Rodney Comegys – The Mechanics of Indexing at Vanguard (EP.498)

Rodney Comegys is the CIO of Vanguard Capital Management and its Head of Global Equity Indexing, where he oversees $8.5 trillion in index assets across domestic, international, and multi-asset strategies. Rodney joined Vanguard twenty seven years ago and has worked across operations, customer service, risk management, and investing. Our conversation covers the philosophy and mechanics behind running one of the world's largest index fund operators. We discuss Vanguard's ownership structure, values, product selection, and mechanics of delivering an index fund. We then turn to common issues around indexing, including concentration in U. S. equities, corporate governance, private assets, and AI. Learn more about our Strategic Investments: Thema http://www.thema.ai/ted. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (⁠ https://thepodcastconsultant.com/https://thepodcastconsultant.com https://thepodcastconsultant.com/⁠ https://thepodcastconsultant.com/)

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  There's the original concept of indexing, which is capture as much of the world's investment universe as possible, and you put it into a total market fund. For those, you're just trying to get from the largest security in the US to the smallest one that you can invest in. What you're looking for there is all the securities that are equities. And then you're thinking, are they liquid enough and available enough for us to invest in? Then you include them all. That's the simplest version of indexing, and we do that all around the globe. Thirty percent of the S and P 500 is made up by seven companies. The S and P 500 should not be your benchmark nor your portfolio. If you do that, you're exposed only to US large cap companies.

• 0:43Speaker 00

  500 securities, any investor wants diversification, needs to add small cap securities in. A total market solution, you need global securities. By the time you're done with that, you've increased your universe about 50%. You've taken that exposure down by about half by global market cap weighting the globe, and you need that in bonds.

• 1:13Ted Seides?

  I'm Ted Seides, and this is Capital Allocators. My guest on today's show is Rodney Kama-Chies, the Chief Investment Officer of Vanguard Capital Management and its Head of Global Equity Indexing, where he oversees $8.5 trillion in index assets across domestic, international, and multi-asset strategies. Rodney joined Vanguard 27 years ago and has worked across operations, customer service, risk management, and investing. Our conversation covers the philosophy and mechanics behind running one of the world's largest index fund operators. We discuss Vanguard's ownership structure, values, product selection,

• 1:58Ted Seides?

  and mechanics of delivering an index fund. We then turn to common issues around indexing, including concentration in US equities, corporate governance, private assets, and AI.

• 2:11Ted Seides?

  Before we get going, this week marks the ninth anniversary of Capital Allocators. It's a moment that's not at all noteworthy. Seven was my lucky number growing up. Eight represents wealth, good fortune and prosperity in China. And ninth is, well, one before 10, which is a random round number. So despite the unremarkable nature of the milestone, it's a wonderful time to reflect on this journey you've taken with me. We're approaching episode number 500, which is actually the 583rd episode. And I'm so grateful to have the opportunity to conduct and share these conversations with the best capital allocators with

• 2:54Ted Seides?

  you. But we have work to do before hitting the round number 10 a year from now. And you know what's coming if you've listened this far. Think of that friend, colleague, or fierce competitor who doesn't know about the podcast. I mean, at this point, they're hopelessly behind you. And the only thing worse than being behind is being a full decade behind. Well, we have a year to correct that. So let's follow the lead of our former leaders of the country who left no child behind by leaving no worthy investor behind, which only happens if you take the next step. Thanks so much for spreading the word about Capital Allocators.

• 3:36Ted Seides?

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• 4:21Ted Seides?

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• 5:06Ted Seides?

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• 5:49Ted Seides?

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• 6:28Ted Seides?

  relationships with LPs are the ones that have both strong returns and strong operations. AI raises the stakes on operations and having Juniper Square as your operations partner helps ensure your data is organized, accurate, and accessible so you can unlock operational alpha. That's why thousands of GPs trust Juniper Square. Learn more at junipersquare.com/capitalallocators. Please enjoy my conversation with Rodney Kamijis.

• 7:03Ted Seides?

  Rodney, great to see you.

• 7:04Speaker 00

  Nice to see you, Ted.

• 7:05Ted Seides?

  Why don't we start with your background and path to joining Vanguard a quarter century ago?

• 7:10Speaker 00

  It's been a heck of a 25 years since I joined Radnor Business School. I grew up in a small town in Delaware. My parents didn't go to college. My mom took a job at the University of Delaware as a secretary so that I could get free tuition to the University of Delaware. I got exposed to some folks who were looking at other schools. I was fortunate enough to get into the University of Pennsylvania, but it was a little bit too pricey for my parents. I looked and remembered that I enjoyed my dad's stories from the Navy. I put the two things together, a chance to go to Penn with a Navy ROTC scholarship, which paid the Penn tuition and got me to go to a great school where I studied engineering and then I owed the Navy. Five years of service,

• 7:53Speaker 00

  which I turned into six and a half on a submarine out of Groton, Connecticut. That was a fantastic experience where I got to see a little bit of the world. I got to see some great leaders and learn about leadership. From there, I went to business school at HBS where I met you for the first time. Part of the reason I went to business school because I didn't know what I wanted to do. I tried a summer in consulting and it turned out that I like doing things a lot more than giving advice on how to do things. I went back to school second year looking for a place to work that had a great mission, a great value set, and was Philadelphia-based. My wife was already here. She had finished a PhD at Brown and was on a postdoc. We were from the local area and thought this would be a great place to live.

• 8:35Speaker 00

  One of our professors, Andre Perol, introduced me to Tim Buckley and Jack Brennan, and the rest is history.

• 8:41Ted Seides?

  I'd love to hear the difference in what you learned about leadership in the Navy and what you saw at business school.

• 8:48Speaker 00

  What I saw in the Navy was the human aspect of it. Young sailors at the time on a submarine, it was all male. Today, it's integrated men and women. They were 18-year-old kids who were really smart. Often, the Navy had high standards to join a submarine, but they might not have had the right opportunities. They were not fortunate enough to get an RTC scholarship to Penn. They also had real-world issues. Children with developmental needs, learning needs, they had a spouse, they might be going through a divorce. I've learned from Captain Holland how to balance the need for excellence and results. We were gone from home 70% of the time. I was on board with the need to care about the human beings.

• 9:30Speaker 00

  Anywhere from what's the issue of today that you're trying to deal with at home to what do you want to do when you get done in the Navy? Do you want to re-enlist and do 25 years and get a Navy pension? In our case, we had young sailors who said, no, I want to get out of the Navy. I want to go to law school. We have a gentleman in the engine room with me, probably joined the submarine force, 18, 19-year-old sailor who I saw him go back to school. He ended up being a judge in Wisconsin. Those are the types of stories of how to treat people. Business school, on the other side, especially for those that hadn't managed people, was often an academic exercise. Every case that had too much cost, then it was lay the people off. The military guys would go, who's going to actually do the work? How's that going to affect your morale?

• 10:15Speaker 00

  There's clearly a balance between those things because sometimes you do have to do the layoffs, you do have to do the hard things in business. That balance is what I learned and could see the between and betwixt between them.

• 10:25Ted Seides?

  When Andre introduced you to Vanguard, what was it that resonated for you?

• 10:30Speaker 00

  It was the Vanguard case study that resonated, and it's the Vanguard story that resonated. Andre had written a case about Vanguard, and Tim Buckley had actually worked on it, who became our chief investment officer and eventually our CEO at Vanguard. You read the case and you go, this is an organization. That is owned by its shareholders for its shareholders and returns its value back when it grows by lowering its fees. That's a really great outcome. You could already see it. We were in the early days, the choice of the direct investor, those that were interested in saving costs. By the time I got here, we were almost 25 years into the history. We'd already driven expense ratios down. We had democratized investing or the start of it.

• 11:13Speaker 00

  We were the first place you could really go to direct rather than through an advisor. The fees at the time were probably on average 30 basis points. The industry was probably 100 basis points. We were still 80% active at the time, 20% passive, but you could see what we were doing. We were the low cost leader with high quality products. Andre introduced me to Tim and to Jack, and I had a chance to come here. Originally, I worked in operations, 401k operations are part of it. I went to Arizona and ran our 1,200 person call center, which I loved. That was the frontline of Vanguard. Welcome to Vanguard. How can I help you? Trying to answer those questions for their first savings vehicle for their children's

• 11:54Speaker 00

  college or the start of IRA for retirement or whatever their financial need, hopes and dreams were.

• 12:01Ted Seides?

  When you look at some of the drivers you talked about, shareholder ownership and some of the principles of the firm, I'd love to hear your sense of the most important values of the firm over the last quarter century.

• 12:15Speaker 00

  Number one is be honest, be transparent and be clear. If you're talking to someone about an investment product, talk to them about the benefits and the risks. We care about low fees. We care about trying to make the investment landscape better for all investors, not just our investors. My team, for example, has worked very hard in the last couple of years to make the closing auction in India possible because we buy a lot of Indian securities in our index funds and auction makes it more efficient and makes it cheaper to execute and gives better price discovery. That's the type of zeal we're doing on behalf of our investors on a global basis. It's that transparency, low cost. Make sure we believe in the investment vehicle or investment product.

• 13:00Speaker 00

  It should be something that's long-term and enduring. It's always been a challenge for us. If you think about those investors that I talked about. Wanting to serve your mom and pop investors in mainstream America, they probably need broader diversified, more straightforward things. We now have a much more sophisticated investment base 25 years later with advisors who need a bond product with more complexity to it, or want to target a part of the curve, or a more active type decision. We've had to adopt, but every product that we offer, we want it to be best in class and competitive from a cost perspective, if not the lowest cost.

• 13:39Ted Seides?

  What was your path from starting in operations to where you're sitting today?

• 13:43Speaker 00

  I went to work as far from money management as you could be. We were taking the payroll in for big 401k clients and making sure that that weekly paycheck was getting invested on behalf of the investor with accuracy and trying to make sure operationally it was good. I then went to Arizona to a call center, taught me about frontline customer service. And then I did two years of corporate work, running our Six Sigma Quality Improvement Program. A decade into Vanguard, I've done nothing but operations, including the old days of answering the phones myself as part of our Swiss Army to try to serve our investors, but it really made you learn about the retail investor and our 401k investor. And I had an opportunity, Vanguard likes to rotate people. I got a call from my boss.

• 14:26Speaker 00

  He said, how would you like to go to work for a gentleman named John Hollier, who is head of risk management and is working to globalize risk management? I said, that's near the funds, isn't it? Mike's like, yeah, you're going to learn about it. I went to see John Hollier and John said, Roddy, I need some help on my operations and my management. I said, John, how do you do like staff meetings? He goes, what do we need a staff meeting for? I just have a yellow sticky and tell people what to do. So I hope John put in place processes that help scale his business. For that, I got to learn from John, who's one of the world's greatest risk management folks about how to reduce risk in the funds and how to allow people to take risk. John taught me the basics. John was a fixed income guy. He loved all the complicated fixed income stuff.

• 15:10Speaker 00

  There was less interest in the equity side. I loved equity indexing. From there, I did two big things early in my time. And investments. I helped launch a lot of the ETFs globally. I went to Canada and helped with the launch of products there. I went to Europe and helped there. I went to actually Hong Kong and helped launch some of those. I also worked a lot with the index providers. I worked specifically with CRIS, the Center for Research in Securities Pricing. I end with FTSE to make some changes to our index products to reduce costs. It helped me learn from Gus Soder, who was the legendary CIO of Vanguard, who was really an indexer. What were the key things about indexing that you needed to do to run a great index and helped do that? And now those products are run today for us.

• 15:56Ted Seides?

  I'd love to dive into some of the mechanics of how you go about indexing. Part of it starts with what index to create into a product. How did you think about launching new products?

• 16:10Speaker 00

  There's the original concept of indexing, which is capture as much of the world's investment universe as possible. And you put it into a total market fund. For those, you're just trying to get from the largest security in the US to the smallest one that you can invest in. What you're looking for there is all the securities that are equities. And then you're thinking, are they liquid enough and available enough for us to invest in? Then you include them all. That's the simplest version of indexing and we do that all around the globe. We have a total stock market fund here in the US for American investors. We have an Australian index fund based in the ASX 300 for Australians. Total bond, total international, total world, capture the whole equity.

• 16:54Speaker 00

  Then you start to go, if you're going to cut the index into pieces, what makes sense? One of the challenges in this business are people are slicing the indexes into pieces that don't make sense. There's not an investment thesis for it. We've stayed more pure to it. We've cut the indexes into what I would call logical blocks. We started with size, large, medium, small, value growth, sort of the Morningstar nine box. We have dividend strategies, higher dividend strategy and dividend quality strategy that we believed in.

• 17:28Speaker 00

  We've given some investors some choices with the ESG index is, but we're trying to find things that are still capturing, I would call it a factor, something logical for investors. We've stayed away from things that are hot or nichey. I don't think you're going to see us offer a jet index like others have done, capturing airline returns, too narrow, too specific for us. Better served by an active investor. That's the basics of it. Capture the investment return. Then you think about the practical implications of making it liquid and available.

• 18:00Ted Seides?

  Once you've picked one that you're going to work with, and for simplicity, you could say S and P 500, what goes into the implementation that makes it work?

• 18:09Speaker 00

  Number one is there are people in our operations teams that have to make sure the index arrives every day and make sure that the portfolio manager knows what's changing in the index. You got to have an accurate index. The second thing, you have not much money you have. Every day, my portfolio team, 50 people on a global basis, they're putting people's money to work. If you send us a check for a million dollars, we've got to make sure that we invested at four o'clock at the end of the day, perfectly in line with the index. That's one aspect of it. The other part of it is how we do that. You've got to know what the index is. You've got to know what you own. You've got to know how to put the cash to work. If you're going to execute, you're balancing four things.

• 18:52Speaker 00

  One, you want as close to tracking as possible. That's how the world judges an index fund. We have to be excellent at that. If the index has 5% Apple in it, you look at our portfolio, you're going to see us have 5.0001. We might have a little bit of it, basic thumb roll of over and underweights. Then we have more sophisticated models using an axioma risk engine that looks at it in an optimizer. Tracking is one thing. While you're tracking, you're managing three other things. Number one is if you're going to do differently than the index, you want to outperform. You don't want to leave money on the table. At times, we will do small deviations from the index where we see that we can recover value

• 19:35Speaker 00

  for our shareholders. Maybe there's a corporate action. Maybe you could take cash or shares. We're going to take the one that has the greater value. Maybe the index treatment's different than that. We believe we can add a little bit of value back. It's positive excess return for investors. The third one we're always thinking about is taxes. You don't want to pay a capital gain out of an index fund or an equity index fund. You're trying to always think about taxes. Maybe you do a tax harvest. Maybe you use the ETF's creation redemption mechanism to balance your taxable gain situation. Finally, there's a hidden thing in indexing. When you buy a stock that's added to an index, that price might go up. You might have market impact.

• 20:17Speaker 00

  You hate to see the market go up because the indexers are buying it just to come back the next day. The index, you have zero tracking. You have zero value added or destroyed, yet the under investor paid more for the stock than maybe they could have. I have a team globally that makes that trade off between those four things. Excess return, market impact, taxes, and where you can positive excess return. That's what goes into it and I'm fortunate to have a team of 50 people who do that every day for us.

• 20:45Ted Seides?

  One of the things you hear about a lot are the index rebalancing itself. New components coming in, a couple going out. How do you think about that balance of tracking and value add when there's a change in the constituents?

• 20:57Speaker 00

  We think about it in a risk adjusted way. For every fund here, we have expectations of tracking error. That's how we're judged. Number one is track the index. Something like a 500 index fund, we're going to see tracking error be no more than a couple basis points. Typically, less than one. We're not going to take a lot of risk there. You can imagine if Apple's number of shares in the index are changing because there's a buyback and we're having to sell some Apple. We're going to be largely on the close with that stock. We're not going to be able to take a position. Many investors are trading Apple. We have no ability to know where that's going. On the other side of it, in an international portfolio or global portfolio, maybe there's not the liquidity

• 21:41Speaker 00

  in the Philippines to help us with the add. The risk is small. It's a large portfolio. The Filipino add, it might be a small addition. Might take us a week or two to buy the number of shares. On our trading desk, the portfolio manager and the trader, it's one job, one team. When you go to most investment managers, portfolio managers sit in an office, think great thoughts in what stocks are going to buy. The traders are doing the execution on the trading desk. Most of our portfolios are not optimized. They're largely replication. The most important thing we can do is think about that trade execution. How we do those things matters a lot more than what we're owning because we're going to own them all.

• 22:21Ted Seides?

  What are some of the other ways you try to add value to returns?

• 22:24Speaker 00

  We look for places where there's an asynchronous return, where there's more upside than downside. That's our basic role and we don't do a lot of it. An example would be when a company brings a secondary offering to the market. They're selling new shares and raising money. We would participate in that. Statistically, we've seen that we can buy it from the bank at the time of offer. And by the time it's added to the index, we've usually bought it at a lower price than when it's added. Do we win on every one of those? No, we take a risk controlled way. We think about that corporate actions are another. How we elect to take when maybe two companies are merging together? How we get through there to the end result? There might be two paths.

• 23:06Speaker 00

  You might be able to keep the shares you have and it turns into the new company. You might be able to sell in the market and use your cash to buy another company. We're always looking for places like that where we might be able to add some value. One of the ways we add some value is with regard to the securities lending program. In securities lending, if someone wants to borrow one of our securities, they're willing to pay for it. Maybe a hedge fund wants to put a short position on. We lend out what we call specials. Specials are ones that have a high rate paid to the person giving the lend out. We will lend those out for a fee. That money flows back into the fund as positive excess return. 95% of the money made in the program goes back to the fund.

• 23:49Speaker 00

  The 5% of it is kept to run the program. We think that's a good way.

• 23:54Ted Seides?

  Once you own the portfolio, how do you think about the value creation of the market itself?

• 24:02Speaker 00

  Governance is all about companies that are well-run to do well over a long period of time. We have a stewardship team in internal to Vanguard and that stewardship team has always thought about making sure the company is well-run. We want a board of directors capable of overseeing the strategy of the company. We want a board of directors who is going to make sure the company gives investors information, make sure that you can see the financial returns, the risks that the company is talking, so investors can make great decisions. We want to make sure that the executive compensation is aligned with long-term shareholder value. We want to make sure that the executives are paid when the company does well. Finally,

• 24:45Speaker 00

  we want to make sure that the board of directors is thinking about shareholder rights. Our rights are protected as an owner so that we have the ability to have the vote. We stay away from things like telling the company what business to be in, or how to operate their business. We're more about making sure we get good governance over a long period of time. We've introduced investor choice. Investor choice is allow the shareholders of our funds to express a point of view around how they want the companies in our portfolios to be run. For that, we think about returning the vote to them and they can choose one of five policy portfolios. They could decide to vote with management. They could decide

• 25:26Speaker 00

  to use Vanguard stewardship. They might have an ESG point of view. If you want to take a point of view on how companies should be run, you make that choice. We've never made that choice, other than to make sure the board is well governed and well running.

• 25:39Ted Seides?

  What are some of the subtle ways that you've found that Vanguard's implementation is excellent that maybe some of your competitors or some other people wouldn't necessarily understand?

• 25:51Speaker 00

  Number one is this portfolio manager trader is one person or one team. It's the ability to instantaneously make the trade-off between I could trade something exactly like the index, I think I might be able to add value. I can make that decision because I have the knowledge of what the risk is of doing so. I have the knowledge of do I think the trade or the alternative choice is going to be successful and add value. We have the right risk oversight of those choices to make sure that we don't let people do crazy things with their portfolio. We're going to get the outcomes we do. That's the number one thing that

• 26:33Speaker 00

  differentiates us. This is a career for folks. I have out on my desk, a gentleman, Mike Perry, who's been running our emerging market portfolio. He's been in this group 25 years. Mike got to Vanguard, he worked in fund accounting, he got to be a portfolio manager and a trader. That's all he wants to do. And we have a career path that goes up through senior portfolio manager and officer. Mike is now showing the next generation how to run a complex emerging market global portfolio. I have roughly 30 people here in the US. I have another 20 folks globally. I have a team that reports to me in Australia that cares as much about American investors as we do. A team in London that cares

• 27:17Speaker 00

  about American investors as much as we do. And we're completely globally integrated. We do work on behalf of them for an Australian global fund that needs US exposure. The folks here are doing it for them. So it's a very integrated focused team on indexing.

• 27:32Ted Seides?

  That first point in trying to create value added, you can imagine the expectations of an investor in one of your index fund products is to get the index fund. How do you think about the trade off of potentially adding value, which could have some upside versus if that doesn't work, disappointing expectations?

• 27:53Speaker 00

  We're taking very small bets where we have 25 years of history of running index funds where we believe this is something where we can add value. It's no different than an active manager. It's a measured risk. It's extraordinarily tiny compared to taking an overweight or an underweight in an active fund. We're not going to use all of our tracking error budget on one active decision or choice. Tracking error first is the best way to put it.

• 28:20Ted Seides?

  As you look at the equity index business today, what's the range of products and asset size across of it?

• 28:28Speaker 00

  We have about eight and a half trillion of index fund assets. That would include our fixed income index assets, which a colleague of mine runs on behalf of investors, along with the active fixed income space. That's one big business for us. Within equities, we have two teams that run assets today. One is the team that reports to me, the global equity team. We run about $5 trillion of assets. They range from total stock market broad exposures to global broad exposures to value and growth exposures and country exposures. We're running Australian and UK. They're a wide range of outcomes, along with running target date suites.

• 29:10Speaker 00

  Over on the other side, our SE team or strategic equity team, they're running size and value growth sector funds for US investors. They're close to what you would see in Morningstar, Nike box type things, along with sectors, maybe some unique sectors like dividends, country exposures for our non-US investors.

• 29:33Ted Seides?

  I'd love to dive into some of the common topics that come up around indexing. Part of the biggest these days is the concentration of the S and P. Curious to get your thoughts on that, given your global historical perspective.

• 29:46Speaker 00

  30% of the S and P 500 is made up by seven companies. The S and P 500 should not be your benchmark nor your portfolio. If you do that, you're exposed only to US large cap companies. 500 securities, any investor wants diversification, needs to add small cap securities in. A total market solution, you need global securities. By the time you're done with that, you've increased your universe about 50%. You've taken that exposure down by about half by global market cap weighting the globe. And you need to add in bonds. You need to add in about 40% bonds for a 6040 portfolio.

• 30:28Speaker 00

  Natural diversification takes care of some of the concentration. What's the alternative? The market has decided the price of Apple and Nvidia Tesla. If we make a deviation from that, we've said the market's wrong and suddenly we've created an active portfolio. It's also not the first time that we've had high concentration. The US has been concentrated before. Those businesses are not one business. Some of our colleagues in our investment strategy group are doing research on this alphabet. You have an amazing search engine business. You have an amazing business around YouTube. Is it one business or two? The counter argument will be it's one price and one P ratio that

• 31:11Speaker 00

  we could argue whether it's the right valuation or not. I can't tell you it's the wrong valuation. I'm the indexer. That is what all the world's active managers, retail investors have decided is the right price of alphabet. Why should I fight it?

• 31:26Ted Seides?

  You mentioned the S and P 500 as not a good benchmark. Further thoughts on that, given that it does seem to be the universal benchmark in asset management?

• 31:35Speaker 00

  It is the right benchmark if you're a large cap active manager. You've got to go compete with it. That's the universe. If you're a CIO of a pension fund or you're running an endowment, you've got to think about a much wider universe as your benchmark. The 500 is a narrow part of that. You got to add in the international, you got to add in bonds. You have to add in your availability of what you can do in the private space. We believe privates belong in everyone's portfolio. The private space, they got to be low in cost. We like that at Vanguard. To be a good private manager, they got to be top quartile. We believe over time, we can add that into someone's portfolio. That's how you have to think about the benchmark. Shortcut to the role when you watch TV is the 500,

• 32:18Speaker 00

  but not the right benchmark. If you're on the serious side of investing, you have to have a more well diversified benchmark that reflects your fishing universe of where you can go look for investment returns.

• 32:31Ted Seides?

  Irrespective of the benchmark you use, for a long time, we've had shrinking number of public companies, particularly in the US. How do you think about what that means for the future?

• 32:41Speaker 00

  I'm not sure we know quite yet what it means for the future. The shrinking number of companies from a peak in the US, 6,000, 7,000 securities, about the time we graduated business school, down to about 4,000 US companies is just the fact. When you go and you dig into it, you discover what we lost was a lot of really small companies, a lot of micro-cap securities, a lot of small-cap companies. And for long-term returns, it's not clear you lost much. We are seeing companies stay private longer, which does mean there may be less return in the public space. It's hard to know. There's SpaceX and others sitting out there waiting to come public.

• 33:22Speaker 00

  I would love to have had them in my index fund back when they were a $100 billion company before whatever trillion is. I still believe the best place for companies to grow their business is the US public markets. There's no place that trades as well. There's no place that has as much liquidity. There's no better place to raise capital. What I don't know is whether this staying private for longer is a permanent phenomenon or not. Let's find a way to get some high-quality private assets into retail investors' hands over time.

• 33:54Ted Seides?

  With that money that's gone into some of the successful, large, private companies, should they go public? And there's some noise that some of the bigger ones will this year. How do you think about integrating that into your index products?

• 34:09Speaker 00

  The minute a company comes public, it belongs in an index fund. We've had that belief for a long time. You might need a few days for it to get trading and figure out price discovery. Our best indexes add those securities in day three or day five. That's the best practice. Why should they not be in investors' portfolio from there? They should be float-adjusted. Most companies come public, only bring 5% to 10% of the company public. We only want to buy 5% to 10% on the day of the IPO. Many years ago, Yahoo came public with a small float. Indexers bought a lot of it and the price went up. The demand was greater than the supply. Gus Soder and Mike Buick, people long before me on this desk.

• 34:52Speaker 00

  Pushed really hard for all of our indexes to be floated, just in which they are today. That reflects what's available in the marketplace and therefore an indexer doesn't oversize the amount of shares brought to the market, but get them in there quickly, have it be part of the investment return.

• 35:07Ted Seides?

  How do you think about what that implies for one of these big businesses in terms of the supply and demand of where one of these new IPOs could settle out?

• 35:19Speaker 00

  IPOs are always difficult to predict in this space. Demand early on can outstrip supply or the reverse. Facebook came public and the story was Facebook's going to go to the moon and beyond. Facebook broke price, went down and stayed down for nearly a year. Facebook is an amazing investment return story. In the first days, it's very hard to predict which way supply and demand will equal. There are people, in the case of any company that comes public, that want out of there. There's a demand, whether it be retail, index funds, active managers. It takes some time for those things to even out.

• 36:00Ted Seides?

  So in this period of time where the number of stocks keeps coming down, Vanguard assets keep growing. How have you thought about your concentration of ownership across all the companies in large cap indexes?

• 36:15Speaker 00

  We own on average about 8% of every company in America that's free floated. Most importantly, we say, who are we owning them on behalf of? These are 50 million Americans, not Vanguard owning 8% of the company. You have to understand that mindset. We are a long-term, permanent owner of these companies. Therefore, we should make sure they're well-studied and well-governed. That's our role to play.

• 36:43Ted Seides?

  What's different in how you think about the fixed income markets from the equity markets?

• 36:48Speaker 00

  At a high level fixed income indexing, you can't own every security. They have to do a lot more with their sampling and with their optimization around it. I would say it's easy. If you control your duration, you control your credit quality, you can get the index return. They have choices. Do they own bond A versus bond B? They're always looking and saying, we want a bond that's going to stay in business. They don't want a credit default. So they use the credit process to try to identify securities that might have a slightly wrong price or one that might be headed in the wrong direction. They're just as index centric as we are focused on tracking here. They have different levers to do,

• 37:33Speaker 00

  and they also have optimization to do there. We've always had active fixed income at Vanguard run in-house. We have continued to increase the size of our team, the depth of our team. We believe we can outperform in the fixed income market in those portfolios because we have the right team. At the classic Vanguard low price, we believe we do provide institutional quality active management for investors.

• 37:59Ted Seides?

  I'd love to ask you about the business of Vanguard, some of the decisions along the way. You weren't the first mover into the ETF space. Now one of the biggest. How did that decision process play out in the organization?

• 38:14Speaker 00

  All of that, Ted, started before I got to the investments side of Vanguard. We did launch ETFs after I was at Vanguard two years. At that point, I was working the 401k operations. It had nothing to do with the original couple ETFs we brought to the market. The history goes back to Jack Bogle talked to the American Stock Exchange about the SPY product, and he said, what, are you crazy? Trading intraday is the worst thing for investors. In the early days, Jack Bogle was highly opposed to this. Forward, probably a decade or so, Gus Soder came to Jack Brennan and said, we should offer these. Gus pitched it to Jack Brennan and said, this is an alternative distribution vehicle.

• 38:59Speaker 00

  Interday trading is not what we're about. It does open the aperture of getting our products to more people, making indexing better. Jack Brennan threw him out of the office the first time. Gus was tenacious and went back in and said, you really should. This is a way for us to take our business from being just a direct place where we sold mutual funds to putting it out there on a brokerage platform that today advisors can use it. It's widened the use of index funds. Jack Bogel still hated him. He would still talk to him. I got an earful on a number of occasions from Jack as to why would you give someone the ability to trade interday? No one ever needs it. They need to buy it once a day, sell it again in 20 or 30 years.

• 39:42Speaker 00

  The majority of our investors are long-term holders, whether they're in ETFs or mutual funds, holding periods of Vanguard or five to 10 years. They're not using it in an inappropriate way, but it does give more access to more folks. That's been part of our success over time and it's allowed us to be used by advisors.

• 40:01Ted Seides?

  You're most well-known for equity index funds. There's a lot of other spokes that have come up, not the least of which is low-cost active management. I'd love to hear your thoughts on this balancing of running passive index funds and active managed funds.

• 40:16Speaker 00

  We love all forms of investing that are low cost. Our history is active management. Our oldest fund is the Wellington Fund, second oldest mutual fund around. That fund is a Vanguard fund, balanced fund, 60/40, active equities and 40% active bonds. Wellington runs on our behalf. What we believe is you can outperform inactive if you do two things. One, you have a great manager, one that has the skill to do so. It's a tough job to do to outperform. The other thing you have to do is keep your costs low. Even if you're outperforming, if your fee is too high, you're going to destroy your alpha. The third part of active management is you have to be patient.

• 40:57Speaker 00

  We watched some of our best active managers perform poorly for a few years, five years, and their style of investing returns. So colleagues that do nothing but oversee, hire, and sometimes fire active managers who they believe have the ability to outperform and have those skills, they work for a Vanguard price, which is lower than anyone else in the active space. We love active management.

• 41:24Ted Seides?

  How have you brought those principles together in private equity? An area that is broader for diversification, but notoriously much higher cost.

• 41:33Speaker 00

  It's still the early days. We do have a partnership with Harbor Vests for some of our high net worth retail investors. We've had some success there gathering assets. We've gotten the equation of a high quality manager, fund of funds manager. They're working for the right price for us. We would love over time and we'll see what the government does with allowing more availability of private access for investors. We want to have great managers at a reasonable price in that space. The only way you're going to succeed in the private space. Only time will tell and it's very early days.

• 42:08Ted Seides?

  In those early days, how have you thought about it in that you might get a low cost with Harbor Vests, but ultimately there are fund of funds investing in higher fee managers?

• 42:18Speaker 00

  We've said, hey, we might not have this scale to drive costs. So let's go get a great manager. Make sure that investors know what they're getting and it gives them the diversification of it.

• 42:28Ted Seides?

  What's on the forefront of the newest initiatives in indexing?

• 42:32Speaker 00

  You could go two directions with it. One is something that's not good for investors. That's cutting the index into small pieces, calling it an index fund where it's simply an act of exposure. Even worse is if you put leverage to it and triple leverage it and claim you're giving a negative or positive 3X return and you are for one day and you're not for the long time series. Unfortunately, a lot of index innovation is marketing, positioning for sales and not good for investors. The second aspect is every day coming in, running the index in a more efficient operational way. We're trying to think about corporate actions and what could AI tell us in large language models?

• 43:15Speaker 00

  Rather than 25 years of Mike Perry's history having to be transferred to the next person. Let's look at our history and pull together what worked and what didn't work for us. Try to put that into an AI model. We're trying to also put efficiencies in. Let's touch the portfolio less. We don't touch it a lot today. You don't trade on average a trillion dollars of execution on an annual basis by going in and touching every stock. We're using algos technology to do it. We should continue to do that and even more of it.

• 43:47Ted Seides?

  How has AI enhanced what you've been doing?

• 43:51Speaker 00

  AI has made the price discovery in the market better. We want every active point of view in the portfolio. And if AI is helping the active managers to make a better decision, we have better pricing and better knowledge. Indexing is perfect for AI as a broad investment concept because it takes advantage of all the pricing. If somebody finds an AI version of the stock price is wrong and they buy it, that information is priced in the market. We've tried to think about the decision-making process, trying to find ways to capture it and understand it so we make better decisions in the future. We're relying less on the human being's historical knowledge to improve our decision-making. It's very early in that process.

• 44:36Speaker 00

  Riding a Waymo who's driving me around city streets without a driver, think about what will it be like five, 10 years from now in terms of how we run an index portfolio? I'm positive I won't recognize the place.

• 44:49Ted Seides?

  What do you think Vanguard looks like five or 10 years from now?

• 44:52Speaker 00

  We look like we are today, which is the best place for an investor to get an investment product. I suspect, like we have seen in other areas, AI will help to enhance our customer service experience in a way like the web has. When I first got to Vanguard, people would call up every day for a price of the fund and their value. No one does that anymore. They're going to their phone app to do it. You've got to imagine it's going to continue to help investors make better decisions through engines that also make it more personalized. Your financial situation is different than mine. The more information we can get with the right advice engine behind it

• 45:34Speaker 00

  gives you better bespoke advice that's specific to your family's situation, your wealth level and everything else. We're in the early days of that at Vanguard and in the industry. Customization of advice will be one of the big areas.

• 45:47Ted Seides?

  Rodney, I want to make sure I get a chance to ask you a couple of closing questions before we wrap up. Before we get to the closing questions, I want to tell you about one of our strategic investments. We've made a few and each are working on a product or service we think will be valuable to our community. One is Thema. For all the private equity managers out there, Thema uses AI to help map the landscape and source private businesses. It's incredible what a well-designed AI tool can do to accelerate the discovery of businesses in private markets. There's a link in the show notes so you can learn more. And here are those closing questions. What's your favorite hobby or activity outside of work and family?

• 46:27Speaker 00

  I have a pinball collection. Old school, buttons on the side, flippers. I have about 40 pinball machines. I like to play in pinball tournaments. I have made a lot of good friends across the globe by playing in a very niche hobby. It's been a part of some things my family does with me too, which is play pinball. My kids do. My wife has no interest in the topic.

• 46:51Ted Seides?

  What does it take to be a good pinball player?

• 46:53Speaker 00

  Youth is one of the things. It's a hand-eye coordination. It's fundamentally a shooting game. You're hitting a ball with a flipper at something. Young folks just got better hand-eye coordination. Then there's some level of knowledge of the game, the ability to move the game around. I'm not great at it. I'm okay at it.

• 47:09Ted Seides?

  Which two people have had the biggest impact on your professional life?

• 47:13Speaker 00

  One is from our early career days, which was the captain of the USS Archer Fish, the submarine I was on from 1993 to 1996. Captain Bob came on maybe six months after I was there, Captain Holland. He said a standard of excellence. He said, "We're going to be the best ship in the Navy every day because we have a mission to do on behalf of the United States." He treated folks like adults. "What do you need to do your job? Let me help you get that." Maybe around the edges, "Hey, why don't you think about that differently?" "We'll only step in if there was some real reason to." It showed me the early form of delegation to young people who are talented. Second person was a guy

• 47:55Speaker 00

  named John Hollier I mentioned earlier. John was head of risk management. He was my first boss in the investment management side. What John taught me was always think in investments. What is the worst outcome? What's the thing that could happen that you suspect will never happen? Assume it happens. Can you live through it? If not, you shouldn't be doing it. That's what John taught you was this common sense approach to risk. Also, you had to do your homework to understand the risk. Too often in this business, people go, that's never going to happen. You go back and you, oh yeah, it happened in the great financial crisis. It happened at this point in time. If it can happen, it probably will, so be ready for it.

• 48:37Ted Seides?

  What's your biggest pet peeve?

• 48:39Speaker 00

  Two pet peeves. Don't be late to a meeting. Please don't let the meeting run over. State of the time block.

• 48:45Ted Seides?

  How about on the investment side, investment pet peeves?

• 48:47Speaker 00

  Rocket Vanguard, that's the easiest answer ever. High cost.

• 48:51Ted Seides?

  What's a mystery you wonder about?

• 48:53Speaker 00

  Interest rates. Everyone spends a lot of time talking about them and whether they're going to go up or go down. I find the whole thing to be a bit of a mystery and very hard to predict. We spend a lot of time in this business talking about them.

• 49:06Ted Seides?

  Rodney, last one. How's your life turned out differently from how you expected it to?

• 49:11Speaker 00

  I might not have thought as a kid who went to college, who had flown on an airplane one time, that I'd have the amount of experiences that I've had on both a professional and a personal level. My family and I had a chance to move to Australia for three years where I ran the investment team. I had a chance to go to China as a part of work. I've had a chance to go an incredible amount of places on personal travel. Never thought I'd see the world and understand the world as a creator grew up in a small town in Delaware with 1,500 people.

• 49:41Ted Seides?

  Rodney, thanks so much for diving into how index funds work. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.

• 50:01Speaker 02

  All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.