two weeks ahead of time, XYZ is looking to move money wherever. The first question that we’re going to ask on the desk is is it open to in-kind? Obviously it’s favorable for us from a tax point of view and from a trading point of view and a lot of times for the client who’s leaving rather than receiving cash and then turning around with whoever the new asset manager might be and buying again it’s easier for them as well, as long as they have- we’re going from one the same like benchmark, or a benchmark that’s very close to it.

And Rich also mentioned tax loss harvesting. We have a great accounting team that notifies us multiple times a week where we stand and so there are times throughout the year where it may be opportunistic to put on a tax harvest. So if we see, hey we have a number of names here that we have huge losses on, that we can harvest those names. You do have to be aware that there’s a wash sale period of 30 days so we work very closely with the risk teams to make sure that you don’t have any kind of sector bets, where you’re selling a huge amount of names in one sector. So we do that in such a way that even if you do have a tax harvest, that in terms of potential tracking error it is minute. And so that’s something that we have available as well. As well as some of the other tools that Rich spoke about as well.

Rick Ferri: Let’s get into the cost of running this fund. This is news to me. When I was doing my research prior to the call, that the cost of running the fund according to the 2020 annual report was around 422 million dollars. That was the total cost to run the fund. Of that, 176 million was attributed to the Investor share class, so this share class is really expensive, it’s like 41% of the cost of the fund. And I was absolutely surprised that there are still people in the Investor share class.  I mean why hasn’t everybody moved over to the Admiral share class, which is less expensive.

Rich Powers: Yeah, a couple things that inform that, Rick. One, the Investor share class is used by target date portfolios  that Vanguard offers, and so there’s a range of different target date portfolios that we offer for individuals, institutions, and it scales as AUM [Assets Under Management] scales and so for a portion of our clients they’re using the target dates they’re using the Investor share class.

There’s a portion of clients who can’t access Admiral shares on other brokerage platforms, so because there’s kind of minimum holding, minimum size requirements to get into Admiral shares and some other brokerage platforms aren’t able to conform to that the only available option for them would be to utilize the Investor shares with those portfolios.

So those are kind of the two kinds of drivers as to where the vast majority of Investor AUM would occupy. But certainly I’ve been here and Gerry’s been here long enough to know that that was 100% of the AUM twenty years ago and then over time it’s slowly whittling down and I would expect that trend to continue. If you just look at the organic activity within the portfolio, the preponderance of the assets are coming in through the ETF and then through Institutional and Admiral, secondarily with Investor shares mostly being a function of rebalancing or new plans that decide to use a target date fund.

Rick Ferri: I find it interesting that ETF is so cost efficient at Vanguard. It, the total cost for a management and administration of the ETF share class was only 36 million, so it was a fraction of what the Investor share class or the Admiral share class was, clearly very cost efficient to Vanguard to have people in the ETF share class and Rich, you could discuss that.

Rich Powers: Sure, yeah. When you think about who the historical users of ETFs have been, financial advisors have carried the water as it relates to their adoption at Vanguard and elsewhere in the marketplace, and most of those financial advisors will custody their assets at some other discount brokerage platform, or they might be at a broker dealer. And so when you’re thinking about kind of the scale benefits that come from the hundreds of millions or billions of dollars being in other platforms it certainly removes some costs from how Vanguard has to support those products day-to-day administratively, and so the rough number here is about 10 percent of our ETF AUM is on a Vanguard platform and the balance is held at some other discount brokerage. And so, as you’d expect, the cost that would come with those types of assets would be pretty materially lower than for those kind of directly sold or directly held clients that might be in a Vanguard platform, either in a 401k plan or in a direct investor relationship.

Rick Ferri: And one of the reasons why ETF share classes have a lower expense ratio, although it’s only one basis point lower than Admiral shares, is because it doesn’t cost as much, correct?

Rich Powers: That’s exactly right. So we, a couple of years ago some of our investors would have noticed that historically the Admiral shares and our ETF shares of the same fund would have had the same expense ratio.So I think Total Stock a number of years ago would have had a five basis point expense ratio for Admiral and ETF but now as we sit here today we’ve seen the because of the growth and adoption of ETFs we’ve seen the ETF expense ratio because it’s scaled moved down to three basis points and the Admiral shares is at four basis points, both incredibly compelling but certainly highlights that the costs that we bear in managing those portfolios, administering those portfolios is different for the ETF.

Rick Ferri: One other thing about cost is that you’re able to do security lending, and I noticed again in your annual report that you had about six billion dollars out of security lending and you’re able to acquire from that about 170 million dollars of income to the fund which helped to offset the expenses of the fund. Yeah so Richard, you could talk about security lending and how that helps to offset the cost.

Rich Powers: Yeah. So securities lending is an exercise that we’ve been involved with for a long time. We only lend securities on our equity portion of our portfolios. We don’t lend any fixed income securities. Our analysis there is that the cost to administer is not worth it relative to the benefit that you got, and so. But there is clearly a benefit for the equity side, and so what we’ll do is we have a securities lending desk that operates on behalf of our funds and goes out and lends those securities that are in great demand. And there could be any number of reasons why those securities could be in demand, because of a opportunity from a corporate action that’s coming up, perhaps there’s activity from a hedge fund that maybe is interested in acquiring additional shares, and so we’ll lend those securities in our portfolio up to a limit where we see that there’s value.

We actually approach securities lending from a value-based approach. Some of our peers will basically lend everything they have and try to just maximize the amount of income they generate by lending as much of the portfolio is available. We only look for those opportunities that are really ripe, have a big return for minimal lending and so we employ this approach where we’ll lend those securities out in the marketplace; in return for that lending we’ll effectively get back cash that we’ll invest in a money market instrument that will earn a yield and the return to our shareholders for that special name that we’ve lent out in the marketplace. There’s a premium that was likely paid but then also there’s a capture of the yield that happens for the duration of that lending on that security. And so that income that is generated is returned to the fund that is lending that security.

And so about 95 percent of the income that’s generated goes back into the fund NAV [Net Asset Value]. That five or so percent that doesn’t go back into fund NAV covers the cost of us administering the program. And so that’s a hallmark of the Vanguard program that differentiates us from many of our peers, because other firms will lend securities out and they’ll do a 50/50 split between the management firm and the lending fund. And so we believe that if you’re lending securities and you’re bearing some level of risk in the marketplace you should be compensated with all the rewards after cost and so that’s the approach that we take in in our lending program.  Gerry I know you have a couple things probably out there.

Gerry O’Reilly: Yeah, absolutely. Rich, great, great summary there. So we work very very closely, Rick, with our counterparts in security lending and you know there’s certain funds where there’s huge demand for the holdings from the sell side who are, and maybe it’s someone who’s looking to short a stock, right, and you have to secure the borrow, so they’ll call Vanguard, as Rich mentioned. They have to put up collateral, a lot of times 102% of whatever it is that you’re looking to borrow, and then we’re going to invest that with our fixed income teams to make sure that–and the one thing I would point out there, they’re very conservative in terms of how they invest that money, and I know if you go all the way back to ‘08, some asset managers were trying to swing for the fences in terms of how they invested that money and it came back to bite them a little bit. So security lending is one way and if you look at some of our small cap, particularly in the small cap growth and value, it’s meaningful the amount of dollars that they received from security lending to the point where I’ve seen it in years where it’s north of eight basis points, nine basis points to the fund, that’s coming in from security loan. And as Rich mentioned, 95% of that is going directly to the funds that loaned it out. So that’s one way you mentioned earlier, Rick, about the four basis points for the expense ratio in Total Stock, so I would say security lending is one way that we try to eat into that in terms of can we do better than the four basis points that we should underperform the benchmark. Security lending is going to help with that.

We also have a very very experienced desk. I think the average tenure on the desk is about thirteen years, so over time you learn strategies, proprietary strategies, about how to work index changes, rebalances, complex corporate actions, and so we’ve also been heavily involved in syndicate offerings, whether that’s just a company that is issuing new shares to maybe pay off debt, or whether it’s IPOs [Initial Public Offerings] that are coming along and we have a team that focuses on that. So every day here around 10 after four you’re going to get the phones to start lighting up with brokers calling us about syndicate offerings that are happening. And obviously you know Vanguard’s going to be a top three holder in almost every name out there so we tend to get the call. And as long as it’s greater than five percent of the shares outstanding index providers are going to make the share change. CRSP will make it tomorrow if we get the call tonight and so we will participate if we think it’s going to add incremental value to the fund.

So very very busy here around 4:15 with calls coming in on syndicate offering and 2020 was probably one of the busiest years we’ve ever had on that front. I think we had over 400 between syndicate and IPO. So very busy. Those are some of the ways that we’ll try and eat into that expense ratio and so if we can do that in a risk controlled manner it’s a win-win.

Rick Ferri: From what I understand from reading the numbers in the annual report about 170 million of income came in from security lending. The total expenses of the fund were around 420 million so about 40% of the expenses of the fund were made up with security lending, is that fairly accurate?

Gerry O’Reilly: Yeah, I mean I would say Rick that you’re looking at Total Stock, but depending on the fund that’s not at all surprising because that group, as Rich mentioned earlier, 95 of the revenue that they bring in goes directly to the funds that loaned out those securities and in terms of Total Stock I’ve seen that number be a basis point, maybe a one and a half basis points, and when you consider that our expense ratio is four that’s a meaningful contribution to the perform to the value add for the fund.

Rick Ferri: Let’s go into just a couple more things because we don’t have much time left. I want to touch on this because it is a little bit of a controversial topic and I know that you may or may not be involved in this. To what extent you are you could let me know but it has to do with voting proxies. And Vanguard is a large part of the US market, 10% of the market if you will, and how does that all work at Vanguard? So that shareholders understand how proxies are voted at Vanguard.

Gerry O’Reilly: Yeah, so a lot of times Rick we will get a call here on the desk from an issuer looking to talk about a proxy issue and we are fortunate, if you can imagine like say total stock where we have 3,800 securities, if every company if I  was to be involved in that, I couldn’t do my job, right. Because a lot of these are not simple issues. They can be complex. So fortunately we have an investment stewardship group run by John Galloway at Vanguard and his team and they will analyze all of these proxies. That is a team that’s dedicated to everything proxy related. So if a call comes in immediately we send that call or give them the email address for John’s group. This is the team you want to get in front of and they will then obviously reach out either email conversations about what the issue is and there are certain things that that group in terms of their principles- if you think about it, we are the ultimate owner, right? We’re going to own companies potentially forever and so it’s in our best interest to make sure that the board, the boards, are going to represent the interests of shareholders. So that group that John runs, they look at things like executive compensation, board composition, oversight of strategy and risk as well as shareholder rights.

So those are some of the key principle things that they would look at. I know they subscribe to some of the proxy advisors like ISS [Institutional Shareholder Services] and Glass Lewis but that’s just one of the tools that they use and they’re going to make decisions that they feel are in the best interest of our shareholders, and it’s not always aligned with the companies. You know one of the high profile ones that we recently just had was the Exxon proposal proxy fight and you know Vanguard voted with the dissidents on this one where they supported two dissident director nominees and I would also say it’s very transparent. If you want to see how did Vanguard vote on a particular proxy you have the ability to go online and see exactly how we voted on it.

And so fortunately, from my point of view Rick, I really just passed those calls on to that investment stewardship team and they do a fantastic job analyzing it. And I know they have folks who specialize in certain regions. I know there’s a team in the UK as well that handles the same thing for our European counterparts, but it’s a robust team that works very closely with the issuers and they’ll hear all sides of the argument and then they will make decisions based on what they feel is in the best interest of our shareholders.

Rick Ferri: Thank you for that answer Gerry. I appreciate the thoroughness of it and there’s also always a lot of noise out there about these types of things so thank you for covering that. I want to get into one last question and this, you could be a little bit personal on this. You’ve heard the charges of indexing. In fact the worst one I guess you could say was in the Atlantic Magazine called Could Index Funds be Worse Than Marxism. You know, indexing is ruining the market and indexing is creating corporate sloths and and shareholder gorillas and and so forth and this is bad and Congress needs to look at this and they need to break up these index funds. You’re there and every day doing this. I mean is any of this something to worry about?

Rich Powers: Sure, Rick. I think there’s a couple things we can look at to kind of disprove this notion that indexing is creating some type of harmful effects on the marketplace. So the first one you look at is the impact on trading, right. Equity indexing as an example about five percent of all trading that happens in the marketplace can be tied to an equity index. That in of itself tells you that while indexing as a strategy has grown remarkably the nature of indexing is a long-term buy and hold, it certainly isn’t kind of infusing itself into terms of how price discovery is happening in the marketplace. You can look at dispersion of returns over time, over the last twenty or so years. Not a noticeable difference in dispersion of stock returns over that period.

Rick Ferri: When you’re talking about dispersion of returns you’re referring to dispersion between stocks correct?

Rich Powers: That’s correct.

Gerry O’Reilly: Rick, if you look at the Russell 3000 for example, and we define dispersion as plus or minus 10 percent over the index, if you go back to the early ‘90s when indexing was still, if you want to talk about indexing in terms of what does it represent of mutual funds, that was maybe in around the 10 percent back then. It’s now growing to about 50 percent in terms of ownership of mutual funds and over that time period the dispersion, so plus or minus 10 of the Russell 3000, that’s remained consistent at 70 percent. So the argument you sometimes hear on top of the Marxism argument is that “Hey, indexing is lifting all boats right, as indexers they’re just buying and they don’t even care about.”  When you have dispersion levels at 70 percent that tells me that there’s opportunities there for good active managers to outperform. So the rise of indexing I don’t think is hurting that at all in terms of opportunities available.

And on the trading side, as Rich mentioned, if I think about it, Rich mentioned the number five percent of daily trading that’s a very, very small portion of the overall pie. If I think about even on our desk on some of our busiest days, two billion dollars is not that unusual that I might trade here on the desk. If you think about an average trading day, Rick, it’s about 450 billion dollars. So my two billion dollars that I’m spending Total Stock, it’s less than half a percent of an average daily volume and it’s spread out over 1200 – 1500 names, and believe me, those names I’m making sure that whatever I put in the auction it’s not going to be too impactful, so price discovery is alive.

There are names, if I think about our REIT Fund, probably in terms of ownership it’s probably highest among our REIT names, especially if that REIT happens to be in Total Stock and it’s maybe in Index 500. There are lots of names like that are massively underperforming where we are at today. And even though the ownership level might be in the high 20’s – 30 in terms of passive ownership across the board so the fact that that name happens to be in an index, there’s bad news that’s coming out, that fund is going to get it.

You know I’ve seen lots of different things out there. I tend to focus on what are the positives that indexing has brought to the market here. I attended a number of these Boglehead forums when you were on campus and the number of people who came up to me and said “Hey, I’ve been investing in your 500 fund for 30 odd years it’s put my kids through college, it’s helped my retirement.” I mean you want to talk about walking back on air after that conference. When you get a bunch of those stories that make you feel pretty good about the fact what indexing has brought to so many people. I just feel really passionate about the fact that indexing absolutely benefits, absolutely hugely over any kind of detractors that you might see out there, and a lot of the stuff that I read out there just doesn’t hold any water at all.

Rick Ferri: We all thank you for everything you’re doing, and your dedication to helping us as investors. I know we’ve run out of time. I want to thank you Gerry and Rich very much for taking the time today to talk with us about the Total Stock Market Index Fund and a lot of things having to do with how things work at Vanguard, including the proxy voting, which I appreciate you chiming in. On behalf of all the Bogleheads, thank you so much for everything you do. And keep up the great work and thanks for being our guest.

Gerry O’Reilly: Thank you, Rick, it’s been our pleasure.

Rich Powers: Thanks, Rick.

Rick Ferri: This concludes Bogleheads on Investing podcast number 37. Join us each month as we have a new guest and talk about a new topic. In the meantime visit Bogleheads.org and the Boglehead wiki, check out the Bogleheads new YouTube channel, Bogleheads twitter, Bogleheads Facebook, find out about your local Bogleheads chapter, and tell others about it. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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