The sleeping giant of Valley Forge
A triumvirate of US asset managers dominate passive investment. Between them, State Street Global Advisors (SSgA), Vanguard and Barclays Global Investors (BGI) manage over $3.5trn (€2.3trn). But while BGI and SSgA have built hedge fund and active management businesses, and have swept up business in European pension markets, Vanguard has until now been much slower in its growth outside the US. While BGI managed €366bn for European clients and State Street €270bn, according to the IPE Top 400 Asset Managers 2007 survey, Vanguard had just €20bn.
Vanguard has largely stuck to its knitting since its foundation in 1975, even if sticking to your knitting seems quaint in the current age of asset management, dominated as it is in seemingly equal measure by innovation and marketing spin. “We offer a unique focus on our investors and we are the one firm that does not have a conflict of interest with our investors since we are investor owned,” says Gus Sauter, (pictured right) Vanguard’s CIO and head of its quantitative equity group and fixed income groups.
Probably best known in the US for its retail mutual fund business, Vanguard does manage some $50bn for pensions, endowments and foundations, where the likes of SSgA and BGI have provided some top notch competition. “They are top competitors. The passive side is very competitive from a price standpoint but we tend to do well in that environment,” says Sauter.
But could this be an inflexion point for Vanguard, and a point at which it decides to expand its business on a greater scale? “Our European institutional business is around $30bn and growing. We got off to a slower start Europe than we did in Australia but at this point we are starting to hit the acceleration curve. We have seen tremendous growth in the last two or three years,” says Sauter, who joined Vanguard in 1987.
“We are excited about our opportunities both throughout the western world, in Europe and the UK, as well as throughout the Pacific Rim and other selected markets,” he continues. “We have been less involved in the pure institutional market, the defined benefit and foundation market place, and we think that is a tremendous opportunity for us at this point.”
Vanguard’s European presence is not new, with a European office in Waterloo, outside Brussels, headed by Joanne Voelcker and François Passant, and two satellite sales offices in Amsterdam and Paris. In January it made a play for the European liability-driven investment market with the launch of two long-duration bond funds. Sauter says a lot of institutions, particularly Dutch ones, have shown interest in Vanguard’s low tracking error enhanced indexing capabilities.
Where BGI, SSgA and Goldman Sachs have all invested in untested areas for institutional investors, like 130/30, Vanguard has remained cautious. Sauter says Vanguard certainly has the capability to run 130/30 funds, but that it is more interested in developing its quant capabilities per se, and equity market neutral in particular.
“The 130/30 area is certainly something we have capability to run,” he explains. “We are running long-short market neutral, which effectively would be 100/100, and that uses the same techniques. We have been running a long-short market neutral fund on paper for six or seven years but we have been managing real money for over a year now. It would be the exact same process for 130/30; we just haven’t offered people that yet. We have debated whether or not we should offer that and we think there are many arguments to say that long-short market neutral ported on top of a market would be more efficient. But I understand that a lot of people are willing to somewhat dip their toe into this process with 130/30.”
Vanguard has so far kept out of traditional active management, preferring to outsource to best-of-breed external managers. “We will probably stay away from traditional management,” says Sauter. “There we think our model adds a lot of value in that we have access to the best money managers throughout the world.”
As investors rediscover the attractions of one-stop asset management solutions - through fiduciary management in the Netherlands or through implemented consulting and diversified growth funds - an asset allocation and manager selection capability could be a hidden gem. Does Vanguard have the capability to become a fully-fledged multi manager? Sauter sees the point. “We use 26 different external managers and a very sophisticated group that is constantly scouring the globe for more managers. As we find them we find money for them to manage.”
And growth is good for Vanguard. “We do not have any goal to grow for growth’s sake but we think that our investors benefit when we grow. Also our expense ratios are less than half of what they were 20 years ago,” Sauter concludes.
This year Vanguard has again come to the defence of passive investments in the form of a study of actively managed funds* - not that the institutional world needs much convincing.
In the study, which evaluated 884 international actively managed equity funds versus their indices in the 10 years to the end of 2006, Vanguard noted that 75% of them did not beat the benchmark and half trailed their benchmark by as much as 200bps. This is largely down to costs, according to the authors, and repeating the analysis over a five-year time frame led to similar results.
The European investment industry is also failing to capitalise on the potential for cost efficiency savings in cross-border mutual funds in offshore centres like Dublin or Luxembourg. Some 70% of offshore funds underperformed.
And it does not get much better when it comes to less efficient markets like the emerging economies, where it has traditionally been seen that active managers have more scope to add value. Vanguard found that 69% of active emerging markets funds underperformed their benchmark, a higher rate than either Japanese, UK and Europe ex-UK funds.
The authors noted: “Over long time periods the case for indexing across asset classes and sub-asset classes remains robust. Further, as … more funds enter the arena, indexing’s advantages are likely to become more robust.”
The results for actively managed fixed income funds are even worse than for equities, with 95% of the 1,120 dollar-diversified, euro-diversified, euro short-term and global fixed income funds under analysis underperforming their benchmark over a five-year period. “As a result of the narrower return distribution across fixed income returns, a low cost strategy has the potential for an even greater relative impact. And because a significant majority of funds… underperformed broad-market benchmarks, a low-cost strategy means that an index vehicle again has an edge versus active funds in long-term performance,” the study says.
It also notes that the relative illiquidity of bond markets means that fixed income funds may incur a performance drag that can be attributed to costs. Conducting the same analysis over a rolling 10-year basis produces similar results, Vanguard found.
“Every dollar you spend on costs is a dollar less in return and investment is clearly one place where you do not get what you pay for,” says Sauter.
*The Case for Indexing; European and Offshore-Domiciled Funds, Vanguard, Christopher B Philips and Sarah Floyd Gus Sauter is CIO and a managing director of Vanguard, and as such is responsible for some $600bn (€389.1bn) managed by the firm’s fixed income and quantitative equity groups. He is a member of the equity markets committee of the Investment Company Institute, of the Council of the Graduate School of Business of the University of Chicago, and is on the advisory board of the Journal of Investment Management Conference Series. He is a former member of the Institutional Traders Advisory Committee of the New York Stock Exchange and the NASDAQ Quality of Markets Committee. Sauter has also served on the trading committee of the Securities Industry Association and the AIMR Best Execution Task Force. Before moving to Vanguard’s Valley Forge, Pennsylvania, offices in 1987, he previously worked for First National Bank of Ohio. He holds an AB in economics and an MBA in finance.