Greg Davis on Vanguard Portfolio Management | Masters in Business

Greg Davis, welcome to Bloomberg. Thanks Barry, great to be here with you.

It's a long story. Originally I went to school for engineering, got to school, realized that I wasn't very good at mechanical drawing, which is a big part of aerospace engineering curriculum, so I started to look at other opportunities, primarily in the business space. So I started examining opportunities in finance, real estate, and insurance. Penn State was one of the few schools that actually had an insurance major, and with the goal of becoming gainfully employed when I graduated college, I thought having a somewhat unique background would be helpful. It worked out, and I had multiple job offers coming out of school from a number of different insurance companies, and I had an opportunity to be an underwriter for a few years before I decided to go back to school to get the MBA.

I ended up going through the Wharton program. I did an internship in the summer at Citibank Securities in fixed income sales and trading. I got a couple different job offers across the street, but the reason I went to Merrill is because they had this unique global debt rotation program that allowed you to rotate through a couple different business units in fixed income sales and trading, and I knew I wanted to do trading.

But that experience got cut short because right around that time when my class started, it was the tail end of the Asian financial crisis, the Russian ruble devaluation, and then you had Long-Term Capital Management blowing up. So there were a lot of changes happening across the street in terms of layoffs, and our program got cut short. I ended up getting placed in a non-trading role, and decided to look at other opportunities outside, and came across this great opportunity to pursue trading at Vanguard, 24 years ago.

It was interesting because I was pretty keen on staying in New York. I had a number of relationships that I built up and had another job lined up in New York City. But one of my best friends that I grew up with actually worked in the HR department at Vanguard, and she was like, 'You should come down and talk to some people at Vanguard.' At first I kind of blew it off, but she was pretty persistent. So I came down, met with our head of the Portfolio Review Department, which oversees our external managers, met with our head of brokerage, and then met with the head of bond indexing, who was Ken Volpert at the time. Me and him had an instant connection, and so Ken was the main reason I came to Vanguard. Vanguard had a great reputation already, we were much smaller at the time, but Ken had a track record of bringing new people onto his team, developing them, and seeing them move into bigger jobs over time. As somebody who was relatively new to the industry, that's the kind of mentor and boss I was looking for. Ken ended up being one of the best bosses I've ever had in my career.

No. So my family and I moved to Melbourne, Australia, where our office is. It was a fabulous experience both professionally and personally. Just having an opportunity to work in a different country, embracing the Australian culture, but being part of the Asia Pacific region because at the time we had an office in Hong Kong as well where we were starting up our ETF business. It was a tremendous experience because I had started off in bond trading, worked my way into portfolio management and running the bond indexing team for a number of years, and then I got asked to take this responsibility which was much broader. So I was a mile deep on a subject matter of bond indexing, but now I had the opportunity to lead an equity indexing group, the entire fixed income team, our investment strategy team that does research for our clients around portfolio construction, those types of things. But the other big part of it was having an opportunity to be on the Australian executive team that actually ran the business. So from a broadening standpoint, I'm an investment guy, but that was an opportunity to actually learn about the business, how Vanguard Australia operates in the ecosystem, how we're trying to market our products and services, how we're engaging with regulators, the media, the whole nine yards, and then also being part of the board of directors down there. So from a broadening standpoint, that experience was unbelievable. I valued every minute that I was down there. Unfortunately or fortunately, depending on how you look at it, the three to four year assignment ended up being 13 months, but I got a great opportunity to come back to run the fixed income group as you had mentioned. But the time in Australia was fabulous for both myself, my wife, and the kids.

That's very, very true. But it's also one of those things that you don't necessarily appreciate until you've been doing a certain job for a while. So if you would have said to me when I first came out of grad school, 'Hey, I want you to go to the business side,' I would have said, 'No thank you, I really want to do trading and portfolio management.' But you get to a point in your career where you feel like you've learned a lot, you've developed a team, and you're looking for new challenges and a chance to stretch yourself and grow and learn, and that's exactly what that opportunity provided.

Well, it's a lot. There's a tremendous amount of meetings. The way I would describe it, Barry, it's a mix: it's client related, it's media like we're doing today, it's also being part of the senior team that runs Vanguard, the business of Vanguard. Some from a client strategy marketing standpoint, and then overseeing the investment team. So a variety of risk meetings, a variety of economic meetings. Any given day could be slightly different, but it typically will capture those categories over time. There's always plenty of stuff going on in the marketplace and in the business that keeps us very busy.

Yeah, you're absolutely right, Barry. It's been a lot in terms of the changing perception in the marketplace of how investors invest. You think back 30 years, there were so many people who were focused on individual security selection, picking individual stocks. The reality is that we know that's very difficult to do and outperform the broader market. So there's been a big push for folks to get the appropriate level of asset allocation in a highly diversified, low-cost way. The ETF wrapper allowed people to get that exposure inexpensively, holding it in a brokerage account. So it provided a nice tailwind to folks in the indexing space who provided those products, and Vanguard is one of the big beneficiaries of that migration away from individual stock selection to broad-based index exposure, to say the least.

Yeah, it's a great question. One of the things we try to focus on is, as part of our interview process, always trying to assess and engage the willingness and interest for folks to develop the leadership competencies in addition to the technical competencies. When we think about our investment professionals, clearly they have to be technically sharp, they have to learn those skills to do their job day to day. But if they also want to be the head of a trading desk and lead a major function within our group or within broader Vanguard, they also have to be really good at identifying talent, developing talent, maintaining really strong relationships, being strategic thinkers, and things of that nature. These are the types of things that we have a number of programs that we run to help us assess how people are progressing through that leadership journey. We help develop people on that leadership journey along the way, but the assessment process also allows us to figure out where people might have gaps and need an opportunity to go back and do a bit of a refresher. We've been very actively involved in that whole process for our investment professionals, and it's paid off in spades. It helps us make sure we're recruiting the right people, it helps us in terms of retaining folks because when you work for a great boss, you're motivated to stay at that firm. It's difficult to make a strong connection with a boss at times, and to the extent that Vanguard has great leaders in the seats and we feel like we have some of the coolest jobs available to people, you couple that with great leadership, it's a win-win formula for long-term success for our organization.

We are very heavily involved. In our group specifically, we have the Investment Management Development Program where every year we have a cadre of summer interns as well as full-time folks who just finished their undergraduate studies who come to us in a rotational program that gives them exposure to equities, various points in fixed income, and risk, and our Portfolio Review Department is a nice entry point for people to explore and see what they really want to do. We just had a cadre that launched to their final placement earlier this week, and there were seven individuals that spanned the range from risk to high yield trading to investment grade research. It's a nice talent pipeline. The great thing is the talent that we're seeing today is so much greater than the talent that we were able to attract 20 years ago. The level of awareness, understanding of markets, the technical skills from an IT and data science standpoint that these folks are bringing to the table today is pretty amazing. That's really the pipeline for us. Then we will supplement that with experienced senior hires if there's turnover and we don't have somebody on the bench ready to move into a bigger seat, or if we're trying to build new capabilities like we've done in the past.

It really starts with the people. Making sure that we have unbelievably talented professionals who are truly dedicated to managing these index funds on a day-to-day basis. The way we think about it, our PMs also serve as traders, so they're working very closely day by day making sure that the Total Stock Market Index Fund and all of our other equity index funds are minimizing tracking error, also trying to make sure that we're minimizing transaction costs as we're transacting in the marketplace, also being cognizant of the tax implications of trading activity, and then also looking to add value at the margin through opportunistic ideas, through rebalancing, corporate actions, new issues, and things of that nature to try to eat into the expense ratio at the margin, but again in a highly risk-controlled way. The great thing is we have a team of folks who've been doing this for decades, and they're unmatched in the industry because they're dedicated to doing indexing. A lot of firms, you find folks start with indexing and move on to something else. At Vanguard, this is a career destination for a lot of these folks, and they love every minute of what they do.

For Total Stock Market, the Total Stock Market Index Fund is a CRSP fund that is run by the University of Chicago. They create the benchmark. We help them in terms of identifying and creating the parameters around how that index should be constructed. The biggest things are primarily when there are corporate actions, there are IPOs. Those are the things that typically drive changes because again, this represents the total market, so you have small cap, mid cap, large cap, you have growth and value and blend in there. The turnover is primarily driven by corporate actions and IPOs. The team spends a lot of time just making sure they handle those really well to minimize costs, make sure that tracking error remains relatively tight. The other thing the team does, and we have a securities lending team that also spends a lot of time making sure that we're getting value for the securities that are in demand, and that those earnings from the securities lending revenue, net of the cost to run that group, goes right back to the fund. So our shareholders benefit whenever there's a lot of demand for certain securities that we own. That's another contributing factor to performance in those funds as well.

We tend not to create the index. That's an outsourced process. It's really a function of whether we have gaps in our lineup. We get input from the various business divisions, whether it's our Retail Group, our Institutional Group, our Financial Advisor Services Group. Are there gaps where we feel like we don't have a relevant offering that's needed by our clients? Then we do research. The Portfolio Review Department does the research to figure out who would be the best and most well-equipped index provider for that type of mandate. Then our team works very closely with them in terms of the due diligence process and making sure that index is constructed in a way that we're comfortable and the right levels of controls are in place. Once that's set up, the team is ready to go to start managing against that newly defined index.

Yeah, these need to have enduring long-term investment merit. That's one of the key defining principles before we launch a fund: is there real value long term for this type of investment strategy? You're absolutely right. Vanguard is not the type of firm that will launch thematic products focused on AI, water, whatever. That's just not what Vanguard does. We're looking for long-term enduring investment solutions and products that will provide our investors with long-term opportunity that will serve them really well.

The main thing, Barry, it's a great question. The main thing goes back to what's the enduring philosophy, what are we trying to accomplish for our clients. At the end of the day, they come to us to try to get long-term exposure to a segment of the market. We want to do that in the best possible way, making sure they're getting the market return minus the expense ratio, which again we will try to offset with securities lending revenue and thoughtful rebalancing strategies. But at the end of the day, it really boils down to broad-based exposure in a low-cost, diversified way for our clients, which we think will ultimately serve them really well as they're constructing their portfolios.

A big part of it is really around when there are more complicated corporate actions happening that entail a level of risk. There are conversations that happen with our Risk Management Department to make sure we're comfortable in terms of what kind of exposure that creates in the fund.

Yeah, exactly. So when there's major turnover like that, you always have the option: can you do it exactly on the time that it enters the benchmark? Do you need to do some of it ahead of time? Do you need to do some of it afterwards to try to smooth out the process? That's a risk decision that you have to make: how much liquidity is going to be there when there's a major activity? Is the pricing more attractive right away versus waiting until it starts trading in the secondary market? Those are the considerations and the conversations that we have with our risk team and our senior investment professionals on the equity side.

On the bond side, we have both. We do bond indexing in a highly diversified way, cutting across segments including treasuries, governments, corporates, mortgages, and things of that nature. Global portfolios that give you tremendous diversification, hedged back to the US dollar, which in a highly diversified way is a great way to get bond exposure. To your point, in terms of active fixed income, we do have a very large active fixed income team that has been very successful in being able to add value over the long term. When you look at some of the results, a big chunk of that comes from our credit research capabilities within the team, both investment grade, emerging market, as well as high yield. 92% of our active bond funds have done better than the average fund over the Morningstar averages over a five-year period, and 87% of our active fixed income funds have outperformed their benchmarks on a three-year basis. If you look at a five-year time horizon, it's 77%. So our active team has been successful outperforming the benchmarks. A big part of it is having the credit team that can do the due diligence because credit is where we think we can add the most value by credit research. We see that on the municipal bond side as well, where we have a very active municipal bond franchise, and the credit research allows that team to consistently add value relative to their benchmarks, providing better outcomes for our clients long term.

Yeah, in fixed income, because it tends to be a defensive asset class, what you want to do is try to avoid the losers. What's the upside when you invest in a bond? You get your money back, you get your coupon payments and your principal at maturity on time. The downside is you get zero because the company files for bankruptcy and there's no recovery value. So for a defensive asset class, we've always thought that you want to limit the amount of risk that you take in what's supposed to be balanced in the portfolio. The way we're able to accomplish that is because we have so much scale and ability to keep costs low at Vanguard. At the end of the day, our active fixed income managers don't need to take the same level of risk as some of our competitors simply because they don't have the same level of headwind. Our expense ratios are lower, so when things don't look attractively priced in the marketplace, you don't need to sit there and try to overcome a heavy expense ratio all the time. We can be patient, we can wait until the market's a bit more attractive, and when we feel we're being rewarded for risk taking, there's a little multiplier effect from the low-cost side of Vanguard.

Yeah, for our teams, our active teams' performances are valued on a three-year basis. So when we think about how those teams are evaluated, it's a three-year number. How did you perform? Because in any given quarter, any given year, you could have winners and losers in terms of strategies. But what you're trying to do is string good periods together, and over a three-year period, we feel like there's enough opportunities for teams if they're good at what they do to add value. That's what we've been able to demonstrate over time.

Well, it's a great point, Barry. But the reality is when you're running portfolios in a highly risk-controlled way, you're trying to manage the downside. So when you have three years, you have three years again because you're trying to make sure people have an opportunity for their strategies to play out over time. But you're also making sure that you're constraining the risk so that even if you do have a bad year, it's not going to be so bad that investors start running for the hills. We want investors to stay in these products long term because we think they provide good long-term enduring value for our clients.

It's interesting. There are certain segments of markets that did quite well, certain segments of the business. But you also have a period of time when there's repricing that happens in the fixed income space like we saw, and it was pretty rapid last year. You had 500 basis points of rate increases. When you saw the US Aggregate Bond Index down 13% last year, for folks who are investing for retirement and in their 529 plans, they're not concerned about it. But when you translate that to folks who might have a heavy municipal bond portfolio, those folks who are in retirement, they don't like principal losses. They like tax-free income, but they also don't like principal losses. So when you have a big backup like that, you tend to see outflows in that segment of the market more than you would see in the taxable market, which tends to be in our case more long-term retirement oriented. So you will see some pressure on munis in those types of interest rate environments.

It's interesting. We've heard that over and over again. It was a tough year for investors in terms of both stocks and bonds being down. Stocks were down about 20%, the US Aggregate Bond Index was down 13%. When was the last time we saw stocks and bonds down double digits? It was like 1981, somewhere in that time horizon. So it's not something that many investors have been accustomed to or have seen in their lifetimes. But the reality is, when you think about the components in terms of long-term investing, the bond portion of the equation provides that balance and diversification. Now again, in any one given year, you can have a 60/40 portfolio that underperforms and both sides of the equation go down. But for a long-term investor who's saving for retirement, that balancing diversification has proved and delivered really good long-term returns. If you go back to 1926, a 60/40 portfolio has returned 8.8% on average over that time horizon, which is impressive. Because it provides diversification, it reduces some of the volatility. But there will be periods of time where that type of portfolio, when we were in an environment where interest rates were held down to historically low levels, when they reprice, it's not surprising that you see losses on the bond side. But if you go back to the period before 2022, from 2019 to 2021, a 60/40 portfolio actually produced 14% returns over that time horizon, which is above the long-term average. So in the grand scheme of things, it's not surprising that there are periods of outperformance that ultimately will lead to periods of underperformance.

That's exactly.

Well, look, clearly the equity market has been on a tremendous tear so far this year, up 18%, 19% year-to-date. But the key thing is investors have to keep in mind that that's probably not sustainable long term. The importance of having a diversified portfolio is critically important. Just think about fixed income and money markets as an asset class. For a decade you weren't earning anything in a money market fund because interest rates by the Federal Reserve were pegged to zero, and you had to take on significant duration risk and credit risk just to earn a couple percentage points. Now you're in an environment where money market funds are yielding 5.25%, the U.S. Aggregate is yielding close to 5%, so 4.5% to 5%. In the grand scheme, investors are actually being rewarded for having exposure to money markets and bond funds. If people are truly concerned about a 60/40 portfolio, they should have been concerned about it for 10 years. Now is not the time when you're back to an environment where you're actually getting a real yield in the bond market.

We definitely saw a number of clients who started embracing money markets. The reality for a lot of investors is it truly is free money. When you think about what people are earning in their deposit accounts at banks, banks have historically been very slow to raise deposit rates because deposits tend to be sticky. I've had people stop me at Vanguard in the hallway and say, 'I didn't realize I was leaving this much money on the table keeping a sizeable amount at my bank. I moved it to a money market and now I'm getting a 5.25% yield.' That's amazing when some folks are still getting less than half a percent at the bank. It's shocking how much inertia there is in finance — even if you're just getting your December bonus and you'll pay Uncle Sam in April, leaving that money in a savings account for a third of the year, you're leaving a chunk of change. It's free money.

If you look at our return expectations for the global balanced portfolio, we expect over the next decade somewhere around 5.5% for a global balanced portfolio — a combination of equities, bonds, U.S. and international stocks. Our return expectations for the U.S. equity market are a bit more muted, around 5% or so. International equities, because of valuations, probably 7% to 7.5%.

If you look at what happened over the last 10 years, the S&P 500 vs the FTSE Global All Cap ex-U.S., there was a 7 percentage point difference per year — 700 basis points of outperformance by the U.S. market. Today, the S&P 500 has an earnings yield of about 5%, while the FTSE Global All Cap ex-U.S. has an earnings yield of 8.3%. Even adjusting for sector differences, there's still a big gap. Unless we expect U.S. companies to vastly outpace international earnings — and they might — a lot of good news is already priced in. When you translate the S&P 500 P/E to an implied equity risk premium using the 10-year Treasury yield, you're 200 basis points below the 10-year average.

There are a couple things, Barry. One is whether earnings growth will live up to the expectations already priced into the U.S. market. If so, that's fine, but it won't lead to multiple expansion. A big driver of U.S. outperformance over the last decade was valuation expansion. A lot of that is probably baked in and has run its course. Could it go further? Of course. But at some point people will say, 'I have alternatives — I can buy a money market fund at 5.25% and not take a lot of risk.' Based on our forecasts, U.S. equity markets are somewhat muted because valuations are stretched relative to our fair value model. Investors have alternatives: money markets, bond funds, or international stocks.

The economy can clearly keep rolling along. Over $2 trillion was saved, and about a trillion has been spent down. That safety net is declining, which should slow the economy. But the biggest concern is a continued rise in interest rates, which pressures equity valuations because equities are an ultra-long-duration asset. Higher discount rates mean lower present values. At some point that will bite, though nobody knows when. Higher rates will push valuations back toward normal. The equity risk premium is so much lower than historically that shorter-term investors might ask how much exposure they want. For long-term investors, it doesn't matter.

A lot of investors succumb to recency bias. We've been in a zero-interest-rate environment so people think that's the norm. Our team has done work on the neutral fed funds rate. The market and Fed say R-star is about 0.5% plus 2% inflation gives 2.5% long-term fed funds. Our investment strategy group estimates R-star is closer to 1.5%, which with 2% inflation gives 3.5%. Adding a normal term structure of about 100 basis points gives a 10-year fair value around 4.5%. There's risk rates go a bit higher. The 10-year isn't far from 4.5% — that's not unthinkable by year end.

We try not to play the short-term forecasting game. Forecasting is hard, especially short-term. The Vanguard Capital Markets Model produces probabilistic outcomes from a large simulation, not point forecasts. What we tell clients: you can't control market volatility, but you can control diversification, costs, and investing in a low-cost, diversified way. That gives the best chance for long-term success, as opposed to reacting to daily news.

The data show it's not fruitful for long-term investors. Look at meme stocks — things pop on headlines, people get caught up in easy money, but that's speculation, not investing. Speculating is very risky. If you want to speculate, do it with a small portion of your portfolio. The majority should be invested in long-term, enduring strategies.

I started my career in finance in 1998, so I'm familiar with the dot-com era. Anything with .com ran to the moon until one day you realize companies have to be real businesses that make money. In a speculative fever, people forget that cash flow and earnings matter. It's a lesson to learn early, with less money.

You just have to look at history. Some people learn the hard way, but eventually most find religion and focus on constructing a durable portfolio that meets retirement, college, or other needs.

That's what the market and Fed are operating on. Until they communicate a different message, that's what the market follows. It's also difficult to change strategy when you're behind your current target — if you switch from 2% to 3% because you can't hit 2%, is 3% the right number? For 10 years we couldn't hit 2% on the downside. In an era of massive fiscal and monetary stimulus, does the same target make sense? It's supposed to be a long-term average. The Fed won't change it until they get back close to target, to maintain credibility.

It was a phenomenal experience. I grew up bilingual — my maternal grandmother spoke primarily German to me. When we moved to the U.S. when I was seven, my English was below average. My wife, who taught English, later told me it was my second language. I loved living in Germany and later visiting family.

I watched 'The Night Agent' — it ended but will return in 2024. My kids also enjoy 'All American' and 'Bel-Air.'

Daryl Thomas got me my first internship at Citibank. Carmine Orsilio advised me to move from the sell side to the buy side. Ken Volpert hired me to trade treasuries and mortgages. Tim Buckley gave me opportunities in Australia, leading the fixed income group, and ultimately my current role. I've only had two bosses in 24 years at Vanguard, both phenomenal.

I'm reading 'Plunder' by Brendan Ballou about private equity — my daughter wants to go into that, so I'm doing due diligence. Also 'From Here to Equality' by William Darity and Kirsten Mullen, which examines American history and missed opportunities for a more equal society.

Be a continual learner, master your craft. Career is a marathon, not a sprint. Don't compare yourself to others — run your own race. Focus on getting better every day, and you'll have a more fruitful career.

The power of compounding is a beautiful thing. I wish I'd learned that earlier, and the difference between investing and speculating. Let your investments compound over 30, 40, 50 years. Even small amounts grow into large sums if done consistently.