Bogleheads on Investing- Episode 038 transcript

In this episode of Bogleheads on Investing, Ted Aronson of AJO Partners engages in a candid discussion about Vanguard’s plans to bring private equity to the masses and their addition of actively managed funds to their Personal Advisor Service (PAS) program.

The episode begins with a tribute to David Swenson, the late CIO of Yale Endowment and the founder of the Yale Model, commonly known in the investing world as the Endowment Model. David was outspoken about why individual investors should avoid private equity, and how difficult it is to pick active fund managers who will outperform the capital markets. We then discuss Vanguard’s decisions to, 1) offer private equity to certain individual investors and to potentially include a large allocation in their target-date retirement funds, and 2) shift some PAS client assets into new active managed funds.

Episode 038- guest Ted Aronson

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Rick Ferri, September 28, 2021

Rick Ferri: Welcome everyone to Bogleheads on Investing Podcast number 38. Today our special guest is Ted Aronson. Ted was the founder of AJO, an institutional U.S equity value manager, who at their peak was managing 31 billion in assets. Today we’re going to be discussing David Swensen, the Yale model, Vanguard’s foray into private equity, and Vanguard’s shift towards active management for their personal advisor services clients.

Hi everyone. My name is Rick Ferry, 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. You can find us at boglecenter.net, and your tax deductible contributions are greatly appreciated. Today our special guest is Ted Aronson. Ted has been in the institutional active management industry for more than forty-five years. He has a deep admiration for Jack Bogle and was a personal friend for most of his career. I believe Ted is in a ideal position to have a high level conversation on Vanguard’s foray into private equity investment for the masses and a shift in the investment strategy of Vanguard’s personal advisor services, commonly known as PAS, towards new actively managed funds.

So with no further ado, let me introduce our special guest Ted Aronson. Welcome to the Bogleheads on Investing podcast,Ted.

Ted Aronson: Thank you Rick, delighted to be here.

Rick Ferri: Before we get into this discussion today about whether investors should look at private equity in their portfolio or actively managed funds as they look for return, can you tell us a little bit about your history, your background. Go as far back as you like.

Ted Aronson: Glad to. The beginning may be apocryphal but my parents told me that they had pictures of me– I’ve never found them– of me looking at the stock page while I’m still wearing diapers. I don’t think that’s true but it still makes a good opening tale. I was always a nut when it came to the stock market. In those days I just couldn’t believe all these numbers changed every day and as an undergrad I studied business, and then I went further in grad school attending both undergrad and grad school at the Wharton School, and I studied investment management at the time when I graduated in the early 70s when no one cared about investment management. Everybody wanted to be an investment banker or a consultant or some sexy high-paying job.

Well, little did I know that I would join Drexel Burnham Lambert and indeed start their quantitative equities group when I was still in grad school. So in 1974 I had my first job, which was a summer internship at Drexel, and that led to my opening career. I was always interested in quantitative investing. It was the beginning of what was called modern portfolio theory, MPT, and I was very proud of that quantitative equities group at Drexel. To be hired to run the first equity mutual fund registered with the Security and Exchange Commission (SEC) to use this newfangled theory known as MPT.

So that’s where it all started and in the first years when I was at Drexel I met Jack Bogle, who even back in the mid ‘70s was a force to contend with. So I love to look back on my career and paraphrase Mark Twain, I’ve been a CFA charter holder for 33 years. I’ve owned my own investment firm for 37 years, I’ve been an “FOJ”–a friend of Jack– for 45 years, and I’ve been a horse’s ass for 69 years. So I come to you, Rick, as all the above.

Rick Ferri: Well your firm, AJO, made an announcement last year that it was closing, and it was kind of a sad announcement. I mean I’m going to get into similarities between that and Jack Bogle and Julian Robertson back in 2000. And here we are in 2020 and Ted Aronson is now closing his firm. And it all had to do with bad timing, if you will. Or not bad timing, just the cycles between value and growth. And Jack, of course, back in the late ‘60s, when he was running Wellington Management hired go-go managers to come in and take over almost all of Wellington, and that collapsed on him and caused him to lose his job. And that was sort of the opposite, he went with growth and then growth collapsed and value started to outperform, and the whole thing fell apart on him and that’s how Vanguard got started, so it was a good thing.

Then in 2000, at the peak of the peak of the peak — I mean March of 2000 — the peak of the tech bubble– Julian Robertson closed Tiger Funds. He decided to shut the door. It was a value shop, deep value shop, and he closed. So then along comes Ted in 2020, after this incredible run up in basically large cap growth tech stocks, which is not how you invest, and you make a decision to make a change, tell me about that.

Ted Aronson: Wow!  Leave it to you, Rick. I must admit I’ll take a comparison to Jack Bogle, even if it’s a painful one like that for both of us. Indeed you’re absolutely true, we did pull the plug on AJO a little less than a year ago and it coincided with the longest and deepest run against value. Painful decision, but we decided it was the best decision for our clients and for us. As I joke with my value brethren, and I have many friends that are value managers, I was glad to take one for the team because soon thereafter that trend broke, or it seems to have broke, and at least small cap value did very, very well. 

Yeah AJO was a legacy firm that had been around for 37 years and we were knee-deep in US domestic large cap value stocks, and after a 25-year run of a solid good performance, the prior five years had dragged our record down considerably and that’s where we thought the better part of valor was to give the money back to our clients and shutter and go off and do other things.

And indeed we did. My partner, Gina Moore and I are about to unveil, with a number of colleagues in Boston, a new firm called AJO Vista which will not be as deep a value firm, but of course value will come into play because value makes sense in a lot of settings. So AJO will still exist. However we did return the capital. It was about 11 billion dollars at the time, and we’re also delighted to be continuing with a new venture that will call upon any wisdom we’ve accumulated over all those many years, as I look back on my career. So that’s to come very, very soon.

Rick Ferri: Well that’s great to hear that you’re not out, because…

Ted Aronson: Oh thank you.

Rick Ferri: Well first of all, I mean the difference between value and growth as far as valuations now and what’s going on, it’s truly amazing and we’re going to talk a little bit more about value later on in the show. But first we’re going to talk about David Swensen, and of course David was a heavyweight in the investment industry. He was a pioneer who basically put his career on hold to go to work for Yale as the Chief Investment Officer there, and he created what was called the Yale Model. It’s also called the Endowment Model if I’m not mistaken but yeah most people call it the Yale Model who know David Swenson where he began to use a lot more private equity, venture capital, private real estate investing, as opposed to going into public markets. That was very successful for Yale, wasn’t so successful for other endowments that tried to copy or imitate the Yale Model. In fact I wrote an article, called The Curse of the Yale Model, which was after he wrote his book Pioneering Portfolio Management, which laid out for institutional investors how to do this.

A lot of people tried. But the problem was they just weren’t as skilled as the people who were working over at Yale which brings us to the point of what’s good for Yale is good for Yale but it may not be good for other endowments. It also may not be good for individual investors. David Swensen was very adamant about the fact that most individual investors shouldn’t be trying to do this. They just don’t have the resources to do it. They don’t have the ability to go in. So first of all talk about your experiences with David, and talk about the Yale Model and yeah, what do you think about it all? 

Ted Aronson: I’ll be glad to. Swenson was one of a kind. Not only was he a brilliant investor, I think we all know about his results as the CIO over decades for Yale and their superb performance. But he was a great mentor. He was a great teacher. He was soft-spoken, but he spoke his mind. But it was always a pleasure to be around him and I loved hearing his opinion even if I disagreed with it. He made the point, and this was amplified by Jason Zweig in an obit he wrote for David. He said play your own game, do what you’re good at, don’t just copy people, don’t just say Yale and Harvard did something so I’m going to do the same thing. That’s not due diligence, that’s copying, and he was dead set against it. And I think he was correct. I always think his advice was akin to Warren Buffett who announced a portfolio of Vanguard S&P 500 Index Fund and T-bills would be just fine in many cases. 

David knew his strengths. He was not modest about his strengths, but it was quite an endeavor. He had a seriously intelligent investment staff at Yale. He had serious leverage with managers, by which I mean he could get superior fees. And he was not against funding new ideas and new managers, so that just described quite a few activities that I suspect 99.44 percent of most investors can’t do. Those that can should, and there are a handful of them, but most of us shouldn’t. Alternatives, and you’ve mentioned, Rick, a number of them. Private equity comes to mind because you may have noticed they’re now advertising on TV how good the private equity industry is. Oh boy, didn’t Jack Bogle say run for the hills when you start advertising on national TV. I think he was right on that as well as other things. There is absolutely nothing wrong with private equity, indeed there’s a lot in favor of it. I go back to ‘74 when I graduated from the Wharton School. Clearly money management is more — is sexier. It’s more interesting today and clearly the best graduates from Wharton, Chicago, Stanford, Harvard, they are going into the private equity field. I really feel that. I think marketable securities may have suffered a little because of that brain drain. Private equity attracts the best and the brightest. They have the resources. They have the research departments. They have the means to perhaps make superior investments.

I now pregnantly pause but they also charge too much. So in my opinion any advantage they garner is offset by higher fees. So the success of private equity in the main, and broadly of course, generalizing here to make a point, accrues to the private equity managers, not to the private equity owners. And I feel that very strongly.  Was there a time in the ‘70s where this was available to David Swenson and others? Yes, were their returns more attractive than they are now? Yes, were the fees lower? No, they were higher then too, but there were more returns to support them. I feel very strongly that that is not the case today and it’s fundamental factors of supply and demand. Meaning dough chasing deals has become so distorted that I suspect the next 10 years may be sorry times for private equity investors versus what they think they’re going to get based on the past. 

Rick Ferri: Well that’s important because Vanguard wants to take individual investors into the realm of private equity not just large institutional investors or high net worth investors. In an interview that Barry Ritholtz from Bloomberg did with Fran Kinnery last month in August– Fran is now the global head of private investments at Vanguard– he’s had several jobs. I’ve met Fran several times. They want to take target date funds into the realm of private equity and to a fairly large extent. I mean he was talking along the lines of 30 percent of equity in a portfolio should be allocated to private equity. And I mean that’s shocking to me. That it would number one be that high, but also number two that you know Vanguard making this move into private equity with really no experience at all. Not that they’re not smart people because I know they are and they’re very good people, and their heart is in it and so forth but I question whether they’re at the caliber of a Yale Endowment Fund who can go out and pick the best private equity managers and I guess we’ll have to wait and see. 

Let me get circle back to David Swenson for a second because David Swenson wouldn’t agree with Vanguard. David talked about this in his book, Pioneering Portfolio Management, the second edition. He also wrote another book called Unconventional Success, which was for individual investors and he writes about it there too. Basically he writes that no middle ground exists. Low-cost passive strategies as outlined in Unconventional Success suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high-quality active management decisions. The framework outlined in Pioneering Portfolio Management applies to only a small number of investors with the resources and the temperament to pursue the grail of risk-adjusted returns. 

This was in 2009, and in 2012 at a conference for John Bogle, it was the John Bogle Legacy Forum, which both you and I were at, interesting, and there was a book about it by Newt Ross, The Man in the Arena, which talked about this conference and a lot of other things, where he quoted Swenson in here and he was even more adamant there, where he said that I think the only sensible way to structure an active management program is to have a group of incredibly highly qualified professionals who devote their entire careers to trying to find managers or investment strategies that can beat the market. So he’s even stronger than what he wrote about in his book.

All right, so now we have Vanguard come along saying the target date retirement fund should have private equity in it. Now granted, it isn’t going to be the individual who’s going to be trying to pick the private equity manager, Vanguard has already done that. They’ve gone out and picked a company called Harbourvest. It’s a global manager. They have a global footprint. It looks like they’re managing about 80 billion in assets. What do you think about Vanguard’s foray into private equity, and what do you think about adding it to the accounts that they manage, which would be institutional accounts’ target date funds, and also the Personal Advisor Service PAS?

Ted Aronson: Oh boy, multiple questions. Let me let me try them, try to hit all of them.  First and foremost, I think Jack is spinning in his grave, that is if he’s still there, if he hasn’t gone somewhere else, and you summarized it well. I  don’t know Harbourvest except what I’ve read in the news of Vanguard. Nor am I privy to the details because this is a personal investment. It’s not the public markets with Vanguard’s great disclosure and transparency. I think if we had a crystal ball and we could look forward, and we looked back, the private equity Vanguard will introduce with their good points you mentioned about them: they’re thoughtful, smart people. The returns will probably be competitive after fees with the returns from the public markets even though I think the public markets are relatively high now, just as private equity deals are high. So both those numbers may be in the low single single digits.

I understand from a business point of view why Vanguard is pursuing this. They have their trillions of assets and they want to provide all they can to their clients and they don’t want assets disappearing to some other operation, organization that will be offering private equity. I get it. However, I wonder. I don’t have a lot of first-hand experience with private equity but I have a lot of second-hand experience with private equity. One in particular, Spelman College, I’ll outline in a second. I think they will do a good job of providing private equity, however when their fees they’ll have to add on top of the costs of Harbourvest and all the other related charges, I don’t think they’ll have anything that’s particularly competitive, certainly not as competitive as their rock bottom fees, an area that they really pioneered. For all intents and purposes lots of competition now. We all know they started this, Jack started this in the ‘70s and he was successful even beyond his expectations. Institutions, it can subcontract with the talent you mentioned, Rick. They can hire really smart consultants and there are a number of them. Dealt with them all my career. So they can in a sense get the investment thinking they need and those consulting firms that are worth their salt really do a great job. However, and by the way I’m sorry, one other thing, institutions can negotiate in many cases like Swenson I mentioned earlier, negotiate some favorable fees. However the aggregate fees are so large compared to what Vanguard provides in its meat and potatoes work that there’s really no comparison and I fear that investors will get involved with the Vanguard offering expecting it to be more outstanding, to be unique in the area of fees, just as their passive index products are. And I think that will be a major misunderstanding which will cause problems.

Vanguard is good at communicating. They’re good at getting the word out there so I think many of their clientele, much of their clientele may just go along with the startlingly large private equity allocations you mentioned a moment ago. They surprised me as well.

Rick Ferri: Let me circle back to the interview that Barry Ritholz Bloomberg Opinion columnist, had with Fran Kinnery and this is on Masters in Business podcast, but there’s a few things that struck me. Number one the firm that they chose Harbourvest has 75 billion or so under management and commitments to 80.

Vanguard is roughly an 8 trillion dollar company and Vanguard is managing maybe 4.5 trillion of equity in total and they were talking about taking– the numbers don’t make sense–but you know up to some percentage of that moving it over slowly to private equity. And the reason I say it doesn’t make sense is because Harbourvest is only managing, like I said, 75 billion and I mean just a little bit of movement by Vanguard and shareholders over to this fund is going to flood Harbourvest. 

And I don’t think it will happen because I don’t think that Vanguard and Harbourvest will allow this flood to occur. So we’re really talking about a small amount of money from Vanguard investors actually going into this product. But if they did democratize this, because Fran says right in the interview and I’m just taking this right off of Barry’s website, because they have a printout. It took us 35 years to do this in indexing, 20 years to do it in active. So maybe 20 years from now private equity and exact access to world-class managers for the average investor will look very much like indexing did over the course of 1975 to 1995. In other words they’re trying to democratize private equity and make it accessible to everybody at somewhat relatively lower fees.

But how can you do that? I mean how can you pour so much money into private equity and make it kind of index-like and expect to get the same return?

Ted Aronson: Rick, you really can’t. Let me take your democratic image back, so in 1974 when I’m a young turk running money at an old established firm in Philadelphia, the market wasn’t available. You had to hire a money manager to get the market, to get a diversified portfolio, to essentially get what now is called beta exposure to capital markets. What Jack did in his democratization program was democratize capital market returns. They are out there from the entire economy which in capitalism has companies which make money and pay out dividends and retain earnings and grow blah blah blah. We all know the story and that’s a wonderful, wonderful thing, and Jack deserves credit for that. You really can’t make the leap to a specialized alpha-seeking operation like all the private equity and make the same comparison. You have a limited number of deals being chased by an infinite amount of money and it just doesn’t compute. It can’t be. So I think that’s the bullishness coming out despite the growth goals of Vanguard’s private investments. It’s an impossibility; it just can’t be done. I think in all the private equity they found something like a trillion dollars of dry powder of committed capital, something like that. So, and those are the biggest numbers that have ever been seen. So can you imagine throwing a couple other trillion on top of that chasing the same deals? I don’t think so.

Rick Ferri: And you have at least one right now, they’ve picked one private equity manager, Harbourvest, just one company, and so you only get exactly– you’re only going to get the deals that they’re in now.  Harbourvest will then go out and sub-advise or hire sub-advisors. According to their website they’ll hire sub-advisors in various areas and get in other advisors deals, if you will, so that they can get broader exposure. Because one thing that Fran Kinnery said in the interview with Barry was that you’re looking at maybe 600 to 800 operating companies in the fund that Vanguard investors will be in and the only way that could have happened, and again I went to the Harbourvest website and I read that they’re going to go out and they’re going to hire other managers. So they’re going to be just taking deals of other private equity and venture capital.

But let me quote what the expectation of return is, and here’s where I almost kind of fell over, if you will. Okay, so first Fran was talking about Harbourvest has been getting 700 to 800 basis points over the public markets. That’s what they’ve been saying, but you know what Vanguard’s forward-looking estimates to our investors– and this is just quoting him– get between 300 to 400 basis points or three to four percent more than public equity. Wow, really?  I mean everybody’s going to get that? Seriously, it’s going to be just that easy. I don’t know, tell me.

Ted Aronson: Well my first reaction to what you said Rick is bingo, because of course no one’s going to get it. It’s silly. Could they do 300 or 400 over the next couple of years before fees? Maybe. Fees will reduce it to maybe 100 basis points. So now we’re talking about public markets plus a little alpha, if you will, thrown in. Let’s call it alpha because that’s what active managers are all about. 300 or 400 is silly; 700 or 800 may be true but that was when Harbourvest was small and that’s when there were a limited number of deals. I’m not saying there aren’t smart enough people to get returns like that. I would love to run out and hire them when they’re young and they’re new. But because they’re young and they’re new, nobody knows about it or very few people do, so the return expectations are in my opinion scary and silly as you note.

Private equity returns are very close to lower cap value returns, at least historically and that’s absolutely true with one addition — and that’s leverage. Private equity deals usually entail leverage, not always wild amounts of leverage, but some leverage. And if you do that to things like mid cap value returns you get private equity returns. 

Rick Ferri: I want to circle back to a portfolio that I put together. I called it the total economy portfolio. And let’s say I want my portfolio to look more like the economy than the stock market, okay. So what do I need to add to this portfolio to make it look more like GDP [Gross Domestic Product] or national earnings rather than the stock market earnings. And so the first thing that pops out is real estate. You need to have a bigger real estate component because so little of real estate is actually securitized in the stock market. So you add to your total stock market US and total international fund, you add a real estate fund– and I’m not going to get into international real estate, it makes it too complicated– let’s just add 10 percent to the Vanguard Real Estate or an actual REIT fund because the Vanguard fund is no longer just a pure REIT fund anymore. 

Second thing; how do you emulate all the private equity? Something like half, let’s call it half of all of the national earnings are from companies that are privately owned, and the other half, and this is very general, is from publicly traded companies. So how do you emulate the other half? And the answer is, as we touched on, is to use small cap value. Small cap value emulates to some extent– and I know if you leverage it it emulates it more– the performance of private equity. So in my total economy portfolio which I created I don’t know how many years ago, and I have it on a website called Core4.com. This total economy portfolio concept, and it is closer to what the total economy is and less of what the stock market is. Now circling back to what you brought up, if you want to do private equity and you don’t have small cap value in your portfolio why not just add that first, and that’s a question to you?

Ted Aronson: Oh, I’m just shaking my head. Bingo, yeah, why wouldn’t you? I’m with you, but go back tell me that website again, you have– I don’t,  I’m not familiar with it.

Rick Ferri:  The website is core “c-o-r-e-4”. What that website is, and I don’t want to belabor this, but they’re just simple portfolios. In other words, if you need income use these four funds; if you’re looking for the total market type strategy use these funds; and like I want to have the portfolio look more like the economy than the stock market they use these funds. My whole view was like you can do anything you want with four funds. You don’t need more than four funds because there’s so much product out there right now that you can create whatever you want, any strategy you want, with four very low cost index funds. So that was the whole concept. Even ESG [Environmental/Social/Governance],  I have that as part of it as well. So that’s what that is and that’s where this total economy portfolio is. It’s a free website. You can go there. It just goes on its own. I  don’t even know how many people visit it, but it’s there so that’s where I have this total economy portfolio.

But I also wrote an article about it for Forbes back in the– I don’t know, 2007 and 2008. And I talked about this and it kind of gave people a backdoor way to get into small cap value who maybe ordinarily wouldn’t have gotten into a small cap value.

Ted Aronson: Yep, I understand and I think it’s absolutely brilliant.

Rick Ferri: I should just end the podcast right here.

Ted Aronson: Yeah, anyway go into that business and get out of this crazy stuff. And yes, it was a Harvard professor, I remember him well, a couple of years ago, Randy Cohen, who convinced me that he used mid cap value. He said simply leverage mid cap value stock right at 60 percent. Set it up in a vehicle, that you could value it on a lag three month basis, make the liquidity not instantaneous, not totally liquid, and you get private equity, or you get more than private equity.

I buy it. I agree with it. Think of what private equity firms do — except for the Heinzes of the world, and those sort of takeovers — they’re after value-oriented companies in the small and mid-cap range who can have value exploited. Duh, I mean that’s what they’re doing. And throw in that use of leverage which scares most investors and you have the return stream that mimics it.

I agree. But Rick, you also know so much on Wall Street is sold not bought. I’m involved with an unnamed state investment portfolio as an advisor and they have public meetings on a monthly basis and it used to be in person. It hasn’t been for quite a while and I’m telling you from the dais where I sit you can pick out the private equity sales people. Why? Because they’re the best looking and the best dressed. It’s obvious, it’s so obvious that you know after a couple of beers it’s a really funny game of picking them out, and I’m telling you they are all good looking. The men are good looking; the women are good looking. They’re like, you know, the quarterback and the prom queen. And they’re dressed to the nines. It’s hilarious.

So you nailed it and you get it. And that’s what’s going on because this is not logic, this is sales. This is what Wall Street is so good at. They are expert at separating clients from their money and they continue to do so, and unfortunately, to some extent, there to a small extent, Vanguard has become part of the problem I’m sorry to say.

Rick Ferri: Yeah, well I mean if Vanguard’s getting into this of course Fidelity will get into it and others, Schwab will too.

But if people do decide to go down this road, first I would say instead of leveraged midcap just look at deep small cap value. And I can give you some fund names: Avantis Small Cap Value, or the DFA Targeted Value or Invesco Pure S&P 600 Small Value, RSCV [Russell Small Cap Value] and full disclosure: I own RSCV. This is just simply saying, look I want to have something other than beta in my portfolio because I think that it might help improve the performance in the long term. I’m not going to get access to good private equity without paying an arm and a leg. Just do a small cap value fund instead, do a small reit fund, do the total economy portfolio which is what I do. That’s my strategy in my own account and be happy. And do it for 20 years.

Ted Aronson: Yeah, absolutely. That’s a given.

Rick Ferri: I think that Vanguard has been going down the path lately not just with this announcement which actually was kind of an old announcement. It came out last year, but more recently adding new actively managed funds to their Personal Advisor Service. They’ve added three new actively managed funds for people who want them. So Tim Buckley, who’s the CEO of Vanguard seems to be pivoting towards active management and towards the idea that somehow Vanguard has the secret sauce and can pick active managers that will add alpha. Have you noticed that?  Because that’s certainly what I’ve been picking up.

Ted Aronson: I have been picking up and listen, I’m an active manager. I still have faith against all odds that I can add value. Most of my brethren are the same. That Tim thinks that way, okay again. They’re smart guys and they have a lot of resources. Their fees may be low, but when you multiply a basis point times 4.5 trillion dollars you’re talking about real money. Maybe they can, but I’ve always found Vanguard to be realistic in their expectations. They’re solidly conservative with their capital market projections. I applaud that. So if they were to pursue active managers I think they would hope for alpha in the 50 basis points to 150 basis point range, something reasonable that may be achievable for a limited amount of their assets.

Rick Ferri: But is Vanguard successful at picking active managers?  And this is meandering down the road towards active managers’ stock funds and private equity. Are they the Yale team, so to speak? And I question that because we have data on Vanguard’s active managers and you know what Vanguard likes to put out is data — well the last thing I read was the data on 10 years — and again this came from Fran: 30 of 37 Vanguard stock funds outperformed their Lipper Peer Group averages. Now notice they didn’t say outperform the market, okay.

Over a 10-year period of time however they didn’t talk about the funds that closed. And over a 10-year period of time they actually closed nine funds and most of that was from not performing well. The latest casualty was the Vanguard US Value, but over that ten-year period of time they had closed nine actively managed funds mostly because the performance wasn’t. And so, yes I know the narrative is that look at the funds that we currently still have, you know survivorship awareness, three-quarters of them outperformed the average fund in their category. Therefore we must be good, and you know maybe they are, and granted– I mean I’ve done a lot of work on fees — if you have lower fees, if you’re able to negotiate lower fees with active managers you will get closer to the market return on average. You won’t outperform the market from what I’ve seen but you can get closer to the average market return because your fees are lowered. To me it’s mostly a random event.  I mean you’re going to go out and hire some good managers but whether they continue to outperform or not it gets to be a random event. If you look at SPIVA [S&P Indices versus Active] data and you look at other data you know the ones who did outperform the top quartile, some of them stay in the top quartile, so if your fees are low enough maybe you know you’re going to be in that upper Lipper category.

But you know when you start looking at your performance by taking away the survivorship bias it just doesn’t look so good and we’ve had no experience — maybe I’m wrong on this because he did say that they had — Vanguard manages all in very large institutional portfolios and there they do go out and try to select private equity managers. So they have some experience doing that but not not on this scale, right. So now, you know Fran, who is in charge of all this, going out on a very large scale to try to find one private equity manager who’s going to be it. I just see that they’re probably going to have to add more managers as they move along here, right?

Ted Aronson: Oh, absolutely. I do have to tell you my love of Jack Bogle. I really did. He was a professional friend. I adored him. My love of him lets me forgive the marketing comments that you so eloquently just hit upon. Yes it hit me when I read that statistic of 30 out of 37 that what happened to the ones that didn’t survive. I mean that’s the oldest game in the book. I’m not sure if Bogle would have let that pass him on his watch, but okay all Wall Street seems to do this. And Vanguard it’s just being typical.  You hit upon it, right. Vanguard is changing its complexion a little. We hope not a lot, or at least I would not be in their funds if I thought a lot, and I forgive them some of their sins because they just want to get involved more and more. So I get what they’re doing, but you would expect it more from other shops.

Vanguard is clearly changing to some extent. No doubt about it. So I can’t disagree with all of your observations.

Rick Ferri: Well interesting, when they announced three new actively managed funds for the Personal Advisor Service PAS program they put in their press release that these funds will complement diversified and low-cost index core portfolio holdings in PAS accounts. Vanguard believes the funds’ concentrated higher alpha strategies are an ideal fit for PAS clients with sufficient risk tolerance and patience for active exposure, as they can materially impact portfolio performance even at a relatively small allocation. That’s not something Jack Bogle would say. And it’s not something — and David Swenson wouldn’t say it either, and again circling back to David Swenson we’re kind of pounding this thing home. He says, look if you believe that you have the ability to outperform the market, if you believe they have the ability to pick active managers who can outperform, why would you index anything? You know, you go out and you buy all active managers. I mean what about– why doing this core and satellite thing– what’s the, why bother why?

Ted Aronson: Touche.  In the funds that you’re referring to, the active funds, do they publish the names of them or did they just hold this out as a generic category?

Rick Ferri:  The new funds that they’ve announced are: the Vanguard Advice Select Dividend Growth Fund, the Vanguard Advice Select Global Value Fund and the Vanguard Advice Select International Growth Fund. Those three actively managed mutual funds, they’re not ETFs, they’re mutual funds, will be available to PAS or Personal Advisor Service clients going forward.

Now I have my own theories on why they’re doing this, and has nothing to do with active management, has to do with complexity is job security. Okay, in other words so my comment tongue-in-cheek is that complexity is job security and the reason I say that is because I’ve been an advisor for 33 years.

Ted Aronson: Oh please, I’m with you.

Rick Ferri: If you just put four funds in a portfolio, the total stock market, the total international, the total bond, and the total international bond, which is the four funds that Vanguard puts in every PAS client’s portfolio. If they go there in cash they’re going to get these four funds. I, as an advisor, and now I’m just doing an hourly model so I’m not managing money anymore. So people come to me and say what do you think? I say well you know it’s pretty easy for you to just manage those funds yourself. I mean why would you pay point three percent right.

And oh, by the way, the LifeStrategy funds have the exact same four funds in it that you could just buy one fund and get the same thing for a lower price so why would you do it? And a lot of clients, a lot of the clients had already terminated Vanguard and were terminating them or making a decision whether to go to Vanguard or not. Now I think that PAS program is great if you need to have somebody else manage the portfolio for you, and especially if you have this estate planning thing where you know if something happens to you and you’re the one who’s doing all the money thing at home and yep if you’re afraid of your spouse or your family not being able to manage the money, great. PAS is wonderful. Though I think they’re wonderful, there’s no return incentive there. Well this now creates a return incentive and why would you do that? Well maybe because they’re losing assets from people who say I can do this on my own and you make it a little bit more complicated, you know, make it a little bit more scary in a way. Maybe retain more assets. That’s my biased opinion from being an advisor for 33 years.

Ted Aronson: Well wow! You’re something. You are something else, but your reputation preceded you so I was aware of it. I agree, I agree, and oh do I  agree.

Now new paragraph. I think their low cost consulting services, the 30 basis points for this Personal Advisory Service makes sense in ways that you can appreciate as an advisor that I can appreciate as an institutional money manager. People do need hand holding. They do need advice. They do need help. It’s just funny to me — it used to be Vanguard had a single focus, a crystal clear focus. Well they don’t anymore, and they’re getting into some of the same nonsense that plagues Wall Street. Not going to swear off consulting services. Although I’m not a consultant,  I think there can be value, but I think all the reasons you just said are absolutely true as well. So I can’t really defend it strongly.

New paragraph because I was preparing for this call, just kind of daydreaming, thinking I realized that the Ted Aronson investment philosophy for the ages, which of course is stolen from Jack Bogle and everybody else I respected. But it’s under three things. One is keep costs down and costs are not just fees, they’re taxes, and all that other crap, so keep costs down. Two, diversify, arguably the only free lunch in capital market theory. And three, the one that’s a surprise, take risk. And take risk would fall under your small value. Okay that’s riskier than the S&P 500 without a doubt. Could it be for David Swenson private equity and venture capital? Absolutely, but he kept the cost down and he diversified even those bets.

So that triumvirate has served me well when you think about it. You can fit a lot of, cram a lot of stuff into those three categories. So if someone wants to sleep well, they want to be tucked into a handful of Vanguard index funds, fine and be done with it and leave it alone. You want to have some fun and take some risk and maybe make more money, do it intelligently, diversify and get it as inexpensively as possible. It’s really that simple.

Rick Ferri: And you eat your own cooking because if I recall over the years you’ve been very vocal about how you invest your family money and you use a lazy portfolio. Could you just talk about that for a second?

Ted Aronson: Sure, yeah. All the lazy portfolio, and it was kind of a fun silly exercise with a reporter named Paul Farrell many years ago, where he said yes, David Swenson, the same thing, he was in the same sort of survey, what would you recommend a portfolio for someone that has a day job. So assume you do your regular institutional big shot money management practice dead but what do you do with your own money on the side and that’s where I said and indeed it’s true, a handful of Vanguard mutual funds and never change them. Now people went crazy and they said how dare you give advice. I published something about 60 or 70 percent equity and 20 percent fixed and 10 percent cash and they said how dare you give that advice because everybody’s unique. I said please all I was saying was of course you should reflect your risk profile and the needs of a particular family or individual but in general I was reflecting what I had learned since the ‘70s, which was the Yale Model, the Endowment Model in equity bias invest in inefficient markets don’t worry about liquidity leave it there leave it alone and diversify. And so the sense behind an endowment model wasn’t like you know the Ten Commandments from on high it was tried and true investment principles that were reflected and David was smart enough to say be careful how you manifest these unless you’re set up to do so. This is your point break about full-time staff  competence blah blah blah those sort of things. So David had no illusion to why Yale did so well. Yes he was a long-term investor. Yes he took advantage of big dips like ‘09 dip, but the other principles were things that have served investors well forever. They really have.

Rick Ferri: So, Ted, it’s been really great having you here. In closing, is there any special memory that you have about Jack?

Ted Aronson: I do Rick. A year before Jack died the CFA Institute, which I’m a proud member of, held its annual conference. A couple thousand people here in Philadelphia, obviously before the pandemic, and Jack being the local hero in the Philadelphia area agreed to participate on one condition, and that condition was that it’d be a question and answer and that I am the moderator. Now you say, wow Ted. I think you’re an interesting guy but I didn’t think you were that interesting. Why would Jack want you as moderator? And the reason is the following. And we did this Mutt and Jeff act dozens of times. He would get up and then he would announce why would I, the king of indexing–he never said that– but the indexer have a 40-year friendship, so a couple years ago, with an active manager Ted Aronson? And there’s a pregnant pause and then he would say because Ted and his partners at AJO put their money where their mouths are. They’re active managers which charge fees according to the performance-based principles and when we don’t deliver the outperformance we say we cannot deliver, our fee is zero. Zero. And that was the perfect segue into all the stuff that Jack said so eloquently. True story, there are two thousand people in the audience and I of course was embarrassed and it also made my career because I loved being that foil, I loved playing that role to Jack Bogle. Oh my god, how flattering was that. So that’s my tale.

Ted Aronson: Oh, Rick, it’s my pleasure.

Rick Ferri: Good luck with your new venture.

Ted Aronson: Thank you, Rick. Appreciate it.

Rick Ferri: This concludes Bogleheads on Investing, episode number 38. 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, and 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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