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Taking stock: A conversation with Vanguard CEO Bill McNabb

August 05, 2014 recently sat down with Vanguard Chairman and CEO Bill McNabb for a wide-ranging conversation on the financial markets, the economy, and the investment management business.

This is the first of a two-part interview. Read part two »

Can you give us a quick pulse check on the stock market?

Bill McNabbWe are in the midst of a very strong bull market. It is actually the fifth-longest bull market in history. From the market bottom in March 2009, U.S. stocks are up more than 235% through June 30, as measured by FTSE US All Cap Index.

This large run-up has left the U.S. stock market "expensive" by some valuation measures. As a result, our research suggests that returns for global stocks over the next ten years will be probably a bit below the historical average.

Because of the anticipated rise in interest rates, anxiety persists in the bond market. What are you hearing from investors?

For the past two years, we've been hearing dire predictions about rising rates and their effect on the bond market. And we're still waiting for those predictions to materialize.

Given the current low-rate environment, we expect bond returns to be significantly lower over the next decade than they have been historically. But bond funds can still serve an important role in a portfolio as a diversifier, and Vanguard investors continue to embrace this approach. In fact, roughly 25% of the money clients have invested with Vanguard this year has been directed to fixed income funds.

One reminder for long-term investors: There's a silver lining to rising interest rates. If your time frame is longer than the duration of the bonds you're invested in, you actually want interest rates to rise. Even though your fund's share price may fall in the near term, if you're reinvesting your returns, your fund's managers will be buying bonds that have higher yields, which in turn will boost your total returns over the long run.

What's your overall take on the U.S. economy?

I've talked a great deal in the past year about uncertainty surrounding government policy and how this "uncertainty tax" weighs on the economy.

Last spring, there was uncertainty around regulatory policy, foreign policy, monetary policy, fiscal policy, and the national debt. We are seeing some of these uncertainties dissipate, and that's a good thing. We've seen a number of indications that confidence is slowly being restored. We hope this translates into growth in business investment. Consumers appear to be feeling more at ease with the ground gained in the markets and with the U.S. housing recovery, so we might see more spending.

These are all signs of optimism, but there are still reasons to be cautious. Geopolitical tensions are on the rise, and domestically, we are watching closely how the Fed pulls back on its bond-buying stimulus program.

What are some of your concerns about the current investment environment?

One of my chief concerns is the aggressive marketing of "new" strategies for investors. For example, there has been quite a lot of buzz recently around the role of "alternatives" in a portfolio. These are investments that borrow a page from the hedge fund playbook—including high costs—and can use nontraditional approaches such as currency plays and shorting strategies. They have proven to be very expensive and have delivered middling returns.

Some of these strategies can make sense for investors with highly specialized needs, but for most investors, we say "buyer beware."

And "smart beta"?

I believe the term smart beta is still widely misunderstood. A recent survey from Russell Investments showed that three-quarters of institutional investors are considering smart beta strategies, but there seem to be wide-ranging interpretations of what these "new strategies" entail. At the end of the day, smart beta tends to be nothing more than active factor-based tilts away from a broad market-cap portfolio. And the rampant back-testing of such strategies is a concern.

We believe that market-cap weighting is synonymous with indexing. While investors may conclude that exposure to a so-called smart beta strategy is appropriate for them in the context of their broad asset allocation, I'd caution that these strategies amount to an active bet, rather than indexing, and shouldn't be considered substitutes for traditional index funds.

Indexing is reaching new heights in popularity. What's behind this growth?

Indexing's importance is growing as more and more people invest in index funds—market-cap-weighted index funds in particular. Much of this growth is due to the adoption of exchange-traded funds (ETFs) by financial advisors. In 2013, $164 billion went into market-cap-weighted ETF products, whereas only $10 billion flowed into non-market-cap-weighted index ETF products and $14 billion flowed into actively managed ETFs.

Another source of growth is in employer-sponsored retirement plans. For example, among defined contribution plans managed by Vanguard, indexed assets grew from 28% of total assets in 2004 to 47% at the end of 2013. This is great news because more investors will begin to reap the benefits of indexing —low costs, tax efficiency, and broad diversification.

There has also been movement on the regulatory front. What are the main issues that could affect Vanguard investors?

There is a big question around whether the Financial Stability Oversight Council, a federal regulatory committee created as part of the Dodd-Frank reform legislation that was enacted in 2010, will designate mutual fund companies like Vanguard as "systemically important financial institutions," or SIFIs. We believe a SIFI designation could have considerable negative effects on Vanguard and our clients, who are working hard to save for retirement and other goals. Among other things, a SIFI designation would, in our view, create a tax of sorts on designated asset managers and would ultimately be a cost burden that fund shareholders may have to bear.

We feel strongly that asset managers and mutual funds are already properly regulated by the SEC with extensive investor protections—in particular those established under the Investment Company Act of 1940. We worry that a SIFI designation could pose a conflict with the "40 Act" by restricting the ability of asset managers to act in the best interest of their shareholders.

High-frequency trading has also come under the regulatory spotlight. What is Vanguard's view?

This has been an important topic in recent months, and it's one that calls for clarity. Unfortunately, some in the media have used high-frequency trading (HFT) as shorthand for predatory practices by big investors gaming the system against small investors.

First, let's not ignore that changes in regulations and improvements in technology have resulted in better functioning markets and lower costs for investors. Indeed, there are some bad actors out there, and regulators need to deal with them.

Unfortunately, the swirl around HFT takes the focus off the real issue: market structure reform. We are actively engaged on this topic in Washington, and we believe SEC Chairwoman Mary Jo White has outlined a very sound plan to review the functioning of our markets. Our markets continue to evolve and improve, but they are not perfect. Continued refinements are necessary as we believe that publicly displayed liquidity is the foundation of transparent and efficient markets.

And what about the SEC's newly approved money market fund rules?

It's encouraging to see a solution set forth by the SEC on this issue. While some surely will find faults with various provisions, we believe the SEC took a balanced and thoughtful approach.

We also believe that a money market fund is a high-quality, low-risk investment option for investors with short-term savings goals. The majority of Vanguard's individual investors who invest in money market funds will not be affected by the new rules. On the institutional side, we will likely see a change in how institutional investors use money market funds with the shift to a floating net asset value (NAV). As we understand it, these investors have time to adapt to these changes, as the compliance date for the floating NAV and fees and gates is a few years out.

Look for Part 2 of this interview on next week.


  • All investing is subject to risk, including the possible loss of the money you invest.
  • Fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
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