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Webcast replay: A look ahead to 2017

January 13, 2017

Replay and transcript from a recent Vanguard webcast

In this replay of a recent webcast, Vanguard Chairman and CEO Bill McNabb and Chief Investment Officer Tim Buckley look ahead to 2017.

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Transcript

Rebecca KatzRebecca Katz: Well, good evening and welcome to this live Vanguard webcast. I'm Rebecca Katz, and Happy New Year. I can't believe it's 2017. Have you made any New Year's resolutions yet, broken any New Year's resolutions yet, already just a few days into the new year?

Well, tonight we will be taking a look ahead at what 2017 might offer us investors, and we have two people in the studio with me that, hopefully, will have some great financial New Year's resolutions that we should take and not break. So joining me tonight are Vanguard's chairman and CEO, Bill McNabb—

Bill McNabb: Thanks, Rebecca.

Rebecca Katz: —and Vanguard's chief investment officer, Tim Buckley.

Tim Buckley: Thanks, Rebecca. You bet.

Rebecca Katz: Thanks for being here.

So, you know, we did a webcast shortly before the holidays with our chief economist, Joe Davis, and many, many, many of the questions were about uncertainty and the possibilities in a Trump administration. And guess what, we got thousands of questions for this webcast tonight, and they were on the same topic. So we'll spend quite a bit of time talking about President-elect Trump's administration without being too speculative since it's early yet. And we have a lot of other things we'd like to cover as well.

Now as we talk, certainly you can submit more questions our way or ask for clarification. I'll see those here on my computer screen, and we'll try to get to just as many kind of broad-brush questions as we can throughout the webcast.

Two quick points of housekeeping. On your screen, you probably see some little icons towards the bottom of the player. If you have any technical difficulties, click that yellow one, and you will get someone right away who will help you with those technical difficulties.

And then there's a green icon that has a little folder on it, and if you click on that, you can see a lot of thought leadership and material related to the things that Tim and Bill and I will be discussing tonight. So check those out.

I thought before I started grilling our guests tonight, always fun to grill the boss, I would ask you guys a polling question. We'd like to know a little bit about you and how you're feeling this New Year. So on your screen, you should see our first poll question, and what we'd really like to know is, are you optimistic, pessimistic, or uncertain about the economy for 2017? So respond now and I'll come back to you. But in the meantime, I'm going to turn it over to our guests again. Thanks so much for being here. I love this time of year.

Why don't we jump into the Trump administration with our first question, and then we'll come back and see how our audience is feeling.

Bill McNabb: Can I deflect this one to Tim?

Tim Buckley: Yes.

Rebecca Katz: I thought we'd have a little bit of a hot potato on this. But our first question is actually from a Tim, so you should answer it, in Maine, and he said, "How might the incoming Trump administration impact the outlook for the economy and the market?" So maybe you can divide and conquer here.

Bill McNabbBill McNabb: Well, when I think about the economy, you know, obviously, it's so soon. You know, we're just starting to see some of the nominees for cabinet positions and beginning to understand some of the early positions. I would say most of the speculation has been around three broad themes. One would be the potential for what I would call a lighter regulatory touch and what that impact might be both on growth as well as the markets.

You know, second, you hear a lot of people discussing the possibility of some sort of fiscal stimulus, the so-called infrastructure spending.

But I think the third area, which is the one that probably gets the most attention, because it potentially has the greatest impact on the economy, is the possibility and the real possibility, really from a bipartisan perspective, of corporate tax reform. And there's a lot of discussion around that, and, you know, depending on how that were to evolve, that's certainly something that could impact long-term growth in the economy. Hard to say whether it would have any real impact in 2017, but certainly 2018, '19, and beyond.

You know, as far as the markets, I think the markets are baking in some of these assumptions.

Rebecca Katz: Yes, it has felt pretty good lately.

Bill McNabb: You know, and, Tim, you know, I know you've talked a lot with your colleagues about this.

Tim BuckleyTim Buckley: Yes, Rebecca, Bill and I would both agree on this one, that it's, that markets have gotten a bit ahead of themselves, in the sense of when I say ahead of themselves, there's a lot of speculation, and we always caution people against speculation.

The markets going into the election, Bill, we've talked, going in they were, well, some might argue they were fairly priced. Some would say they were expensive going to the election. Since then you've had a run-up, 5, 6%, a little bit more in some of the smaller-cap markets. And the fundamentals of the market didn't change at all. The underlying fundamentals of these companies didn't change. Now people are starting to speculate what will this infrastructure spending mean? Less regulations, that means new small companies, new jobs, more consumption. Well, what will happen with corporate profits if they come back on shore? The problem is there isn't even plan one in place yet—

Rebecca Katz: Right.

Tim Buckley: —so it's tough to react to like, how does it, if you're going to value a company and all the company's make-up, say the S&P 500 that you're valuing, well how do you do a bottom-up analysis when you don't really know what the plan is yet?

Rebecca Katz: Yes.

Tim Buckley: So that's where we're much more, don't react to what the market's doing right now.

Rebecca Katz: Yes.

Tim Buckley: Often, when you look at how a market's reacted from the election to the inauguration, it has nothing to do with what will happen afterwards. So this is a speculative period right now and would caution people against reacting to it.

Bill McNabb: There's a really interesting statistic. You know, at the end of the day, we think fundamentals drive markets over the long run. You can certainly have other elements in the short run, change things on the margin. But if you look, you know, we've actually taken a look all the way back to 1853 and looked at stock market returns. Whether it's a Democrat or a Republican president, it's been essentially the same market returns. So whatever your political persuasion, in the long run, the fundamentals of what's going on in companies is what drives stock prices more than who's, frankly, sitting in the White House.

Rebecca Katz: Okay, interesting, but I do want to come back. You said, "caution," the word "caution." I do want to come back to that because if the markets are ahead of themselves and they've been very strong, we have to worry. But we did ask our audience how they're feeling. Actually, I'm surprised to see so much optimism. About 41% of people responded that they are optimistic, 9% pessimistic, but about half are uncertain. So does that surprise you at all? We've been talking a lot about uncertainty.

Tim Buckley: Yes, uncertainty, if you were to describe the markets right now, and markets always have uncertainty, but most people would describe them as uncertain. What's going to happen? Everything Bill just said, everything I just said, no one really has that crystal ball to know what the effect will be. So uncertainty would be, uncertainty and I'd probably throw, we didn't ask them this, but I would have said speculative in there right now.

Rebecca Katz: Yes.

Tim Buckley: But those two things right, hand in hand right now.

Rebecca Katz: Okay. Well, you know, I want to go back to this idea about the markets being ahead of themselves. Robert in Texas says, "We are probably close to the peak of the market. What argument exists to encourage continued new investment in the market at this time?" So do you think we're at the top of the market, and why would you keep investing if that were the case?

Bill McNabb: I wish you could find someone who could tell you when you're exactly at the peak of a market and what's going to happen next.

Tim Buckley: I've been in this business 25 years, Bill, over 30 years. We've yet to find that person. So we can tell you that when markets are relatively cheaper or relatively more expensive—they're more on the expensive side now—but that does not mean you're at a peak. It doesn't mean that there will necessarily be a pullback. We could have a pullback. Even if, let's say, we have a pullback in the first half of the year, Rebecca, you shouldn't react to it. You should stick with your plan.

And regardless if the markets are going up or down, stick with your plan. If you try to react to them, you will lose.

Rebecca Katz: Yes.

Tim Buckley: Now you want a little encouragement to move on and to keep going into equities. Equities are, they're there for your long-term growth. And if you look at the P/E in the market right now, its valuation, at about 21 on trailing earnings on the S&P. It's really right where it was let's say in 1992, my second year in this business; and the P/Es were about this level. And there were people saying, "Well, get out of equities; they're too expensive."

Rebecca Katz: Right.

Tim Buckley: Well, over the next decade, they went up, they went way up. Right, we had a— You remember the dot-com boom and then the bust? But if you went the ten years from '92, and you did the average annual return, you're getting about 8% from equities. Now that's not bad.

Rebecca Katz: No.

Tim Buckley: We would take that today. We're looking out, say would be a little bit more cautionary to think, Bill, you'd say 6 to 7% is what we'd expect from the market?

Rebecca Katz: Actually, they were up 12.

Bill McNabb: Yes, I mean the markets, you know, these past 12 months have been stronger, I think, than anybody anticipated. You know, again, to put it in a little bit of perspective, Tim said it right, you can't time this stuff. And so we think all the talk about what's going to happen in the next quarter, what's going to even happen in the next 12 months, to a large degree, it's all interesting and it's fun to do, and we all do it, but it's actually not that valuable in terms of being an investor. You know, you really have to think in terms of longer time frames.

And as Tim said, you know, over the next decade, we expect returns might be a couple percentage points lower than long-term averages. And based on where we are today, that's, we think, a pretty good bet. But that doesn't mean you shouldn't be in equities.

The second thing I would point out is even when you are looking at markets sort of trending up over 10 or 20 years, roughly a third of the time you spend in bear markets. So part of being an equity investor is learning to deal with that kind of volatility, and you will have fairly long periods of time where you're actually not doing well. And, you know, again, historically it's been about one-third of the time.

Actually, what's so interesting about where we are right now is from 2009 to today, it's one of the longest bull markets in history. And we really haven't had much interruption, just a couple little blips if you think about it.

So we're actually kind of due for a prolonged negative period at some point, and that's just going to be part of the process, if you will, to generate long-term returns.

Rebecca Katz: So maybe 2017 is a year I don't look at my statements and don't look at the internet.

Well, no, I have someone challenging us a little bit on something that you said earlier. Scott is saying, "You mentioned corporate tax rates. Cuts in corporate tax rates under Hoover, Reagan, and Bush led to massive market crashes. So why should we believe another cut would be any different?"

Bill McNabb: So I don't necessarily think that we're talking about corporate tax cuts. You know, part of what has been talked about is tax reform, which would simplify corporate taxes. It may mean, it may lead to lower overall rates, but perhaps less exemptions and so forth. But I think, as you know, we've got a very complex tax code. There's certainly evidence that the complexity of the tax code and the way we tax foreign earnings has actually driven some business offshore. So, again, what we believe is a simplification of that could actually be a very positive thing.

Tim Buckley: And the bit that everyone's so upset about is this pot of gold that's sitting overseas.

Rebecca Katz: Right.

Tim Buckley: All of the corporate profits that have not come back to the U.S. The idea is, can we get those back to the U.S.? Well, let's say you can, and maybe there's a tax break, a tax haven, whatever, a tax holiday on it. It matters what you do with that money. That's where you'll truly find out. If that money is then invested in businesses, where you're investing in plant property, equipment, you're investing in R&D, you're investing in things that will drive productivity later, that's good for business. If you're just buying back your own stock, well, that may just kind of give us a short-term sugar burst in the market but is not lasting. So it does matter what happens with that money if it comes back onshore, even with a break.

Rebecca Katz: Okay, lots of considerations. Lots of uncertainty. You know, another challenge to something you said earlier, Richard in New York says from a, he's a long-term investor, and he usually stays the course, as Vanguard recommends all the time, but, "Is there ever a point at which some kind of change in the market or government actions or a big world event that should cause you to change course and to reallocate or maybe to limit the downside and move it in cash?" Ever?

Tim Buckley: Well, I would tell people, invest globally. Diversify globally. But when you're thinking about your asset allocation, be very, very local. Very local. In other words, don't let events in Russia or a financial crisis in Venezuela or a regime change here in the U.S. affect your asset allocation. Your asset allocation should be about what's happening in your life. Did you just have a child? Did you just get a big promotion? Are you about to retire? Those are the things that should affect your asset allocation, not what global leaders are up to. That's very interesting but shouldn't affect your long-term asset allocation.

Bill McNabb: Yes, I think the only time somebody should change their allocation dramatically is if they have a dramatic change to their own situation, for one of the reasons Tim described. And it shouldn't be an exogenous factor. It should be something that has changed in their circumstances and, therefore, in the assumptions they had in assembling a portfolio.

Rebecca Katz: Okay, that's good advice.

Bill McNabb: And, look, I would tell you it's one of those things that is so hard to do. It's very emotional. Rebecca, you've heard me tell this story before, but my second job is really being the chairman and CEO of Vanguard. My first is being my mother's financial advisor. And during the global financial crisis, as the markets were going down, my mom was appropriately very worried about what was happening.

And we got to March of 2009, no, I'm sorry, March of, yes, March of 2009, the absolute trough of the market, and I got the call, "We've got to sell everything." And it would have been the exact wrong time to do it. But, you know, in the moment, you could feel the emotion. And, fortunately, we didn’t, she didn't, and she's happier now.

Rebecca Katz: It's good to have people that work for Vanguard that you can call. People call me and I say, "I moderate webcasts, so don't ask me these questions." I ask the questions.

Bill McNabb: I have a number you can give them.

Rebecca Katz: That's right, Bill.

We have a question from William, again, we're going back to some follow-up to things that we've talked about. William says, "My understanding is that taxes don't drive jobs offshore. Labor at ten cents on the dollar drives jobs offshore." What are your thoughts? So I know we've had quite a number of questions about globalization, offshoring of jobs. I don't know which one of you might want to tackle this.

Tim Buckley: I'm going to change the argument a little bit on the offshoring of jobs and the loss of jobs. Yes, many jobs have gone offshore, but the true— If you look back through the past few decades and you see the loss of, say, manufacturing jobs, and you see the decline of these, what we'd call middle-income jobs, a lot of it is from the automation of the repeatable task. And technology has been truly disruptive in that, and the real challenge then is not what's going offshore, what's staying onshore, but how are we embracing technology and how are we upskilling our decisions in the U.S., upskilling the workers in the U.S.? How are we upskilling them for the next job, because a lot of the tasks are being automated. And this is a threat. It's a threat for the U.S. It's a bigger threat for countries like China where automation could wipe out huge industries, a huge number of jobs. And so to really think about, technology's not going away. How are we embracing it, and how are we upskilling our workers?

Rebecca Katz: Yes, it's one of these things I have conversations with my 12-year-old to say, "You really need to study coding so you can program the robots. That's where the jobs will be."

Our next question is from Donna, who says, "Speaking of overseas, do we have any thoughts on Europe and the emerging markets in 2017?

Bill McNabb: You know, I'll start and Tim will jump in, I'm sure. Again, you know, in the next 12 months, we have no idea how they're going to perform. If you, again, look longer-term, you know, the rest of the developed world, along with the U.S., is pretty highly valued at this point.

If you, again, look longer-term, you know, the rest of the developed world, along with the U.S., is pretty highly valued at this point. You know, again, our expectations are our returns over the next decade for those markets may be a little bit lower, a couple of percentage points lower than what they've been the last 20, 30 years.

Emerging markets is a really intriguing area right now because the valuations are pretty attractive. And they're attractive because I think people assess the emerging markets, and China, being a big part of that, as being pretty risky. And so it really comes down to your sort of risk-reward appetite if you will.

But emerging over the next decade certainly looks like it's got a better valuation today, which typically means better return, a more normalized return stream over a long period of time. But I think the reason for that is people do assess that there's a lot of risk in those markets, that it's more geopolitical than pure economics.

Rebecca Katz: Yes. Well, we certainly have a lot of volatility in China early this year, last year at this point.

Tim Buckley: You shouldn't forget about that. Now if we think about global and global growth, where is it coming from? Certainly the U.S. has been on this 2% growth trend and maybe we bump out of that, and it's been tough to knock us down from it or push us up from that. Maybe we go 2, 2.5, to 3%. Europe, still dealing with Brexit, right? From an economic standpoint, still dealing with Brexit. U.K. is probably going to have a tough time. Europe on the whole, maybe it grows at 1.5% going forward. China will continue to slow down. It had been a breakneck pace in its growth, and it's a huge economy. The world's second-largest economy.

And it's slowing down, and you think about these economies together as they slow down, as China goes from 7 to 6 to 5. We tick up a little bit. Europe stays basically kind of where it is. You get global growth at 3 to 4%. Right, so it's solid global growth. So let's talk about the risks a little bit, Rebecca.

Rebecca Katz: Yes.

Tim Buckley: I think short term, medium term, and long term. I think short-term you have to think about what will happen around global trade. Do we end up in some sort of a trade war? That would not be good for the global economy. A trade war would not be. That's kind of a short-term risk. Medium-term, Bill, I think we'd still talk about Europe in there. You know, have you dealt with Brexit? Have you dealt with Greece? Europe is still there.

Long-term, watch China. And it's not a hard landing in China. China has a lot of overcapacity and old industries, and they have a lot of debt related to those industries. How will they draw that capacity down and deal with that debt? Will they keep just rolling it over and poorly allocating capital or will they allow the markets to open up for better allocation of capital? And that's the more long-term risk to global growth. So we tend to look at the different parts of it.

Rebecca Katz: So that's an economic perspective, the slowing of growth potentially in their economy. Does that necessarily translate to slowing of their financial market performance?

Tim Buckley: Well, the markets right now, everything I just mentioned, would basically build in valuations; it's surprises to those. If China deals with its debt issues, then it could have a nice run up.

Rebecca Katz: Okay.

Tim Buckley: And the EM could have a nice run up. If Europe somehow deals with— If Brexit actually goes a lot better than people think it's going to go, you could have a nice surprise in the market. And then the reverse is true. The existing, if you hear it in the press, you read it in the press, you hear us even talking about it, for the most part, it's going to be priced into the market. It's surprises to those expectations that change market returns, the ones Bill talked about, and that's what you have to look at.

Rebecca Katz: Markets don't like uncertainty either.

Tim Buckley: That is true.

Bill McNabb: Yes, but, again, and we're going to keep making this point, is in the long run, Rebecca, and, again, I tend to like to look at things in ten-year or even longer. It's where you start from a valuation standpoint that's going to be the single-biggest driver of what the future returns are going to be. It's not the only one, but it's certainly going to be the biggest driver.

And for most companies that are part of capital markets, you know, public companies, from a market capitalization standpoint, they're usually global in nature. So their company, it doesn't really matter if a company's in Switzerland or a company's in Spain or a company's headquartered in the U.S., it's how are they competing in their various sector and how well are they doing in generating earnings and so forth, and then how are they being rewarded in the market? This is, again, another reason why we think it's so important as investors to have an increasingly global perspective in assembling portfolios because it's really difficult to tell who the winners and losers are going to be in each sector of the global economy.

Rebecca Katz: Well, you know, we talk a lot about the long-term perspective and weathering the storm, especially if you take on more risk in something like emerging markets. You talked about your mom a little bit, and we frequently get challenged after these webcasts to say, "Okay, but I'm a couple years from retirement or I'm in retirement," so Maureen in Pennsylvania asks, "How can I insulate my portfolio from this uncertainty because my time horizon's much shorter?"

I mean how do you, it's great in the financial crisis your advice to your mom was to stay the course. But what do you tell retirees on a regular basis?

Bill McNabb: Well, you know, again, this gets down to your basic asset allocation. If you really can't withstand a fair amount of volatility in your portfolio, which typically as you're getting closer to retirement may be the case, then you need to have a pretty healthy allocation of fixed income, because fixed income is the ballast, if you will, to the equity markets.

Now, again, if you take an average couple, age 65, there's a better than 50% probability that one of them is going to live more than 25 years. So you do have to have a, even in retirement, you have to have some hedge against inflation. You need growth. But, in a sense, the less volatility you can handle, the more you have to have in fixed income in terms of balancing your portfolio.

Tim Buckley: That can be controversial for people today, especially when the press is saying, "There's a great rotation going on. Everyone's moved from fixed income to equities, and you should get out of bonds now. Rates are going up." But people have to realize, bonds are not there to drive your growth and your portfolio. As Bill mentioned, look, equities, they're the wind in your sails.

Rebecca Katz: Sure.

Tim Buckley: Right. They're the ones that, that's what pushes you forward and gives you growth. But like wind, it can be stormy. It can be very stormy, and Bill mentioned bonds are the ballast. They're the part, the ballast and your keel, to keep the masts up and the keel down. So don't mistake it by saying, "Oh, well, bonds aren't going to return much." They're there to actually reduce the volatility of your portfolio, to zig when equities zag.

Rebecca Katz: Yes.

Bill McNabb: The other thing that comes up in this discussion, and I'm sure we've gotten some questions on it as we're talking, is, "Hey, that's great, but in a rising-rate environment, one, I see the value of my bonds go down."

Rebecca Katz: Right.

Bill McNabb: And the answer to that is yes, you will, if you're looking at the value of your bond fund. If rates go up tomorrow by 50 basis points, you're going to see a decline in the value of that portfolio.

But what you really need to think about is as long as your time horizon is longer than the duration of your bond portfolio, you actually want rates to go up because you're going to be reinvesting at higher and higher yields. And, actually, when you do the math on this, you're better off. And this is completely contrary to the way most people look at bond funds.

Tim Buckley: Well, take a bond index fund. Well, I use Bill's example here. So if you look at basically a bond index that tracks the Bloomberg Barclays Agg. Last night was yielding about 2.1%, the Agg was, so that's the whole bond market, U.S. bond market.

Bill mentioned that if you were to invest in that and wait ten years and rates don't do anything, believe it or not, you're actually worse off than if in the first two years, and now you have that ten-year period, in the first two years, let's say rates go up 2% a year for two years.

Rebecca Katz: Yes.

Bill McNabb: Which is a lot.

Tim Buckley: So now instead of 2.61, you're at 6.61. That you would think like, oh, that's going to be a huge loss for my portfolio. I cannot handle that.

Rebecca Katz: Right, because prices will drop as yields go up.

Tim Buckley: As yields go up. Thank you, but over time, if you wait that ten years, you're better off by $1,400 on a $10,000 investment.

Rebecca Katz: Wow, because the dividend that it's paying is higher?

Bill McNabb: Because you're reinvesting at higher and higher rates.

Tim Buckley: You're investing at higher rates.

Bill McNabb: And this goes back to your earlier question. So if I'm somebody who, like in that situation, I'm in an intermediate-term bond fund with a five-year duration, if I think I might have a really big cash need in the next 12, 18, 24 months, and I'm worried about rising rates, well, that's one of those situations where maybe you should change what you're doing and you should go into something that's going to be lower-returning but also shorter-duration.

But if I'm a retiree and I'm hoping I'm going to be alive 10 years from now and 15 years from now and 20 years from now, actually, that rise in rates that Tim described would actually benefit me, as long as I don't have to tap my principal. That's a really powerful thing.

Rebecca Katz: Many retirees are actually looking forward to some higher interest rates, higher income on their portfolios.

All right, going back to Trump and future potential changes, we have a question about the infrastructure package. So Kathleen says if there is a trillion-dollar infrastructure package approved and implemented, how will that affect the bond market? Speaking of bonds, you mentioned it might be good for stock markets, but how do these things impact the bond markets, if at all?

Tim Buckley: I'll talk about the different effects that you could see. First, it will have an inflationary effect. If you think about— And when I say the bond market, let's separate out short-term versus long-term. Short-term rates are going to be much more determined by the fed funds rate. Long-term will take into consideration inflation expectations and also the level of debt in the country. A big infrastructure package— We're very close to full employment now. If you have a big infrastructure package out there, over the short run that could be somewhat inflationary. Because you're now going and recruiting workers that are already employed somewhere else, you have to pay them more, and wages will go up. And if they go up over here, then someone wants them back, they start competing for labor and wages go up. Will wages go up without productivity going up? You just really kind of get inflation of you're just hiking up prices. Should get some inflation. So that's the one side of it, which is in the bond market would expect a little bit more inflation.

Hopefully, there's a positive side to it, which is you're going to get growth out of it. And in the equity markets, if you're going to see that growth, the equity markets hopefully would rally from that growth. So you have to think about both markets together.

But the effects on the debt side of things that if you're taking out a trillion-dollar package, and let's say you have to finance that and you're doing that through more debt, the traditional math would say, "You take out more debt, you're going to pay more on it. You're a worse credit. No one knows where the limit is where you finally hit it and everyone says, "No, you have to pay me more." If you're going to actually issue a bond and you have a Treasury bond and I'm going to buy that, I'm going to demand a higher yield because you're a worse credit.

And the U.S. is an incredible credit that we're able to issue a huge amount of paper at a very low rate, but we can't count on that forever. And so but we can't tell you what the tipping point is because if you hit that tipping point, rates would go up because of that as well.

Rebecca Katz: Great. That's a very good answer. Why don't we switch gears a little bit and jump to a couple of Vanguard-specific questions. We have a question from Mike in Chadds Ford, Pennsylvania, who says, "The expenses on the ETF I owned recently dropped. So thanks for that. But I'm not sure that the 20 bucks that's going to save me on my $10,000 investment is getting me to retirement much earlier. So how low can Vanguard go?" Part of our culture, driving costs lower?

Bill McNabb: You know, part of our culture is to continue to, as we see the benefits of economies of scale, we try to pass those on to the investors in the form of lower cost. Obviously, the lower you get, and some of our ETFs are extremely low at this point, it gets harder to do that. So are we done? No. But are we going to have as big drops in the expense ratio as we did three years ago, five years ago? Certainly not.

I would say in terms of getting ready for retirement, changing savings rate is probably going to have a bigger impact than anything we're going to be able to do further on the expense ratio.

Rebecca Katz: What do you mean by that?

Bill McNabb: Well, I think, you know, we will keep reducing expense ratios as we can, but if we save him only $20 by doing that, he's going to get closer to retirement by changing his savings rate by a percent or 2% of his total compensation to set aside for retirement. That's going to make a much bigger difference.

Rebecca Katz: Yes. You've talked a lot about saving more being something, maybe one of those New Year's resolutions we should all have.

Tim Buckley: Yes. I'm going to put in a little plug for kind of the structure of Vanguard and as an owner, he should want that $20. And as an owner, as our clients are owners, that means when the three of us come into work every day, we're driven to make sure they get the best returns, the best service at the lowest possible cost. And that's a real differentiator.

And so when we have banner years, when we make great investments in the business, we grow faster than we expect, we have more scale, we get to pass that savings back to our clients, and we do that. We can't issue, like a normal company, a dividend or buy back stock or give it to a private family. We actually give it back to people in the form of a lower expense ratio.

Rebecca Katz: Well, I was going to say, on someone who had $100,000 or a million dollars with us, that's not $20 and it's every year, so it can really add up over time.

Tim Buckley: Yes, it compounds.

Rebecca Katz: All right, that was a little bit self-serving, but thank you for the question. Our next question is from Daniel, who says, "I have emergency money in a savings account earning nothing. Would you recommend that I move to a bond ETF or a mutual fund instead?" So I think this comes back to the issue of what is it for? How would you answer Daniel?

Bill McNabb: You know, if it's emergency money, you need to keep it in a highly liquid vehicle that is going to maintain principal or come close to maintaining principal. So either in a money market fund or a very ultra-short or short-term bond fund is going to be the best solution for—

Rebecca Katz: Even with such low rates on those funds?

Bill McNabb: Even with such low rates.

Rebecca Katz: That's a good point. Our next question goes back to something you said earlier, Tim. This is from Patrick in North Carolina, and Patrick says, "With U.S. economic growth projected to remain below historical averages around a disappointing 2%, why is the Fed raising the federal funds rate? Isn't that going to impede growth?" So I think there are two things in this. Is 2% below historical averages disappointing? And we have talked about expecting about 2%. And why would the Fed go ahead and raise rates? So I can give that a little bit to both of you or you want to start, Tim?

Tim Buckley: Why don't I take the first half, you take the second half. I'll take the is it disappointing, is growth subpar, below expectations? In a typical recovery, you might see maybe see a 3%, maybe a 4% growth rate, but this isn't a typical recovery. There's other things going on in our economy.

If you go back into the '90s, as we grew, a full percentage point of that growth was from leverage. So it was from consumers levering up and spending, and you had that growth, and that isn't sustainable. We haven't had that type of growth in this recovery. In fact, the consumer de-levered during this recovery. So you haven't had kind of the growth born of leverage, and that isn't lasting. So you've had this sustainable growth.

The other thing we've had was a bit of a headwind. And I don't know if you want to correct for it or not, but we've had a demographic turn. The boomers had been driving growth as they went into prime working age, but now as they go into retirement, they're coming out of the workforce and so we're seeing labor participation go down. And when you see that go down, you're going to see lower growth. So if you adjust for lack of leverage, if you adjust for changing demographics, you really get at a growth rate that is, it's acceptable. I wouldn’t call it, I forget what the client—

Rebecca Katz: Disappointing.

Tim Buckley: Disappointing. They might call it, you know, it's solid. And it's not exceptional. It's solid. We'd like to see it higher, but it's not disappointing.

Rebecca Katz: So is the Fed's action to slowly start raising rates going to potentially chip away at that?

Bill McNabb: We don't think so in a meaningful way. I think, you know, the Fed has certainly been acting very cautiously with that as a concern, but as we're getting closer and closer to, at least by some measures, full employment, I think the Fed is sending signals that it thinks it's time to raise rates. And we don't actually think— And it's going to raise rates very slowly and in very small increments, so we don't think that's going to really have a negative impact on growth.

I actually think there's a positive thing to it. Hard to quantify this, but I think the sooner we get back to a more normal rate structure, and we've been living in an abnormal rate structure for a prolonged period of time. So I think the sooner we get back to a normal rate structure, frankly, the better it's going to be for investors and for the economy as a whole.

Tim Buckley: One thing that, Bill, the other thing we talk about too is if the Fed's raising rates, that should be seen by everyone as a good sign.

Rebecca Katz: It's true.

Tim Buckley: It means the economy is doing well. And the markets, fortunately, have seen it that way.

Rebecca Katz: Well, so, Theodore in California asks, "Will the Fed rates have different impacts on the long- and the short-term bond markets?" You, I think, mentioned they mostly impact the short-term bond markets.

Tim Buckley: I would say the impact is different. We call it flattening the yield curve. So you can expect if you have a steep yield curve, flattening is simply that the long end goes up less than the short end does. So it just flattens out. And that is because the short end is tied exactly to what the Fed does with the federal funds rate. The long end is inflation-based, but also it has to consider the macro or the global environment.

Rebecca Katz: I see.

Tim Buckley: And, remember, we may have rising rates here, but in Europe they still have negative rates. And so if you're an investor and you see rising rates over here, a lot of money can come over and push down rates in the U.S. And then we talk about global inflation. There might be some inflationary pressures here, but there's a lot of excess capacity sitting over in Europe. China's slowing down. There's excess capacity in commodities, in industry. So it's hard to imagine that the long end of the yield curve really jumping very high.

Rebecca Katz: Okay, good. We have a couple questions just coming in, so I'm going to shift to those. Again, another Vanguard question. This is from Field, who says, "We hear a lot about people going to index funds rather than active funds or active management. What are your thoughts and recommendations? And we have both here, although many people only think about us as an indexer; so what is going on in this space and how do we think about it?

Bill McNabb: Yes, so broadly, I think, what the question is really getting at is what I would describe as what's been a secular change in the marketplace, which is there's beyond just Vanguard, much more attention being paid to high-cost versus low-cost investing and there's much more embracing that cost actually does matter in the investment equation. We've been sort of a lone voice on this for a very long period of time. You're now seeing everybody talk about it, and that's a good thing. It's good for all investors.

Indexing is certainly the purest form of low-cost investing, in a sense, because it is where you get the absolute lowest price and we have seen a pretty big shift, and if you look at mutual funds as one part of the equity market. But in the last 15 years this share of money that's gone into indexing has gone from, you know, about 5% to almost 30%, and that's a huge change.

Rebecca Katz: But still not the majority of the market, right?

Bill McNabb: Not the majority of the market. This is for stock funds, by the way, too. Bond funds it's been much slower embracing of indexing there. Again, we do a lot of it, but it's a smaller percentage. So there's still a long ways for this trend to play out, but it is one of the most significant changes I've seen certainly in my 30-year career.

And, again, many long-term Vanguard investors know that we created the first index mutual fund in 1976. Mr. Bogle brought it out and for the first 15 years or so there really wasn't a lot of enthusiasm by anybody around it, except here, and it grew very slowly. And then in the mid-'90s it began to really pick up more attention. But as the case for indexing became clearer and clearer that it was a great way for investors to get broad exposure and highly diversified low-cost investment vehicles, it's really changed the way people invest.

Rebecca Katz: We have a question from Sean in Wisconsin that is there any concern about too many people investing in index funds or is indexing becoming too big? And does that really create problems if we believe in an efficient market theory?

Bill McNabb: Yes, so, you know, Sean's question actually was probably maybe one of the catalysts. There's been a lot of articles on this which we would describe in a lot of different terms.

Rebecca Katz: You're not allowed to use those; it's a family show.

Bill McNabb: Like the simplest one I can say is most of the arguments are inane and completely unsubstantiated from a data standpoint.

When you think of indexing today, so broaden it beyond mutual funds and look at the whole U.S. market, it's 15% of the U.S. market, it's less than 5% of the global market. Trading volumes are even lower because index funds don't typically trade a lot. And so what you're talking about in terms of price discovery and efficiency in the markets and so forth is still being driven by active management. We have a very long way to go in terms of indexing as a percentage of the market before we should even be having these discussions.

Rebecca Katz: Anything to add?

Tim Buckley: Oh, we could get real excited about this one. I don't think you want me going on for half an hour on it, though.

Rebecca Katz: That's great. All right, well, why don't we continue on some Vanguard fund questions. We have a question from Susan talking about bonds and potential for inflation, things like that, "What role do TIPS play in an individual portfolio? Does it depend on your age or objectives? And, also, thanks for the webcast and for providing such wonderful options for investors." So maybe talk about TIPS a little bit in case people aren't familiar with what they are and—

Tim Buckley: Susan, thank you for the compliment. So if you think about inflation-protected securities, a fixed income security that really is good and especially a short-term one for sudden shock, sudden inflation shocks, most investors, you think about most investors in accumulation. So a 40-year-old probably doesn't need to think about them. Equities are actually a pretty good inflation hedge. When you own equities, like, sure, inflation comes along; eventually companies are able to pass along inflation to their customers. They can actually just raise the price of whatever they sell and pass it along to their customers and it comes out in your earnings and everyone is, basically you have an inflation hedge built into your equities.

For a retiree, you probably hold less equities. You don't want to stomach that volatility. You also have a shorter time period perhaps. TIPS can play a nice role to insulate you against sudden shocks where you will get paid kind of the interest rate plus whatever that inflation is. So you're going to get a nice— You'll insulate at least part of your portfolio against sudden inflation shock. So that's how to think about them.

If you're a retiree, we're happy to talk to you about what role they could play in your portfolio, how much you should hold. But for an accumulator who's in their 30s and 40s, like, I wouldn't worry about them, but a retiree, it could play a certain role.

Rebecca Katz: Okay, great. Our next question, well, you know, we talked about inflation shocks in terms of TIPS, but do you expect a big increase in inflation in the coming years?

Tim Buckley: I don't know, Bill, I think maybe we get a short-term blip; nothing much above 2%, but it's not sustained. I mean we've talked about already kind of there's just so much excess capacity in the global economy.

Bill McNabb: It's hard to see where it comes from, Rebecca, and, again, there could be short-term blips, but it's interesting six months ago everybody was worried about deflation.

Rebecca Katz: True.

Tim Buckley: A lot of those elements are still there globally.

Bill McNabb: Right.

Rebecca Katz: Deflation?

Tim Buckley: Yes.

Rebecca Katz: Well, let's talk about that. So we were always concerned about deflation because it means prices will drop, and then people stop spending because they're waiting for prices to drop even more and wages drop.

Tim Buckley: So deflation, right, just the price of commodities, if you think about the price of commodities, commodities rallied this year. You had a little bit OPEC agreement. Do you think OPEC is going to hold together? That's the ultimate prisoner's dilemma with countries that are struggling. So maybe it does. Maybe the price of oil, you know, will be volatile. It's come up. More cheap production can come back on. It can be very evolved. Geopolitical events could push it up, supply events can bring it back down. You take regular commodities, the copper and the such, the raw materials that go into everything we produce, China has been a huge consumer of those. A lot of those commodities stabilized because China had a stimulus package. But that doesn't last forever.

So as China continues to move towards a more modern economy, less kind of industrialized, less building infrastructure, that demand for commodities will come down and there's still plenty of supply there. That's deflationary that the price of commodities, while it's stabilized, could still come down significantly that's deflationary to an economy.

Simply, the appreciation of the dollar has gone up. If you look in the U.S., the dollar's gone up which means all your imports are cheaper.

Rebecca Katz: Most people would think this is a good thing.

Tim Buckley: Yes.

Rebecca Katz: I, as a consumer, would love lower prices.

Tim Buckley: It's bad if you're exporting. So it's great for the consumer, and that's a big part of our economy. But if you're an exporter, you're trying to sell something overseas, well, now it's more expensive to everyone outside the U.S. So you'll hear a lot of people, currency wars where people are trying to depreciate their currency, they want a cheaper currency to sell to you.

But here we often like that people would, "Hey, if a strong dollar means everything I'm going down the street and buying, we have a Target next door, everything at Target is going to be cheaper with a stronger dollar." So the consumer and the manufacturer may have different views on that.

Rebecca Katz: One thing that maybe potentially could impact inflation, this is a question from Elizabeth, is what's been in the news a lot lately. She wants to know, "How would the potential U.S. cancellation of participation in free trade agreements, like NAFTA or TPP, potentially impact the U.S. equity markets?" So might that cause inflation?

Bill McNabb: Well, it could cause a lot of consternation. You know, I think this is one of the big, obviously, this is one of the big topics that's out there and people are wrestling around with it. Some of the early indications were the administration favors more bilateral or unilateral relationships as opposed to these multilateral big trade agreements; they're easier to enforce and so forth. How that all plays out I think remains to be seen.

And I think, again, there is certainly lots of specific instances where there are challenges to these broad trade agreements, and we see them manifest themselves in different ways. But, broadly, we think trade's actually necessary for global growth. And if you look at other times in history when trade has been reduced through top-down policy issues or the like, it's usually been a very bad thing for the economy for overall growth, and it's often been the catalyst for very, very deep recessionary and even, obviously, the Great Depression is the best example of it.

So I think that's the concern, if you will, that's out there. I think it's way too soon to make a judgment as to exactly how those policies are going to actually play out.

Tim Buckley: If the policies get to the point where there's retaliation, it's tit for tat and it goes back and forth, you get into a trade war, you got S&P 500 companies, 30% of the revenue comes from overseas, that can't be good for the market. Supply chains are global and if they get disrupted, that can't be good for the market. So we have to tread lightly and be very careful as we think about these agreements because supply chains and revenues are very intertwined and you could end up doing damage you didn't expect to do. So hopefully wise minds will prevail here.

Rebecca Katz: I was just going to say that. So one other big issue that's out there, Peter asks—a little bit of a different subject, but also something looming—"What is the likelihood that state and national pensions could be sustained if projected returns overall are lower?" And you might want to just give a little background on this topic.

Bill McNabb: Yes, so many state and municipal pensions, so-called public pensions, are defined benefit plans by structure and they rely upon a certain assumed earnings rate in terms of their ability, if you will, to pay retirees out. And if you look at what many of the assumptions are in these plans today, they're at return levels that are higher than many of us think are going to be possible over the next decade.

And what that tends to suggest is those plans are going to need to be funded at a greater level, and funding comes from taxes primarily. So that would mean that many states and municipalities will be faced with challenges how to raise taxes, how to raise money to make further contributions to these pension plans. And I think that's the issue that really has a lot of people who are participants in these plans very nervous. And, frankly, it's a really very legitimate issue and it's a great question because there are no easy answers to it.

Again, there's been some headlines. A couple of the largest pension funds out there are actually reducing their assumed rates of return and they've been very public about that and it changes what the liability structure is. And they've got to figure out how to fund that.

Rebecca Katz: Okay. We have very little time left and so many great questions left so I'm going to just jump ahead to a few more. Tim, a second ago when we were talking about TIPS, you said, "You can call Vanguard and we can help you figure out if TIPS makes sense in your portfolio." And we actually had a question from Chad in Delaware, who said, "Well how can I find an investment advisor and be assured that he or she will have my best interests at heart?"

So you call and we help you. Part of that is we have investment advisors available. But just generally how do you think about finding investment advisors?

Bill McNabb: You know, I think there's a few fundamental questions you want to ask if you're talking to potential investment advisors. One very basic question is how do you get compensated? And our general advice is an advisor who is compensated based on transactions or commissions, if you will, generally or often puts that advisor in conflict, if you will, because more transactions is going to be better from a revenue standpoint for that advisor and not so good for the client. So you are typically looking for some sort of flat fee or fee base, perhaps, as a percentage of assets, but a reasonable fee base.

The second thing is, you know, what kind of qualifications do you have? So is the advisor a Certified Financial Planner? That's a great designation, very rigorous, and there's some real standards around that. Or if not a Certified Financial Planner, perhaps they're a Chartered Financial Analyst, a CFA, a very high, rigorous, demanding designation, and there are a number of advisors out there who have that designation. That's usually a good sign.

All of this leads to the idea that you want somebody who's acting fiduciarily on your behalf. And what that simply means is acting in your best interest and avoiding all potential conflicts of interest. And so I think if you could ask those kinds of questions, it's very helpful in terms of finding somebody who might be able to help you.

Rebecca Katz: Okay, great. And if people are interested in what Vanguard offers in terms of advice, we have that great green widget and you can click on the green widget and there are some resources and information in there about our advice services. But good tips.

Another Vanguard question, kind of related to calling us, Jessie in Pennsylvania says, "I appreciate Vanguard's low costs. That's a mantra I learned from Vanguard; however, when I consider the value of time I spend holding for a knowledgeable Vanguard representative, I question whether Vanguard's costs might be too low. Do you anticipate improving the ratio of client service representatives to clients in 2017?" So for some contacts, we've had some long phone lines recently. Can you talk a little bit about that?

Bill McNabb: Yes, so this has been, again, a great question and one of the first things I would say is we don't trade off cost versus service. We're always going to want to provide the highest level and the highest quality service possible.

You know, the last several months what we've seen is really unprecedented phone volumes.

Tim Buckley: Unprecedented cash flows.

Bill McNabb: Well, let me get to that. So, you know, the phone calls and most of our clients, by the way, deal with us online. So, last year we did 150 million logons and 90-plus percent of all transactions were done online, and that's— Were a great number of people. But even with that great online presence, we took 10 million phone calls and many of those phone calls are complicated in nature and so forth.

And as Tim was alluding to, one of the drivers for sort of an uptick in phone volume, really beyond what we had planned for, was just our success in the marketplace. Vanguard took in more than $300 billion of net new investments last year, which is a very humbling, extraordinary number. We're incredibly grateful and very humbled by it.

Tim Buckley: It's a lot of retirements and educations to take care of.

Bill McNabb: And it's a lot of responsibility. And that actually caused spikes.

The other thing that certainly went on that I think has been evident in some of the questions is a lot of volatility introduced by exogenous factors. Brexit came and was kind of a surprise. I think the nature of the U.S. election was quite different than many people anticipated, so we saw real rises there.

Tim Buckley: Certainly no one expected the market to take off afterwards.

Bill McNabb: Yes. If you may recall, at the end of February, there were a lot of like, should we sell everything because the markets were down 10%? Is this the beginning of a long bear market? So, obviously, that didn't play out. So with all of that what are we doing?

So we're hiring very aggressively. We have plans to add nearly 1,700 new crew members. That's on a base of 15,000 globally. And most of these crew members are going to start by answering phones, and a number of them are already here. So we've been working really hard at this issue. But we know over the next couple of months we're going to, it's all hands on deck, and it's make sure we get to answer the calls in as complete, thorough, and timely a manner as possible.

Rebecca Katz: So if our viewers have young college students that are just graduating and they send their resumes our way, Arizona, North Carolina, and Pennsylvania.

Bill McNabb: We're always looking for great people. Always looking for great people.

Rebecca Katz: So, Tim, I want to throw one last question your way. You know, we talked a lot about investment costs and, obviously, that's really, really important to Vanguard, but you frequently are out there talking to other things that are really critical when you think about investing and cost is not the first one. So maybe just as a recap as we think about 2017 and the key things we should be thinking about, what would you say those are in terms of thinking about your investment portfolios?

Tim Buckley: The personal portfolio rather than the funds.

Rebecca Katz: Yes.

Tim Buckley: Cost is one piece of it. You've heard us say, Bill, I don't know, they could put a counter on us for asset allocation, asset allocation, like stick to your plan, stick to your plan. So having that plan, starting off with what is your plan, it involves your asset allocation, and sticking to it. Having discipline. Ignoring the noise. Like you turn on the TV and you hear, "Oh the markets are down. The markets are up. You've got to get in." Ignore that. Stick with your plan, have discipline. We know you destroy value when you chase return. It was studied time and time again. We're not saying, "Well you—" No, we would all destroy value if we were to chase return. No one's that smart.

So have your asset allocation, have discipline to stick to it, rebalance to that asset allocation and think about taxes. So many people ignore taxes. Whether taxes are going down, staying the same, going up, they are going to consume a big part of return if you don't pay attention to them. And that means what do you have in your 401(k) and your IRA? Those should be your least tax-efficient investments. Maybe they're your bond funds, your taxable bond funds. And keep the more tax-efficient stuff outside of your IRA or outside of your 401(k). So there are rules about location and how you draw things down, but you want to be tax-efficient as well.

Cost is a big component, but—

Rebecca Katz: Taxes are a cost.

Tim Buckley: Taxes are a cost. So we tell people, "Stay diversified, stick to your plan, rebalance to it, keep costs low, think about taxes."

Rebecca Katz: Okay, great. So, Bill, we always end the annual webcast with a few words from you to our clients. I think we've just heard our New Year's resolutions from Tim so I'll let you have the final words.

Bill McNabb: Yes. Well, you know, Tim's wisdom on what investors should do I think is the best reminder for everyone. But, look, on behalf of Vanguard, I know I speak for my colleagues, but I speak for 15,000 very dedicated crew members that we're incredibly grateful and humbled by the responsibility that so many investors have placed in us. And our job is to make sure that we come in each and every day and try to live up to that responsibility. And I can assure you that's what gets us all up in the morning, it's what makes us all excited.

So on behalf of Vanguard, I want to thank all of our clients for just the confidence that you've placed in us and give you our collective word we're going to continue to do the best we can to live up to those expectations.

Thanks, everybody, and Happy New Year! And I hope everyone has a great night.

Rebecca Katz: And thanks to both of you for spending the hour with us. This is a terrific webcast. As all of you know, we will send out a replay of this webcast, as well as highlights in just a few weeks with a transcript. And then if you have two more seconds to hang on there, there's a little red icon; we'd love you to click on it and tell us what you thought of tonight's broadcast.

So from all of us here in Valley Forge to all of you at home, thank you so much for tuning in. And have a very happy and healthy new year.

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