Rodney Comegys – The Mechanics of Indexing at Vanguard (EP.498)

0:00There's the original concept of indexing, which is capture as much of the world's investment universe as possible, and you put it into a total market fund. For those, you're just trying to get from the largest security in the U.S. to the smallest one that you can invest in. What you're looking for there is all the securities that are equities, and then you're thinking, are they liquid enough and available enough for us to invest in? Then you include them all. That's the simplest version of indexing, and we do that all around the globe. 30 % of the S &P 500 is made up by seven companies. The S &P 500 should not be your benchmark nor your portfolio.

0:38If you do that, you're exposed only to U.S. large cap companies. 500 securities, any investor wants diversification, needs to add small cap securities in. A total market solution, you need global securities. By the time you're done with that, you've increased your universe about 50%. You've taken that exposure down by about half by global market cap weighting the globe, and you need that in bonds.

1:12I'm Ted Seides, and this is Capital Allocators. My guest on today's show is Rodney Kamachies, the Chief Investment Officer of Vanguard Capital Management and its head of global equity indexing, where he oversees$8.5 trillion in index assets across domestic, international, and multi-asset strategies.

1:37Rodney Comegys:Rodney joined Vanguard 27 years ago and has worked across operations, customer service, risk management, and investing. Our conversation covers the philosophy and mechanics behind running one of the world's largest index fund operators. We discuss Vanguard's ownership structure, values, product selection, and mechanics of delivering an index fund. We then turn to common issues around indexing, including concentration in U.S. equities, corporate governance, private assets, and AI. Before we get going, this week marks the ninth anniversary of capital allocators. It's a moment that's not at all noteworthy.

2:20Seven was my lucky number growing up. Eight represents wealth, good fortune, and prosperity in China. And ninth is, well, one before 10, which is a random round number. So despite the unremarkable nature of the milestone, it's a wonderful time to reflect on this journey you've taken with me. We're approaching episode number 500, which is actually the 583rd episode. And I'm so grateful to have the opportunity to conduct and share these conversations with the best capital allocators with you. But we have work to do before hitting the round number 10 a year from now. And you know what's coming if you've listened this far.

3:03Think of that friend, colleague, or fierce competitor who doesn't know about the podcast. I mean, at this point, they're hopelessly behind you. And the only thing worse than being behind is being a full decade behind. Well, we have a year to correct that. So let's follow the lead of our former leaders of the country who left no child behind by leaving no worthy investor behind, which only happens if you take the next step. Thanks so much for spreading the word about capital allocators. Capital Allocators is brought to you by AlphaSense. Expert calls have always been one of the most powerful ways to build conviction.

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5:12Their data hasn't kept up. Chasing documents, extracting performance, and reconciling across dozens of funds is a real drag on the people doing serious investment work. Canoe Intelligence purpose-built AI to fix that problem. Over 500 institutional clients, including 40 % of the top U.S. endowments, trust Canoe to process more than a million documents a month across 44 ,000 funds. If your team is still doing this work manually, I strongly recommend you check out Canoe at canoeintelligence.com. Please enjoy my conversation with Rodney Komagis. Rodney, great to see you. Nice to see you, Ted. Why don't we start with your background and path to joining Vanguard a quarter century ago?

6:00It's been a heck of a 25 years since I joined Radar Business School. I grew up in a small town in Delaware. My parents didn't go to college. My mom took a job at the University of Delaware as a secretary so that I could get free tuition to the University of Delaware. I got exposed to some folks who were looking at other schools. I was fortunate enough to get into the University of Pennsylvania, but it was a little bit too pricey for my parents. I looked and remembered that I enjoyed my dad's stories from the Navy. I put the two things together, a chance to go to Penn with a Navy ROTC scholarship, which paid the Penn tuition and got me to go to a great school where I studied engineering.

6:41And then I owed the Navy five years of service, which I turned into six and a half on a submarine out of Grodden, Connecticut. it. That was a fantastic experience where I got to see a little bit of the world. I got to see some great leaders and learn about leadership. From there, I went to business school at HBS, where I met you for the first time. Part of the reason I went to business school, because I didn't know what I wanted to do. I tried a summer in consulting, and it turned out that I like doing things a lot more than giving advice on how to do things. I went back to school second year, looking for a place to work that had a great mission, a great value set, and was Philadelphia-based.

7:17My wife was already here. She had finished a PhD at Brown and was on a postdoc. We were from the local area and thought this would be a great place to live. One of our professors, Andre Parole, introduced me to Tim Buckley and Jack Brennan, and the rest is history. I'd love to hear the difference in what you learned about leadership in the Navy and what you saw at business school. What I saw in the Navy was the human aspect of it. Young sailors at the time on a submarine. It was all male. Today, it's integrated men and women. They were 18-year-old kids who were really smart. Often, the Navy had high standards to join a submarine, but they might not have the right opportunities.

7:58They were not fortunate enough to get an NRTC scholarship to Penn. They also had real-world issues. Children with developmental needs, learning needs, they had a spouse, they might be going through a divorce. I've learned from Captain Holland how to balance the need for excellence and results. We were gone from home 70 % of the time. I was on board with the need to care about the human beings. Anywhere from what's the issue of today that you're trying to deal with at home to what do you want to do when you get done in the Navy? Do you want to reenlist and do 25 years and get a Navy pension? In our case, we had young sailors who said, no, I want to get out of the Navy.

8:35I want to go to law school. We have a gentleman in the engine room with me, probably joined the submarine force 18, 19-year-old sailor who I saw him go back to school. He ended up being a judge in Wisconsin. Those are the types of stories of how to treat people. Business school, on the other side, especially for those that hadn't managed people, was often an academic exercise. Every case that had too much cost in it was lay the people off. The military guys would go, who's going to actually do the work? How's that going to affect your morale? There's clearly a balance between those things because sometimes you do have to do the layoffs.

9:08You do have to do the hard things in business. That balance is what I learned and could see the between and the tricks between them. When Andre introduced you to Vanguard, what was it that resonated for you? It was the Vanguard case study that resonated and it's the Vanguard story that resonated. Andre had written a case about Vanguard and Tim Buckley had actually worked on it, who became our chief investment officer and eventually our CEO here at Vanguard. You read the case and you go, this is an organization that is owned by its shareholders, for its shareholders, and returns its value back when it grows by lowering its fees.

9:44That's a really great outcome. You could already see it. We were, in the early days, the choice of the direct investor, those that were interested in saving costs. By the time I got here, we were almost 25 years into the history. We'd already driven expense ratios down. We had democratized investing or the start of it. We were the first place you could really go to direct rather than through an advisor. The fees at the time were probably on average 30 basis points. The industry was probably 100 basis points. We were still 80 % active at the time, 20 % passive, but you could see what we were doing.

10:19We were the low-cost leader with high-quality products. Andre introduced me to Tim and to Jack, and I had a chance to come here. Originally, I worked in operations. 401k operations are part of it. I went to Arizona and ran our 1 ,200-person call center, which I loved. That was the front line of Vanguard. Welcome to Vanguard. How can I help you? Trying to answer those questions for their first savings vehicle for their children's college or the start of an IRA for retirement or whatever their financial need, hopes, and dreams were. When you look at some of the drivers you talked about, shareholder ownership, and some of the principles of the firm, I'd love to hear your sense of the most important values of the firm over the last quarter century.

11:05Number one is be honest, be transparent, and be clear. If you're talking to someone about an investment product, talk to them about the benefits and the risks. We care about low fees. We care about trying to make the investment landscape better for all investors, not just our investors. My team, for example, has worked very hard in the last couple of years to make the closing auction in India possible. Because we buy a lot of Indian securities on our index funds, and auction makes it more efficient and makes it cheaper to execute and gives better price discovery. That's the type of zeal we're doing on behalf of our investors on a global basis.

11:45it's that transparency, low cost. Make sure we believe in the investment vehicle or investment product. It should be something that's long-term and enduring. It's always been a challenge for us. If you think about those investors that I talked about wanting to serve your mom and pop investors in mainstream America, they probably need broader, diversified, more straightforward things. We now have a much more sophisticated investment base 25 years later with advisors who need a bond product with more complexity to it or want to target a part of the curve or a more active type decision. We've had to adopt, but every product that we offer, we want it to be best in class and competitive from a cost perspective, if not the lowest cost.

12:29What was your path from starting an operations to where you're sitting today? I went to work as far from money management as you could be. We were taking the payroll in for big 401k clients and making sure that that weekly paycheck was getting invested on behalf of the investor with accuracy and trying to make sure operationally it was good. I then went to Arizona to a call center, taught me about frontline customer service. And then I did two years of corporate work running our Six Sigma Quality Improvement Program. A decade into Vanguard, I've done nothing but operations, including the old days of answering the phones myself as part of our Swiss army to try to serve our investors.

13:08But it really made you to learn about the retail investor and our foreign investor. And I had an opportunity. Vanguard likes to rotate people. I got a call from my boss. He said, how would you like to go to work for a gentleman named John Hollier, who is head of risk management and is working to globalize risk management? I said, that's near the funds, isn't it? Mike's like, yeah, you're going to learn about it. I went to see John Hollier and John said, Roddy, I need some help on my operations and my management. I said, John, how do you do like staff meetings? He goes, what do we need a staff meeting for.

13:38I just have a yellow sticky and tell people what to do. So I hope John put in place processes that help scale his business. For that, I get to learn from John, who's one of the world's greatest risk management folks about how to reduce risk in the funds and how to allow people to take risk. John taught me the basics. John was a fixed income guy. He loved all the complicated fixed income stuff. There was less interest in the equity side. I loved equity indexing. From there, I did two big things early in my time in investments. I helped launch a lot of the ETFs globally. I went to Canada and helped with the launch of products there.

14:15I went to Europe and helped there. I went to actually Hong Kong and helped launch some of those. I also worked a lot with the index providers. I worked specifically with CRISP, the Center for Research and Securities Pricing, and with FTSE to make some changes to our index products to reduce cost. It helped me learn from Gus Sauter, who was the legendary CIO of Vanguard, who was really an indexer. What were the key things about indexing that you needed to do to run a great index and helped do that? And now those products are run today for us. I'd love to dive into some of the mechanics of how you go about indexing.

14:52Part of it starts with what index to create into a product. How did you think about launching new products? There's the original concept of indexing, which is capture as much of the world's investment universe as possible, and you put it into a total market fund. For those, you're just trying to get from the largest security in the U.S. to the smallest one that you can invest in. What you're looking for there is all the securities that are equities, and then you're thinking, are they liquid enough and available enough for us to invest in? Then you include them all. That's the simplest version of indexing, and we do that all around the globe.

15:29We have a total stock market fund here in the U.S. for American investors. We have an Australian index fund based on the ASX 300 for Australians, total bond, total international, total world, capture the whole equity. Then you start to go, if you're going to cut the index into pieces, what makes sense? One of the challenges in this business are people are slicing the indexes into pieces that don't make sense. There's not an investment thesis for it. We've stayed more pure to it. We've cut the indexes into what I would call logical blocks. We started with size, large, medium, small, value, gross, sort of the Morningstar nine box.

16:10We have dividend strategies, higher dividend strategy and a dividend quality strategy that we believed in. We've given some investors some choices with the ESG indexes, but we're trying to find things that are still capturing, I would call it a factor. Something logical for investors, we've stayed away from things that are hot or niche-y. I don't think you're going to see us offer a jet index like others have done, capturing airline returns. Too narrow, too specific for us. Better served by an active investor. That's the basics of it. Capture the investment return. Then you think about the practical implications of making it liquid and available.

16:49Once you've picked one that you're going to work with, and for simplicity, you could say S &P 500. What goes into the implementation that makes it work? Number one is there are people in our operations teams that have to make sure the index arrives every day and make sure that the portfolio manager knows what's changing in the index. You got to have an accurate index. The second thing, you have no much money you have. Every day, my portfolio team, 50 people on a global basis, they're putting people's money to work. If you send us a check for a million dollars, We've got to make sure that we invested at four o 'clock at the end of the day, perfectly in line with the index.

17:29That's one aspect of it. The other part of it is how we do that. You got to know what the index is. You got to know what you own. You got to know how to put the cash to work. If you're going to execute, you're balancing four things. One, you want as close to tracking as possible. That's how the world judges an index fund. We have to be excellent at that. if the index has 5 % apple in it, you look in our portfolio, you're gonna see us have 5.0001. We might have a little bit of it, basic thumb rule of over and underweights. Then we have more sophisticated models using an axioma risk engine that looks at it in an optimizer.

18:09Tracking error is one thing. While you're tracking, you're managing three other things. Number one is, if you're gonna do different than the index, you wanna outperform. You want to leave money on the table. At times, we will do small deviations from the index where we see that we can recover value for our shareholders. Maybe there's a corporate action. Maybe you could take cash or shares. We're going to take the one that has the greater value. Maybe the index treatment's different than that. We believe we can add a little bit of value back. It's positive excess return for investors. The third one we're always thinking about is taxes.

18:43You don't want to pay a capital gain out of an index fund or an equity index fund. You're trying to always think about taxes. Maybe you do a tax harvest. Maybe you use the ETFs, creation and redemption mechanism, to balance your taxable gain situation. Finally, there's a hidden thing in indexing. When you buy a stock that's added to an index, that price might go up. You might have market impact. You hate to see the market go up because the indexers are buying it just to come back the next day. The index, you have zero tracking, you have zero value added or destroyed, yet the under-investor paid more for the stock than maybe they could have.

19:20I have a team globally that makes that tradeoff between those four things, excess return, market impact, taxes, and where you can, positive excess return. That's what goes into it, and I'm fortunate to have a team of 50 people who do that every day for us. One of the things you hear about a lot are the index rebalancing itself, new components coming in and going out. How do you think about that balance of tracking and value add when there's a change in the constituents? We think about it in a risk-adjusted way. For every fund here, we have expectations of tracking error. That's how we're judged.

19:54Number one is track the index. Something like a 500 index fund, we're going to see tracking error be no more than a couple basis points. It's typically less than one. We're not going to take a lot of risk there. You can imagine if Apple's number of shares in the index are changing because there's a buyback and we're having to sell some Apple, we're going to be largely on the close with that stock. We're not going to be able to take a position. Many investors are trading Apple. We have no ability to know where that's going. On the other side of it, in an international portfolio or global portfolio, maybe there's not the liquidity in the Philippines to help us with the ad.

20:34The risk is small. It's a large portfolio. The Filipino ad, it might be a small addition, might take us a week or two to buy the number of shares. On our trading desk, the portfolio manager and the trader, it's one job, one team. When you go to most investment managers, portfolio managers sit in an office, think great thoughts and what stocks are going to buy. The traders are doing the execution on trading desk. Most of our portfolios are not optimized. They're largely replication. The most important thing we can do is think about that trade execution. How we do those things matters a lot more than what we're owning because we're going to own them all.

21:12What are some of the other ways you try to add value to returns? We look for places where there's an asynchronous return, where there's more upside than downside. That's our basic role. We don't do a lot of it. An example would be when a company brings a secondary offering to the market. They're selling new shares and raising money. We would participate in that. Statistically, we've seen that we can buy it from the bank at the time of offer. And by the time it's added to the index, we've usually bought it at a lower price than when it's added. Do we win on every one of those? No. We take a risk-controlled way.

21:46We think about that corporate actions or another, how we elect to take when maybe two companies are merging together, how we get through there to the end result. There might be two paths. You might be able to keep the shares you have and it turns into the new company. You might be able to sell in the market and use your cash to buy another company. We're always looking for places like that where we might be able to add some value. One of the ways we add some value is with regard to the securities lending program. In securities lending, if someone wants to borrow one of our securities, they're willing to pay for it.

22:18Maybe a hedge fund wants to put a short position on. We lend out what we call specials. Specials are ones that have a high rate paid to the person giving the lend out. We will lend those out for a fee. That money flows back into the fund as positive excess return. 95 % of the money made in the program goes back to the fund. The 5 % of it is kept to run the program. We think that's a good way. Once you own the portfolio, how do you think about the value creation of the market itself? Governance is all about companies that are well-run to do well over a long period of time. We have a stewardship team internal to Vanguard, and that stewardship team has always thought about making sure the company is well-run.

23:06We want to board our directors capable of overseeing the strategy of the company. We want a board of directors who is going to make sure the company gives investors information, make sure that you can see the financial returns, the risks that the company's talking, so investors can make great decisions. We want to make sure that the executive compensation is aligned with long-term shareholder value. We want to make sure that the executives are paid when the company does well. Finally, we want to make sure that the board of directors is thinking about shareholder rights. Our rights are protected as an owner so that we have the ability to have the vote.

23:45We stay away from things like telling the company what business to be in or how to operate their business. We're more about making sure we get good governance over a long period of time. We've introduced investor choice. Investor choices allow the shareholders of our funds to express a point of view around how they want the companies in our portfolios to be run. For that, we think about returning the vote to them and they can choose one of five policy portfolios. They could decide to vote with management. They could decide to use Vanguard stewardship. They might have an ESG point of view. If you want to take a point of view on how companies should be run, you make that choice.

24:25We've never made that choice other than to make sure the board is well-governed and well-running. We're going to take a quick break in the action to tell you about Ridgeline. Imagine starting your day with reconciliation already done. No spreadsheets, no breaks to chase, no duct tape holding systems together. Ridgeline is the first front-to-back system of record built for investment managers. One platform, one real-time data set. Embedded AI. Investment firms are replacing a patchwork of isolated and data order management systems, accounting systems, reporting add-ons, and client tools with this fundamentally new operating model.

25:03automating complex workflows, scaling personalized client experiences, and unlocking the full value of AI. If this is the year your firm is ready to modernize operations and harness AI, you can learn more at ridgeline.ai. And now back to the interview. What are some of the subtle ways that you found that Vanguard's implementation is excellent that maybe some of your competitors or some other people wouldn't necessarily understand. Number one is this portfolio manager trader is one person or one team. It's the ability to instantaneously make the trade-off between I could trade something exactly like the index, I think I might be able to add value.