The transcript from this week’s, MiB: Greg Davis, CIO Vanguard, is below.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
BARRY RITHOLTZ, HOST, MASTERS IN BUSINESS: This week on the podcast, I have an extra special guest. Greg Davis, Chief Investment Officer at a little shop called the Vanguard Group, which manages $8 trillion. He’s only responsible for $7.3 trillion of it, so kind of a slacker.
I found this conversation to be absolutely a masterclass in how to think about investing risk, how to think about where your returns come from, what sort of behavioral problems lead to bad outcomes, and all of the usual things that we’ve learned over the years from the success of Vanguard.
Few people are in a position to see what’s going on in the world of investing, whether it’s institutional or retail, better than Vanguard CIO. And Greg Davis just does an amazing job. I thought this was a really fascinating conversation. I think you will also.
With no further ado, my interview with Vanguard CIO, Greg Davis.
Greg Davis, welcome to Bloomberg.
GREG DAVIS, CHIEF INVESTMENT OFFICER, VANGUARD GROUP: Thanks, Barry. Great to be here with you.
RITHOLTZ: Great to have you.
So let’s talk a little bit about your background, which is kind of interesting. Undergraduate, you get a BS in insurance from Penn State. What led to an interest in insurance?
DAVIS: It’s a long story, but 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 and primarily in the business space.
So, 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 actually getting, becoming gainfully employed when I graduated college, I thought, hey, having a somewhat unique background would be helpful.
And it worked out and 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.
RITHOLTZ: How’d you end up at Merrill Lynch in the 1990s?
DAVIS: So I ended up going through the Wharton program. I did an internship in the summer at Citibank Securities in fixed income sales and trading. 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.
RITHOLTZ: Were you at the downtown, the World …
DAVIS: World Financial Center.
RITHOLTZ: By the way, that could be the most amazing trading desk. I’ve been there a couple of times. And in the 1990s, when you walked onto the equity floor, you were just hit with a wall of sound and energy. I’ve never seen or experienced anything like that anywhere else.
DAVIS: And the fixed income floor was equally sized, just on a different floor, but also similar type environment. But it was a very interesting place to start a career after grad school. 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
RITHOLTZ: 97 or 98?
DAVIS: 98. I started in the beginning of — I started in September of ’98 and that happened in ’97. But you had the Asian financial crisis, the Russian ruble devaluation, and then you had long-term capital management blowing up.
DAVIS: So there was a lot of changes that was happening across the street in terms of layoffs happening and our program got cut short, 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.
RITHOLTZ: So let’s talk about that. And your bio explains how you were recruited to Vanguard. I thought that was a really interesting story. Tell us a little bit about what brought you to Vanguard.
DAVIS: So 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.”
And 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 bind indexing, who was Ken Volpert at the time. And 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.
And as somebody who was relatively new to the industry, that’s the kind of mentor and boss I was looking for. So, Ken ended up being one of the best bosses I’ve ever had in my career.
RITHOLTZ: We’ll talk a little bit about leadership and crew development a little later. It’s really a fascinating subject, but you eventually served as director of Vanguard Australia and Asia Pacific and CIO of the region. Tell us a little bit about that experience in the 2000s. I mean, the ’90s was its own unique animal, but the 2000s certainly weren’t boring.
DAVIS: No, so my family and I, we moved to Melbourne, Australia where our office is.
It was just 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-Pac region, because at the time we had an office in Hong Kong as well where we were starting up our ETF business.
But 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.
So I valued every minute that I was down there, and 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.
RITHOLTZ: You know, what’s really interesting is everybody tends to think of Wall Street and investing and finance in terms of the investing side. But the business side is really intriguing. There are an endless variety of business models and seeing how people operate that, it’s really an education, one that I think a lot of people coming out of school don’t think about, because you think about the sexy things. “Hey, I want to do venture capital. I want to do this, I want to do that.” The business side is really quite fascinating and somewhat overlooked.
DAVIS: That’s very, very true. But it’s also one of those things that you don’t necessarily appreciate it until you’ve been doing a certain job for a while. So if you would have said to me, you know, when I first came out of grad school and you said to me, hey, I want you to go to the business side, you know, 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, hey, 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.
RITHOLTZ: So now you eventually get, you go to fixed income and then you’re elevated to chief investment officer of all of Van group. Take us through a day in the life or a week in the life of Vanguard CIO.
DAVIS: Well, it’s a lot. I mean, there’s a tremendous amount of meetings and 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, right? So from a client strategy, marketing standpoint, and then overseeing the investment team. So a variety of risk meetings, a variety of economic meetings. So any given day could be slightly different, but it typically will capture those categories over time. And so there’s always plenty of stuff going on in the marketplace and in the business that keeps us very busy.
RITHOLTZ: And you’ve now been with Vanguard for almost 25 years.
DAVIS: It’ll be 24 in November.
RITHOLTZ: So you’re a year away from a big milestone.
That period very much encompasses Vanguard going from an admittedly successful, but not enormous entity, till I think the 2000s, especially the financial crisis, changed how people thought about managed assets, indexing, advisory versus transactional, and Vanguard, along with BlackRock, have been two of the biggest beneficiaries of this. Tell us a little bit about what you’ve experienced over the arc of those 24 years, that you were really there as the company ramped up and then went, they found a whole another gear and just exploded.
DAVIS: Yes, you’re absolutely right, Barry. I mean, it’s been a lot in terms of just the changing perception in the marketplace of how investors invest, right? And you’re right. So you think back 30 years, there was so many people who were focused on individual security selection, picking individual stocks.
And 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. And the ETF, the ETF wrapper, allowed people to get that exposure inexpensively, holding it in a brokerage account.
So it really 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.
RITHOLTZ: To say the very least.
So let’s discuss leadership and what you do to develop crew members and to identify and foster other people’s leadership skills.
DAVIS: Yes, so Barry, it’s a great question. One of the things that we try to focus on is, as part of our interview process, always trying to assess and gauge the willingness and the interest for folks to develop the leadership competencies in addition to the technical competencies. So when we think about our investment professionals, clearly they have to be technically sharp. They have to learn those skills to do their jobs 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. And so 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.
So we’ve been very actively involved and that whole process for our investment professionals. And it’s paid off, it’s paid spades in terms of, it helps us make sure that 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. Because we know 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, hey, we have some of the coolest jobs that are available to people, you couple that with great leadership, I mean, it’s a win-win formula for long-term success for our organization.
RITHOLTZ: That’s really interesting.
A lot of people in finance have been saying it’s difficult to find people in this environment. What is Vanguard doing to keep the seats filled and make sure you have an ongoing source of talent coming to Pennsylvania?
DAVIS: Yes, so we are very heavily involved. We have, 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 as a nice entry point for people to explore and see what they really want to do.
And so we just had a cadre that launched to their final placement earlier this week. And so there were seven individuals that spanned a range from risk to high yield trading to investment grade research. And it’s a nice talent pipeline. And 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.
And so, just 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. And so that’s really the pipeline for us. And then we will supplement that with experienced senior hires as we, if there’s turnover and we don’t have somebody on a bench ready to go to move into a bigger seat as well, or if we’re trying to build out new capabilities like we’ve done in the past.
RITHOLTZ: Really impressive.
Let’s talk a little bit about the Vanguard Total Market Index. That’s become the largest fund in the world. What goes into managing a fund of that size and that importance to Vanguard?
DAVIS: I mean, it really starts with the people. Just making sure that we have unbelievably talented professionals who are truly dedicated to managing these index funds on a day-to-day basis. And the way we think about it, our PMs also serve as traders, and so they’re working very closely day by day, making sure that Total Stock Market Index Fund and all of our other equity index funds are minimizing the 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 and 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, highly risk-controlled way.
And the great thing is we have a team of folks who have 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 who 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.
RITHOLTZ: So a lot of indexers will track somebody else’s index. The Vanguard Total Market Index is something that Vanguard itself creates. There’s a separate index group and there’s a whole bunch of technical ways that’s set up. What goes into making changes in stock memberships? Tell us a little bit about what that process is like.
DAVIS: So for the total stock market index fund, that 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’s corporate actions, there’s 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, value, and blend in there. So the turnover is primarily driven by corporate actions and IPOs. And then the team spends a lot of time just making sure they handle those really, really well to minimize costs, make sure that tracking error remains relatively tight.
And 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 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. So that’s another contributing factor to the performance in those funds as well.
RITHOLTZ: Right. That’s a performance enhancer.
DAVIS: That’s correct.
RITHOLTZ: And ultimately leads to the ability to lower costs to that fund.
DAVIS: Well, it lowers the ultimate drag that you would have from transaction costs. Exactly.
RITHOLTZ: Yes. So how often does Vanguard create a new index? So what’s that process like?
DAVIS: We tend not to create the index. That’s an outsource process. So it’s really a function of do we have gaps in our lineup? And so we get input from the various business divisions, whether or not it’s our retail group, our institutional group, our financial advisor services group, are there gaps where we feel like, hey, we don’t have a relevant offering that’s needed by our clients?
And then we find out, 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. And then our team works very closely with them in terms of the due diligence process and making sure that that index is constructed in a way that we’re comfortable and the right levels of controls are in place.
And then, you know, once that’s set up, the team is ready to go to start managing against that newly defined index.
RITHOLTZ: And when you say there are gaps in your lineup, you’re not talking about trendy things like, “Hey, we don’t have a metaverse index.” Or, “Look, we don’t have an AI index.” It’s always much broader and more permanent, if that’s the right word, or long-lasting, I’m looking for.
DAVIS: Yes, again, 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? And you’re absolutely right. Vanguard is not the type of firm that will launch thematic products that are focused on, whether or not it’s 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.
So a couple of years ago, I wrote a column about this shocking little aspect of Vanguard that I think nobody understood, which is the patents that Vanguard had on the way you manage taxes for mutual funds, which made your mutual funds behave more like ETFs, and that there was no tax pass-through, typically.
It kind of made me think of a question. When you’re the size of Vanguard, how do you balance discipline on the one hand with the need for creativity and occasionally thinking out of the box? You would think they might be at odds. What’s that like?
DAVIS: Yes, the main thing, Barry, it’s a great question. The main thing goes back to like, what’s the enduring philosophy and what are we trying to accomplish for our clients? And at the end of the day, they come to us to try to get long-term exposure to a segment of the market. And 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 security 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 as they’re constructing their portfolios.
RITHOLTZ: Most people think of Vanguard as passive first. Tell us a little bit about what the chief investment officer does for the passive side of an investment business.
DAVIS: A big part of it is really around when there’s more complicated corporate actions that are happening that entail a level of risk. There’s 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.
RITHOLTZ: And when you say corporate actions, we’re talking about M&A, IPOs, bankruptcies, anytime somebody outside of your decision-making process either exits or enters a market.
DAVIS: Yes, exactly. So when there’s a major turnover like that that happens, you always have the option, “Hey, 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?” And that’s a risk decision that you have to make. How much liquidity is going to be there when there’s a major activity that happens? 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.
RITHOLTZ: So it’s pretty well established amongst the academic research that passive on the equity side beats active over the long haul, but that’s not true on the fixed income side. Active on the fixed income tends to be passive because the choices amongst fixed income are just so much greater than what you have in equity. Tell us a little bit about what you as CIO do on the bond side.
DAVIS: So on the bond side, we have both. So we do bond indexing in a highly diversified way, cutting across segments, including treasuries, including governments, corporates, mortgages, and things of that nature, global portfolios that give you a tremendous amount of diversification that’s 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 where that team has been very successful in terms of being able to add value over the long term. And so when you look at some of the results, and a big chunk of that comes from our credit research capabilities within the team, both investment grade, emerging market as well as high yield, but 92% of our active bond funds have done better than the average fund over their Lippert Group averages over a five year period. And 87% of our active fixed income funds have outperformed their benchmarks on a three year basis against their benchmarks.
And then, if you look at a five year time horizon, it’s 77%.
So, our active team has been successful outperforming their benchmarks. And a big part of it is, do you have the credit team that can do the due diligence? Because credit is where we think we can add the most value by credit research. And 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.
RITHOLTZ: It’s really quite fascinating on the equity side, two or 3% of the stocks are where all the value is created. On the fixed income side, it seems like eliminating the worst 10, 20, 30% of stocks in terms of either risk or duration is where all the alpha gets generated.
DAVIS: Yes, I mean, in fixed income, because again, it tends to be a defensive asset class, which you want to do is you want to try to avoid the losers, right? Where, you know, what’s the upside when you invest in a bond?
RITHOLTZ: Hey, you get your money back.
DAVIS: You get your money back. You get your coupon payments and your principal, you know, at maturity on time. The downside is you get zero because the company files for bankruptcy and there’s no recovery value. So, you know, again, 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 balance in the portfolio. And the way we’re able to accomplish that is that, 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. We can wait till the market’s a bit more attractive and when we feel we’re being rewarded for risk-taking.
RITHOLTZ: There’s a little multiplier effect from the low-cost side of Vanguard in that you don’t have to swing at every pitch. The ability to say, “No, no, we’re good with this. “We’ll wait till opportunities look a lot more attractive.” I don’t get that sense from a lot of people in finance. They’re judged every month, they’re judged every quarter, and they feel like, what’s the old joke? Never mistake activity for progress?
DAVIS: That’s right.
RITHOLTZ: That seems to be really common in Wall Street.
DAVIS: Yes, I mean, for our teams, our active teams, their performance is evaluated on a three-year basis. So, you know–
RITHOLTZ: Three years?
DAVIS: Yes, so —
RITHOLTZ: That’s amazing.
DAVIS: So when we think about how those teams are evaluated, it’s a three-year number. So how did you perform? Because in any given quarter, any given year, you know, you could have winners and losers in terms of strategies, but what you’re trying to do is you’re trying to 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. And that’s what we’ve been able to demonstrate over time.
RITHOLTZ: That’s so fascinating because I would assume that intellectually, everybody understands that’s true, but emotionally, two bad quarters, and it’s like, we know we told you three years, but we’re getting pressure from investors and we have to make a change. Like to stay with that is really challenging.
DAVIS: Well, you know, it’s a great point, Barry, but the reality is like when you’re running portfolios in a highly risk-controlled way, you’re trying to manage the downside, right? 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, that even if you do have a bad year, it’s not going to be so bad that investors start running for the hills.
Again, we want investors to stay in each product long-term because we think they provide good, long-term, enduring value for our clients.
RITHOLTZ: And Vanguard famously during the financial crisis, not only did you not see outflows, you actually saw inflows. I got to imagine a year like 2022 wasn’t horrible for Vanguard’s asset growth.
DAVIS: It’s interesting. I mean, there’s 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.
DAVIS: And you had-
RITHOLTZ: Hey, 500 basis points of rate increases, we’ll do that.
DAVIS: That’s exactly it. And when you saw the US Ag down 13% last year, for folks, again, 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, and those folks who are in retirement, and 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 a taxable market, which tends to be, in our case, more long-term, retirement-oriented, and things of that nature. So you will see some pressure on munis in those types of interest rate environments.
RITHOLTZ: Really interesting.
So let’s talk a little bit about last year, where all I heard was the 60 portfolio is dead. Discuss.
DAVIS: It’s interesting. I mean, we’ve heard that over and over again. It was a tough year for investors in terms of both stocks and bonds being down where stocks were down about 20%, the US AG was down 13%.
RITHOLTZ: When was the last time we saw stocks and bonds down double digits, like 81, something like that?
RITHOLTZ: Somewhere in that type of horizon, yes, exactly. So it’s not something that many investors have been accustomed to or have seen in their lifetimes, but the reality is, the reality is, when you think about the components in the terms of long-term investing, the bond portion of the equation provides that balance and diversification. Now again, in any one given year, you will have a 60, 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 balance and diversification has proved and delivered really good long-term returns.
So when you go back to 1926, if you were an investor since then, a 60/40 portfolio has returned 8.8% on average over that time horizon…
DAVIS: Which is impressive.
DAVIS: Because again, it provides you diversification, it reduces some of the volatility, but there will be periods of time where, again, that type of portfolio when, we were in an environment where interest rates were held down to historically low levels.
So when they reprice, it’s not surprising that you see losses on the bond side of the equation. 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’s periods of outperformance and that ultimately will lead to periods of underperformance.
RITHOLTZ: That’s right. And I’m glad you mentioned the period before that. Go to the decade before 2022, the equity side was something like 13%. And then whatever you got from bonds was just a bonus on top of that.
DAVIS: That’s exactly right.
RITHOLTZ: People forget that when they see a single year like 2022, and they really forget that in a year like 2023, where everything is going up, I mean, other than gold, what hasn’t been going up this year? How do you deal with the opposite of last year with the first half like this year?
DAVIS: 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 there is, again, investors have to keep in mind that that’s probably not sustainable long term. And so again, the importance of having a diversified portfolio is critically important. And just think about fixed income and money markets as an asset class.
You know, for a decade, you weren’t earning anything in a money market fund because interest rates by the Federal Reserve were pegged at zero. And you had to take on significant duration risk and credit risk just to earn a couple percentage points. And now, you’re in an environment where money market funds are yielding 5-1/4%. You have the US Ag that’s yielding somewhere close to 5%, so 4.5%, 5%. So in the grand scheme of things, investors are actually being rewarded for having exposure to money markets and bond funds.
And so if people are truly concerned about a 60/40 portfolio, they should have been concerned about it for 10 years. Now’s not the time when you’re back to an environment where you’re actually getting a real yield when it comes to the bond market.
RITHOLTZ: I’m glad you brought up money markets because it’s this overlooked area that when you have rates at ultra-low levels, it kind of gets forgotten about. But is it fair to say that this year and perhaps last year, you saw a big shift of client cash assets into money markets?
DAVIS: We definitely saw a number of clients who started embracing money markets. And the reality is for a lot of investors, it truly is free money, right? So when you think about what people are earning in their deposit accounts at their banks, and banks have historically been very slow to raise, very slow in terms of raising deposit rates because those deposits tend to be very sticky.
And I’ve had people stop me, even at Vanguard, in the hallway and say, “Wow, I didn’t realize that I’ve been leaving this much money on the table by keeping a sizable amount of deposits at my bank.”
DAVIS: “I moved it to a money market, now I’m getting a five and a quarter percent type yield, which is amazing when some folks are still getting less than half a percent” in many cases, in the bank.
RITHOLTZ: It’s shocking that this has gone on, how much inertia there is in finance that even if you’re just getting your December bonus that you’re going to 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 on the table.
DAVIS: It’s free money.
RITHOLTZ: Free money, right.
DAVIS: It’s free money.
RITHOLTZ: Quite interesting.
So at what point do you think high yields become a headwind for stocks, or is it just overall part of the 60/40 portfolio? And hey, we’ll either take it on the equity half or the bond half, we don’t care.
DAVIS: Well, I think if you look at what our return expectations are for the global balance portfolio, we’re expecting that over the next decade or so, somewhere in the neighborhood of about 5.5% for a global balance portfolio. So combination of equities, bonds, US and international stocks. And the reality is, our return expectations for the US equity market is a bit more muted. We’re expecting US equity market returns to hover somewhere around 5% or so…
DAVIS: Where international equities, because of valuations, probably 7% to 7.5%.
RITHOLTZ: So let’s talk about that, because that gap in valuation has persisted for a long time. Certainly for a few years after the financial crisis, it seemed like US stocks were pricey, forward return expectations were low and the opposite was true overseas, but the US seemed to be the only place to be.
How durable is that shift, given how large that gap has gotten in valuation between US stocks and the rest of the developed world?
DAVIS: Yes, so I mean, if you were to take a look at what’s happened over the last 10 years, looking at the S&P 500 index versus, you know, like the FTSE Global All Cap ex-US, there was a seven percentage point difference per year by being–
RITHOLTZ: 700 basis.
DAVIS: 700 basis points–
RITHOLTZ: That’s monstrous.
DAVIS: Of outperformance by the US market relative to the international markets. But, you know, so if you were to take a look at where PE ratios are today, between ES and P, which has an earning yield of about 5%, and you look at the FTSE Global All Cap ex-US, it has an earning yield of 8.3%, right? And so–
RITHOLTZ: Not insubstantial–
DAVIS: There’s a substantial difference. Now, there are sector differences. So, you know, and we could talk about that to some degree as well, but the reality, even if you adjust for sector differences, there’s still a big gap. There’s still a big gap in terms of the PE ratios across the US market relative to the rest of the world.
And so, unless we expect earnings for US companies to vastly outpace what’s happening in the international markets, and it might, but there’s a lot of great news already priced into the marketplace. And when you think about translating the S&P 500 PE to an implied equity risk premium by looking at the 10 year treasury yield, you’re 200 basis points below what it’s been for the last 10 years.
RITHOLTZ: So let’s do a little comparison because I’m always skeptical when people focus on a single metric like price to earnings. I want to make that more three-dimensional. So if Europe is at an 8.3 earnings yield and we’re at about a 5%, what’s the growth rate difference between the two, meaning are people willing to give up a little bit of earnings in order to accept a faster growth rate that certainly we’ve seen on the tech side, I can’t speak across every sector.
DAVIS: Well, I think there’s a couple of things there, Barry. I mean, one of it is, do you expect the earnings growth to live up to the expectations that are already priced into the US market? And if so, that’s fine for where we are, but that’s not necessarily going to lead to multiple expansion, right? And a big driver of the outperformance over the last decade of US stocks relative to the international valuation expansion.
RITHOLTZ: Right. And that’s all sentiment.
DAVIS: That’s exactly it. And a lot of, we would say a lot of that’s probably already baked into the marketplace and has run its course. Could it go further? Of course it could. But at some point, there is a tipping point where people start saying, “Well, in the US, I have alternatives. I have alternatives because I can go out and buy a money market fund at five and a quarter percent and I don’t have to take a lot of risk.” And if, again, based on our forecast for US equity markets, they’re somewhat muted because valuations are stretched in our view relative to our fair value model.
And so I think a lot of investors have alternatives. They can buy money markets, they can buy bond funds where there was no alternative for the last 10 years because we didn’t get any real yield when it came to the fixed income or the money market space. But there’s really alternatives today for investors, either in fixed income money markets, or international stocks.
RITHOLTZ: Right. The 2010s were certainly the TINA decade. It’s funny you mentioned multiple expansion. When you look at the 82 to 2000 bull market, something like 75% of those gains came not from earnings growth, but from multiple expansion.
I’m curious if that’s kind of repeating now and the 2020 pandemic fiscal stimulus, which was massive under two presidents. What does that do in terms of resetting the cycle? And can we stay pricey, forget higher for longer, can we stay pricey for longer given all the stimulus that’s coursing through the system?
DAVIS: Well, I think there’s a couple of things. One, it becomes a factor. Yes, the economy can clearly keep roaring along, which we’ve seen. The fiscal stimulus that we’ve seen, there’s over $2 trillion that was saved. Our reports show, and some of the data out in the marketplace shows that about a trillion dollars of that has already been spent down. So investors and savers are definitely eating into that safety net, which over time as that continues to decline should slow the economy down to some degree. So I think that’s going to be a big factor.
But then when you think about the broader equity markets, again, the biggest thing that would be concerning if you start seeing a continued rise in interest rates and that has to put pressure on equity valuations. I mean equities are a ultra-long duration asset.
DAVIS: And if you’re discounting those future cash flows at higher interest rates, that means you get a lower present value. And at some point that will bite. Who knows when that’s going to be? Nobody knows when you could see that kind of return to normal. But you would definitely expect that higher interest rates will put continued pressure on the equity market and get valuations back to something that’s more normalized over time. Because you do expect, if you’re investing in equities, to earn an equity risk premium.
And the fact that it’s so much lower than what we’ve seen historically, it starts to beg the question, how much exposure, if I’m a shorter term investor, how much exposure do I want in that space? For long term investors, it doesn’t matter.
RITHOLTZ: So let’s stay with interest rates for a moment. Interest rates are much higher than they’ve been over the past decade. But let’s look at the past 50 or 75 years, interest rates today are clearly above where they were, but they’re not especially high by historical standards. I think a lot of people confuse those two.
DAVIS: Yes, I think a lot of investors end up succumbing to recency bias, right? So the fact that we’ve been in an environment where interest rates …
RITHOLTZ: Hey, it ain’t zero anymore.
DAVIS: That’s exactly it. So people think that that’s the end. I think what you have to look at, and our team has done work on this, you have to look at what do you think is the appropriate level for Fed funds in the neutral state where it’s not stimulative or contracting the marketplace. And so some of the research our team has done, it says that, look, long-term Fed funds could be higher than what the market is pricing in.
The market and the Fed have said, probably in the neighborhood, R-star is 50 basis points or half a percent. You add 2% inflation on top of that, that gives you a long-term Fed funds of 2.5%.
DAVIS: You know, our investment strategy group, through their analysis, they estimate that R-star is probably closer to 1.5%. So that brings you to a longer term Fed funds target of closer to 3.5% if they’re successful at bringing rates back down to 2%, inflation back down to 2%, I should say. And then if you build a normal term structure on top of that, between three month treasury bills and 10 year bonds of about 100 basis points, that brings you to a 10 year that’s probably fair around 4.5%.
And so — but it all depends on what happens from an inflation perspective, economic growth perspective, and how aggressive the Fed will have to be going down the path here but again, we think that there is some risk that rates will have to go a bit higher here, just given everything that’s going on in the economy and the marketplace.
RITHOLTZ: And the 10-year is not all that far away from four and a half percent.
DAVIS: It is not.
RITHOLTZ: That’s something that end of year is not unthinkable.
DAVIS: That’s right.
RITHOLTZ: Really interesting.
So everybody seems kind of shocked by what’s taking place in 2023, although to be fair, everybody seemed shocked at what took place in 2022. What are your thoughts about how Wall Street plays this forecasting game where everybody’s thrown a dart, someone randomly gets it right, but it just seems like it’s a weird game to be playing with people’s serious money?
DAVIS: Yes, we try not to be in the short-term forecasting game. Forecasting’s really hard, and it’s even harder to the extent you’re doing it for the short-term. And so, when we think about the Vanguard Capital Markets model, which drives a lot of our advice engines and the recommendations that we provide the client, the truly not point forecast in the narrow sense of how people tend to do forecast, it’s really the median results of a large simulation that shows a probabilistic determination of results.
And it runs a scale. And the median is just basically that midpoint of all those observations. And so we have a distribution around that. And so again, there’s going to be periods of time when you’re in the tail, both positively and negatively. But again, what we try to say to our clients, you have no control about how volatile the market’s going to be. What you can control at the end of the day is how diversified you are, how cognizant you are to the cost that you’re paying for the funds that you’re investing in. And doing that in a highly diversified, low-cost way, we think is going to provide investors the best chance for their investment success long-term versus focusing on daily news announcements, what’s happening.
Those are the types of things that create trading activity, but don’t tend to add value for long-term investors.
So you recently came out and criticized some of the market timing that’s been going on. What I found shocking about that was we really have to warn people about the dangers of market timing and overtrading. Isn’t that an issue that the academics have long ago resolved? Yes, but it is, it is, Barry. I mean, the data will show that it is not fruitful. It is not helpful to long-term investors to engage in that type of activity, but we don’t have to look too far past with the meme stocks and things of that nature where for a variety of reasons, things pop on the headline and there’s a lot of momentum and folks get involved and people get caught up and believe it’s easy money and it’s free money.
And the reality is that’s speculation and not investing. And so speculating is, that’s a very risky strategy. And when we think about investing, that’s not the way you construct an investment portfolio. If you want to do that from a speculative standpoint, that’s fine. Do that with a very small portion of your portfolio, but the majority of it should be investing in long-term strategies that will add value and are enduring.
RITHOLTZ: My favorite part of TikTok were the TikTok speculative traders. “Hey, investing is easy. Just buy stocks that are going up. And when they stop going up, you sell them. What could be an easier way to support your lifestyle?”
And as that was happening in real time during 2020, I’m sure you felt the same thing I felt like I’ve seen this movie, I know exactly how this is going to end.
DAVIS: That’s exactly right, Barry. I mean, I’ve been in this industry long enough. I started my career in finance in 1998 and very familiar with the dot-com era and what happened there. And it was very, very reminiscent of that period of time where during that period, anything with a dot com behind it, ran to the moon, and you couldn’t go wrong. Well, that works until it doesn’t.
And then one day you realize that these companies actually, they have to be real companies that make money, produce earnings, and are viable businesses. And in a speculative fever, people lose sight that having cash flow, having earnings matters in the long run, and sometimes people have to learn a hard, hard lesson that, again, that’s not investing, and that’s really speculative.
And it’s a lesson to learn earlier on in your career when you don’t have a lot of money versus later on in your career where you start to accumulate some assets. You definitely want to be more of an investor versus a speculator.
RITHOLTZ: Right, make your mistakes early. You know, there’s a chapter in, I want to say it’s Adam Smith’s “The Money Game” from the 1960s, where he talks about a fund manager running a bunch of young run-and-gun managers. “Why do you have these young kids working for you?” “Oh, because they’ll buy all the stuff that I won’t buy and we’ll make money in it. And when it blows up, I’ll sell early and fire them all and go on to the next group.” I was reminded of that last time.
But it seems shocking, I guess like the market timing argument. We’re still in a debate between meme stock pickers and indexers. It’s fascinating that every new generation has to learn the hard lessons over and over again.
DAVIS: Yes, I mean, you just have to look at history, but some people have to learn the hard way using real money to do that. But eventually, most people find religion and start thinking about, “Hey, how do I actually construct a portfolio that’s durable, that will provide the type of economic return that’s required to meet their retirement needs, college saving needs, or buying that new house, or whatever the case may be.”
RITHOLTZ: Right. So let’s talk about some adult decision-making around a durable portfolio. Internally, we’ve been having discussions about extending duration. If you tightened up duration in ’21 or even ’22, you did better than the index. At what point do you say, “Hey, I’m not getting paid to take risk short-term because of the possibility of those rates dropping, whether it’s ’24 or ’25.”
Where do you start thinking about going back out on the duration curve for fixed income?
DAVIS: I think you have to get to a place where you feel like the Fed is done and inflation is starting to be — you’re convinced that inflation is under control and path towards the Fed’s 2% target. So we think there’s still some ways for that to go. And again, if you go back to what I was saying earlier about R-star and the neutral Fed funds rate, if we believe that’s 3.5% with a normal shape yield curve of 4.5%, we’re not far from that, but it’s also, that’s far from neutral, right?
If we think 4.5% is fair value, we’re not at fair value yet. So that means it also means that, hey, it’s not cheap. So you don’t want to dive in with both feet. When you’re approaching fair value, you want things to actually be cheap before you do that. So the risk is that rates back up more. And so I think you still want to be somewhat conservative when it comes to duration positioning in a portfolio.
RITHOLTZ: So I always have a question about that 2% inflation target. Not to be flippant, but it seems like a made up number. I hunted for some academic research that said, here’s why. And I came up with something, the former Fed vice chair wrote a paper that said, oh, it’s a thing from New Zealand in 1980s.
It’s kind of a made up round number and everybody adopted it. Can it be that simple? We’re using a Fed inflation target that’s just a made up number?
DAVIS: Well, that’s what the market is gravitating towards. That is what the Fed is operating off of. And until they decide to communicate a different message, that’s what the market is going to continue to follow. And their behavior says that, hey, they want to see inflation coming down. It’s also difficult to be changing the strategy when you’re falling behind your current strategy. Because if you say, “Hey, I’m going from a 2% target to 3%, well, you’re at 3% because you couldn’t hit 2%. Well, is 3% the right number?”
RITHOLTZ: Well, if you’re going to make up a number, make up one you can reach as opposed to one you can’t.
DAVIS: But we have to be realistic too, right, Barry? I mean, the reality is for 10 years, we couldn’t hit 2% inflation. We were on the other side.
RITHOLTZ: We were on the downside.
DAVIS: We were underneath that 2%. They were working really hard to try to get to 2% and they couldn’t achieve it.
RITHOLTZ: So in an era of low monetary policy and almost non-existent fiscal stimulus, upside target of 2% doesn’t seem to make a lot of sense. Fast forward to the 2020s, now we’re in an era of massive fiscal stimulus, not nearly as much monetary stimulus. Does it make sense to have the same target when you’re coming from 5% above it as opposed to 0% under it?
DAVIS: Well, the thing is, it’s supposed to be a long-term target and it’s supposed to be an average target over time. So, I haven’t heard anything that would say that they’re in the process of deciding to switch it to a higher number. I think that’s something that’d be debated once you get back to close to your target. And that gives you greater credibility over time.
What you don’t want to do is you don’t want to change, you don’t want to change the mile post while the car is still in motion and you’re running the race. You want to basically say, “Hey, we’re anchored to this. We believe in this. And ultimately we think this is going to allow us to pursue a level of economic growth that continues to give us full employment, moderate price increases.”
Again, it’s debatable whether or not 2% is the right number or 3%. All I would say is that it took us a long time to get north of 2%. We finally got it.
RITHOLTZ: It took $6 trillion in fiscal stimulus, but that raises the question, “Hey, you know, when it gets icy out, you got to slow down.”
DAVIS: You do have to slow down, but the reality is that stimulus is starting to wear off. Those savings are starting to be consumed. You’re starting to see the Fed reduce its balance sheet slowly, but it’s starting to happen. And you’ve seen the Federal Reserve clearly raise interest rates dramatically, 525 basis points in 15 months. They’re definitely trying to slow the economy down.
And so we’ll have to wait and see if that’s enough. But again, we have to remember, we can’t be blindsided by the fact that inflation has been well above their target because of all this stimulus. This stimulus was slowly ebbing out of the system and we’re gradually going back to, we’re going in the right direction. The question is how long will it take for us to get there?
RITHOLTZ: Really interesting. I’m going to throw you a curve ball question which I did not disclose in advance because I wanted to surprise you. You’re born in Germany, raised in a military family, and you speak fluent German with your mom and English with your dad. Tell us a little bit about your experience growing up overseas as a military brat?
DAVIS: It was a phenomenal, phenomenal experience. I mean, I had the privilege of growing up in a bilingual household. And my maternal grandmother was also home, and she spoke primarily German to me. So what was challenging for me was like, actually, when we moved to the US when I was seven years old, I was always good with math, but my English was below average. And my wife is an English, as she taught English at the college level, she said, “You dummy, English was a second language for you.”
DAVIS: And it really was. I didn’t know it even, I went to a US Department of Defense school in Germany, but my primary language that was spoken by my grandmother, who I spent most of my time with, was German. So, that was interesting.
And I loved the experience of living over in Germany, and I had the benefit as a kid, during my teenage years, going back to visit family members and friends over the years going back to Germany, which is also a very rewarding and memorable part of my childhood.
RITHOLTZ: Really interesting.
So I only have you for a few more minutes. Let’s jump to our favorite questions that we ask all of our guests that are a little bit revealing of who they are.
Tell us a little bit about what you’ve been streaming, what’s been keeping you entertained these days.
DAVIS: So from a streaming standpoint, there was a series, went through the first season that ended, they’re going to start a new one in 2024, it was called “Night Agent.” Which was really interesting. There was an FBI agent who was manning a telephone in the basement of the White House.
RITHOLTZ: I saw the first episode of that.
DAVIS: Yes, it’s actually a really good series and the good news is it got picked up and I think they’re coming out with new episodes in 2024. But it was a really, really interesting…
RITHOLTZ: He kind of gets the crap beat out of him in the first episode.
DAVIS: Yes, yes, yes.
RITHOLTZ: I saw that, it was very fun.
DAVIS: It was a really interesting show. So that’s one. And then because of my kids also been, big fans of All American and Bel Air, which are also really cool series that we’ve been watching. So those were a couple.
RITHOLTZ: Tell us a little bit about your early mentors who helped to shape your career.
DAVIS: I had a number and I’ll go back to the first two I had when I started in this industry. Darrell Thomas was leading investment grade capital market at Citibank. He actually helped me get my internship. I met him at a career fair. He helped me get my first internship on Wall Street with somebody I kept in contact with over the years. And he helped me, you know, him and there was another individual Carmine Urciuoli, who also worked at Citi at the time.
Those two individuals gave me a lot of perspective when I was thinking about moving from Wall Street to the buy side. And thanks to some of the words of wisdom from Carmine, he said to me when I was thinking about making a change, he said, “If you could join a well-regarded, well-respected asset manager, you’re going to have a much longer and more fruitful career than if you stay on the sell side.”
And that was advice he gave me back in 1999.
RITHOLTZ: Good advice and good timing.
DAVIS: I send Carmine chats every once in a few years saying thank you for the advice and I appreciated it.
RITHOLTZ: Really interesting.
DAVIS: And then along the way, Ken Volpert who hired me, huge, huge mentor. He hired me to trade treasuries and mortgages on the team, big mentor, advocate, sponsor and friend, and of course Tim Buckley who gave me the opportunity to go to Australia and then ultimately lead the fixed income group and then put me in the seat that I’m in today. I’ve only had two bosses at Vanguard in 24 years and they’ve both been phenomenal.
RITHOLTZ: Wow, really, really interesting.
Let’s talk about books. What are some of your favorites and what are you reading right now?
DAVIS: Right now I’m reading “Plunder” by Brendan Ballou. It talks about the private equity world. I have a daughter who wants to do private equity investing, so I’m doing some due diligence. And the book is actually an interesting read, but it talks a bit about the dark side of private equity versus some of the favorable things that come out of that space as well.
And then there was another book that I read previously that I thought was really interesting. It’s not market related, but it talks a lot about history in the US, it is called “From Here to Equality” by William Darity and Kirsten Mullen. And it really examines a lot of American history that isn’t covered in school.
You know, it’s a deep look at some of the, you know, really pivotal points in the nation’s history that, you know, where we had a number of opportunities to create a more and equal and just society where we chose to go left instead of right. And, you know, we’re still dealing with some of those ramifications in today’s modern age. So I thought it was a really, really interesting book about American history.
RITHOLTZ: Really interesting. What sort of advice would you give a recent college grad who is interested in a career in either asset management or finance?
DAVIS: I would say a couple of things. One is be a continual learner. Master your craft. So spend the time and energy and the effort to learn and become an expert. And the key thing is continuous learning. And there’s opportunities to learn from everybody that you interact from and interact with.
And so the other thing I would say is, for young people, you have to remember a career is a marathon and not a sprint. The problem that people face is that they’re constantly comparing themselves with somebody else who started at the same time or one of their peers who is working at a different firm. And what I always say to the younger joiners to our firm is run your own race. Judge your success by how you’re doing. Are you getting better than where you were a year before? Are you continuing to learn? Are you being developed? And if you focus on yourself about getting better every day, you’re going to have a much more fruitful and long living career than somebody who’s constantly comparing themselves to somebody else.
RITHOLTZ: Really good advice.
And our final question, what do you know about the world of investing today you wish you knew 30 or so years ago when you were really first getting started?
DAVIS: I would say the power of compounding is such a beautiful thing. I just, I wish I would have learned that lesson earlier on. And you know, what we were speaking about before, the idea of investing versus speculating.
As a youngster, it’s always interesting to, you think about an industry or a company and you’re like, oh, it’d be a great investment, but what you’re doing is speculating and you should be investing and let that investment compound over 30, 40, 50 years, and you can see that even small amounts of money will grow into a rather large sum if you do it on a consistent basis.
So I wish I would’ve learned those lessons earlier and earlier in my lifetime.
RITHOLTZ: Really great stuff.
We have been speaking with Greg Davis. He is the Chief Investment Officer at the Vanguard Group.
If you enjoy this conversation, please check out any of the 500 previous interviews we’ve done over the past eight years. You can find those at iTunes, Spotify, YouTube, wherever you find your favorite podcasts. Sign up for my daily reading list at ritholtz.com. Follow me on Twitter @barry_ritholtz until I get back my hacked Twitter account @ritholtz. Follow all of the Bloomberg family of podcasts on Twitter @podcast.
I would be remiss if I did not thank the crack team who helps put these conversations together each week. Paris Wald is my producer. Atika Valbrun is my project manager. Justin Milner is my audio engineer. Sean Russo is my researcher. I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg Radio.