Vanguard is best known for offering low-cost, passive investment strategies, so it might come as a surprise that the firm is among the largest active fund houses in the world, with almost 20% of its global assets ($1.6tn) managed actively.
Its core tenet is to slash costs for investors, with its products often being among the cheapest available. But this is much harder to achieve with active funds, which require more manpower and are therefore more expensive to run than passives.
The most talented managers might conceivably be expected to demand a premium for outperformance and the trade-off between skill and cost is not lost on Vanguard’s head of active equity product, Ryan Barksdale.
“It's seemingly a paradox to obtain top talent at a low price, but it’s one which we've been able to successfully navigate over all these years,” he said. “Some of it has to do with Vanguard’s scale and reputation.”
The Vanguard Global Equity fund, for example charges 0.48%, while the average in its peer group, the IA global sector, is 0.80%.
Below, he unravels that paradox and explains what Vanguard looks for amongst the active managers it selects.
The first consideration is Vanguard’s sheer size. Awarding larger mandates enables Vanguard to negotiate more favourable fees.
There is also a more “opportunistic” argument, as Vanguard has a history of hiring managers who are currently going through a challenging period of performance.
“In order to solve for that paradox, you have to be willing to be opportunistic and a bit of a contrarian,” Barksdale explained.
“At Vanguard, we believe it’s the drivers of performance, rather than performance itself, that can help active managers succeed over the long term.”
Approaching managers when their performance is deteriorating requires conviction that the drivers of performance are still solid. To build up that conviction, Vanguard has a manager research team of 30 people that are tasked with evaluating the best managers around.
They do that with four pillars: the firm, the people, the philosophy and the process.
“We think of those as the real drivers of outperformance over time. Performance can be noisy in the short term, so we try to stay disciplined to the framework,” he explained.
From a firm standpoint, stability is the principal requirement and the main questions the team must answer include: What do the underlying assets look like? How are they spread across a variety of mandates? What is the ownership structure of the firm and how does that drive incentives?
When it come to the people, the key aspects for Vanguard are patience, discipline and a long-term investment horizon.
“If we hire you, our hope is that we'll spend the next couple decades together, so we want to make sure that the team is organized in a way that the people as well as the decision making process are stable and enduring over time. Succession planning is key,” he explained.
One of the main data points Vanguard considers is skill versus luck. Only when the balance is in favour of the former does it make sense to pay an active manager instead of buying a passive investment.
“There are other ways to access value investing, for example, than partnering with an active manager. If value investing did well, we will dissect the performance attribution to see if a manager’s outperformance was due just to the value factor or if it came from within that,” Barksdale said.
Nonetheless, these relationships do not always work out. Typically, Vanguard makes between one and three manager changes each year, which equates to a 10% turnover rate, given that the average tenure of external manager relationships is 15 years.
Oaktree’s mandate was divided between Baillie Gifford and Pzena Investment Management, which have complementary growth and value styles, respectively.
Vanguard tries to avoid behavioural biases towards managers with whom it already invests by taking an “evergreen approach” to manager research and “applying the same exact framework to prospective managers that we do to current managers”, Barksdale said.