#11 - Fran Kinniry: Vanguard, Common Investor Oversights

0:06Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, one of the nation's leading investment advisory firms. Learn more about our show at insightfulinvestor.org.

0:43I'm excited about today's episode. We have Fran Canairi here from Vanguard. Fran, thanks for joining me. Pleasure to be here, Alex. Thanks so much for having me. My pleasure. Fran, you've been at Vanguard for 26 years, and currently you're the principal and head of Vanguard Investment Advisory Research Center. I know previously you were global head of private investments, and then also before that, global head of portfolio construction. So I'm really looking forward to our conversation today. Thank you very much. Me too. Why don't we just kick it off with your background and what led you to Vanguard?

1:23Sure. As early as I can remember, Alex, I was interested in investing, which is unusual because my family doesn't really have a deep history. My mom was a medical research scientist, and my dad was a school teacher. but just got in got the bug in high school and that led me to drexel university drexel was one of the few colleges that had a co-op program and within a track of portfolio management a lot of finance schools were classical finance and and they had a portfolio management track so i went to drexel and it's a five-year program with the co-op and just really loved everything there graduated six months after the 87 crash so jobs in investment you know wall street type jobs were hard to come by so i had to take a little detour and did distressed lending for two years while going to business school and so that was a great experience because you know doing distressed lending is a lot of forensic accounting really understanding the balance sheet the income statement and going to business school at night.

2:30Markets had settled down. My goal was to find a way back to the asset management business. And after getting my business graduate degree, I ended up at a multi-family office, executive investment advisors, the billion dollars under management, three founders, all CFAs, left Wall Street and started their own advisory experience. So I had a great, great time there, six years. And as we see today, the industry going through aggregation, integration, and roll-ups, they ended up going through a roll-up. And I had about a year to decide if I was going to stay at the new firm, but it would require a move to the Midwest.

3:16But I had a year to kind of explore what I wanted to do and just was so lucky that I I happened to see a job opening in Vanguard's personal advisory services. They were just starting advice at the time. Vanguard was a direct investor up until that point, and they were entering into the advice business. So I was able to get in on the ground floor of that. So Vanguard is quickly approaching its 50-year anniversary, which is pretty remarkable. And I've personally always been a fan of Vanguard because it is hyper-focused on doing what's best for clients. and it actually has a unique structure in terms of the way it runs its business.

3:58It distributes profits to clients in the form of lower fees, which is pretty unique. Would you talk to us about the Vanguard story and how it has evolved over the last half century? Yeah, thank you for the kind words. It is very unique. And sometimes the best way to describe it is some people are familiar with a insurance a mutual insurance company where the policy owners own the economics of the firm. And so Jack Vogel, after being at Wellington for most of his career, he wanted to start an organization that was kind of owned by its investors. And what that means is there's many ways you can set up your firm.

4:42You can be a private partnership where the partners share in the economics. You can be a public entity where you have public shareholders. Vanguard was set up to be owned by its investors. And I think what that really does is it aligns incentives to the client. Vanguard is client-focused, client-centric, because the clients are our owners. We're not trying to juggle many counterparties and stakeholders in that equation. And it's been an unbelievable recipe starting out almost 50 years ago at zero and coming in on approaching$9 trillion. Yeah, that's amazing. Vanguard is a pioneer in the industry.

5:27And$9 trillion, that's an insane amount of dollars. And I believe that's been attracted or Vanguard has attracted that capital because it is so focused on doing what's best for clients and for investors, which I think is unfortunately unique in our industry. Would you talk about some of the core tenants of the firm? Yeah, I think that's exactly right, Alex, as you described it. And I think the investing public is pretty smart. They're well-educated. And they end up following eventually to where they feel they're well-served. And so firms like yourself, Adivo, and Vanguard, I think the gravitation of sophistication will find the right home.

6:13And so our core tenet, our mission is pretty simple. And it's take a stand for all investors and give them the best chance of investment success. And so everything we do there is laser focused on what are the best things we can do to generate client outcomes for our investors. And I think that's the reason why we've grown from zero to nine trillion dollars. And a lot of that growth actually has been in the last 25 years. So I joined in 97 and 300 billion is a lot, you know, zero to 300 billion in our first 25 years. But 300 billion to nine children in the last 25 years is just incredible. A big credit to, you know, Jack Bogle founded Vanguard, but his successors, Jack Brennan, Bill McNabb and Tim Buckley, they all planted the seeds to really democratize Vanguard.

7:08Vanguard was at$300 billion large, but certainly many of the things that allowed Vanguard to be scalable were started by Jack Brennan, Bill McNabb, and Tim Buckley. I think a lot of people feel or I guess incorrectly believe that Vanguard is just an index provider. You do so much more than that. As you mentioned, the focus is on net outcomes for investors, thinking of the fees, thinking of taxes and other expenses. Would you talk about the expansion of Vanguard over the years into a lot of different areas besides just index investing? Yeah, well, it is a good point because I think our brand, if you were to do a brand survey or ask the average person on the street, they would say indexing or low cost.

7:58but history be told, Vanguard started as an actively managed shop. Indexing came later, and we're still one of the largest actively managed shops in the world. We have one point, of that$9 trillion,$1.6 trillion is in active investments, both on the equity side, the taxable fixed income side, the tax-exempt fixed income side in money markets. And so You mentioned earlier in my bio about private equity. I helped Vanguard launch private equity. And so that's not low cost, right? So we really think the narrative has to get changed back to net outcomes. And what I mean by that is if you find an asset class or a manager, but that manager is only willing to work for 80 basis points or that manager is only willing to work for 150 basis points and 18 % carry, but you believe that net of all of those fees, it adds to client outcomes, that's something we'll do every day.

9:04And so I think the low cost has gotten a little bit hijacked. And what I mean by that is now you're seeing what are known as lost leaders, where competitors are having low costs where Vanguard is, but leaving the rest of their portfolio at a medium to high cost. You're also seeing a lot of what we call freemium, right? Many of your listeners will know what a freemium is, is you give it away, you get them on the platform. So you give it away for free, for zero. And then you look to monetize the client elsewhere. And so I think this definition of low cost has to really come with context. And that is really that costs are important, but it's only one part of the equation.

9:46You have gross outcomes, like gross outcomes, less costs equal net outcomes. And I think the conversation now has to go back to net outcomes because when I look at cash flow, the last 15 years, 100 % of cash flow has been into the lowest cost quartile. And so people are just not even given any consideration to high outcome active strategies that actually would have positive net outcomes. It's just everything is just being sorted on the lowest cost. Yeah. And sometimes higher cost is worth it because you're getting something that you can't get with lower cost. That's the whole point, right? Exactly.

10:30Exactly. And you have to ask yourself, why would someone give something away for free? That's not normally a business model or a P &L that's sustainable. So you have to kind of ask yourself a question if someone is giving something away for free, or they may have three or four portfolios that are lower in cost, but the rest of the book is higher in cost. Again, back to incentives, is that a partnership you want to partner with? Or do you understand that they're just maybe luring you into a low cost situation to monetize you elsewhere? In terms of active management. What's your perspective on that area in terms of trying to outperform the index?

11:12And what do you believe contributes to reliable outperformance over time? Yeah, we've been studying the active passive performance derby for my entire career here. And we know most of, you know, SPIVA does a great job with it, Morningstar and others. I think the challenge is that people don't complete the whole story. And what I mean by that is, obviously, we believe in zero-sum game. It's hard to refute zero-sum game, meaning that for every buyer, there's a seller. So if I want to sell large growth or Apple, I have to find a counterparty. So I'm disposing of the asset. They're taking the asset on.

11:54net friction, by definition, you know that more than 50 % of managers are going to underperform. And so that evidence is pretty clear. It's well known. Spiva just came out with their results. You know, it's typically 60 to 80 % of managers underperform. And that should be known because of zero sum gain. The question is, is there similarities or commonalities that occur in that 20 % that do outperform. And there we actually see that there are. If you have low cost and you're active and you have talent and you're active, you actually see that you have a good chance to do well. So two things can be true.

12:35It can be true that 80 % of active managers fail to beat the index, but 20%, there is a subgroup that is pretty persistent and pretty pervasive if you look at five-year, 10-year, 15-year performance that can do well. And so I mentioned Vanguard's$1.6 trillion of active. Our funds collectively have added excess returns. And not just to their peer group. We could say we have an advantage to our peer group because of low cost. But our funds collectively have outperformed the friction-free index that their benchmark do. So our funds, not everyone, but when we put them all together, Our equity funds have added between 30 and 50 basis points and our fixed income funds between 20 and 30 basis points.

13:21And that's on the combination of world-class talent and low costs. And I think if you keep those things in mind, world-class talent and low cost, it gives you a higher probability of being on that right side of zero-sum game. Yeah, that makes sense. And also your scale obviously helps with the low-cost side of that equation. Yeah, that's exactly right. So an active manager would want to work with Vanguard. So I'd say a couple of things. One, we get access to the greatest active managers in the world. They want to work with Vanguard. They see that we have 50 million clients,$9 trillion to get to be a Vanguard manager.

14:01That's certainly a really good brand enhancer for, let's say, a Bailey Gifford or a Prime Cap or a Wellington. And then they also know our scale. So they priced their offer to us as if we were a sovereign wealth fund, not selling it to retail investors. So I think that's one of the biggest histories of Vanguard is democratizing access for the average investor. We're able to bring world-class investing to the average common person that would not have access if Vanguard didn't exist. Yeah. And that obviously helps contribute to your continued growth, as you mentioned, faster growth, the second half of your life, the last 25 years versus the first half.

14:48So basically taking advantage of that scale to benefit clients with lower fees and more active areas. Yeah, I mean, it is quite a flywheel effect, right? You serve your clients really well with the performance of the funds. You wrap them with either great advice that we do internally or partner with firms like yourself, Alex, where we're helping work with advisors to deliver world-class advice, service, and that leads to retention and growth. And the flywheel just turns a little bit faster. How does Vanguard decide what to pursue from a product perspective? Yeah, I think one thing maybe not as well known is what Vanguard's product development is mostly democratizing institutional offers or offers that really have served the test of time, but then bring them down, democratizing them for retail.

15:43And what I mean by that is some may not know that Vanguard, we get credited for inventing the index fund, but we did not. Indexing was available pre-Vanguard, pre-Jack Bogle, but it was an institutional mandate. You had to have hundreds of millions of dollars. It was a separately managed account. So what Vanguard has done historically is take the best of investment solutions and retailize them or democratize them. So a long history of taking proven institutional investments that have worked, but weren't really able to be scaled down markets. So I would say that's the first and most important thing that we've done.

16:26And our history shows that even access to world-class active managers that if you wanted to go, let's say, some$100 million, you would not get access to those same mandates. And so it's this, we really think about how do we take what is working really, really well and democratize or retailize that for the average investor. And when you say democratize, I think you're talking about attractive fees. You're talking about access. And also there's an education component to make the average retail investor aware of these offerings. Is that right? That's right. I would add one more to it, and that was really just what is the minimum required investment.

17:12A lot of these offerings pre-Vanguard, the minimum required investment could be a couple hundred million dollars. And now all of a sudden, a teacher or a nurse or a regular investor is on the same level playing ground as a large pension or endowment and foundation with the right education, the right manager, and the right fee point. Yeah, that's great. So Fran, I've been really looking forward to this conversation because one of my main goals for this podcast is to share observations about common oversights that I've seen from clients, investors, even financial advisors. And I'm focused on finding ways to kind of bring some of these oversights to light and to help improve outcomes for all these parties.

18:06And I feel that you, because of your role at Vanguard, have a unique perspective into the way clients think, investors think, the way financial advisors think. And also on the academic side, you have statistical evidence of what reality is. And sometimes there's a big gap between all of that. So I'd like to kind of delve into some of the topics that I think would be helpful for advisors and for investors. And why don't we start with just your perspective about this world of investing and how unique it is relative to other industries and how a lot of it can be very counterintuitive. Yeah, we've probably done a whole 25-year library of myths and misconceptions, Alex.

18:51I would say there's probably much less known about the investment markets than known. Fortunately, I think we're on the side of not knowing the future, and we live in that world of being comfortable of not knowing the future. But there are so many different myths out there and how things work. I'll give you a couple examples. One is this definition or debate or even fight over market efficiency. Like, are the markets efficient, yes or no? And are they semi-efficient or strong efficient? And I think that gets lost when I ask most people what they even mean by market efficiency. So the debate rages, yet they can't even define what market efficiency is.

19:39And so maybe I'll just start there with my own definition. And sometimes I think it helps to have analogies because it takes it out of the capital markets. But the capital markets trade in an auction market and lots of buyers and lots of sellers with bid-ass friends. And so price moves to get buyers and sellers matched. If not, the price does not clear and sometimes price won't clear. Sometimes you could say the market, you know, stocks stopped trading because they couldn't find that balance. And so what market efficiency means is that there's lots of participants with informed information and transparent bid-ask spreads.

20:24And so what that means to me is that I know if I go buy the S &P 500 right now, we're going to get the right price, the price that's consensus price. That doesn't mean, and then you can have October of 87, where the market drops 19 % the next day, or even the next minute, because new information came in. And so the analogy I like to use, and I think it's worked most often, is think about stub-up. When I was growing up, if I wanted to go to a sporting event or a concert, I would walk around the stadium and try to buy from a scalper who was selling tickets. I had no price discovery. I had no transparency.

21:06I didn't know if that was a good price or a bad price. I had no idea because I didn't have comparables. Enter Stubham and you have an open auction market, lots of buyers and sellers. If I buy a seat in row 300, seats two and three, I kind of know based on supply and demand and what is the other inventory that's out there, is that a fair price? That doesn't mean if tomorrow a storm comes along, the whole market is going to price down. Or if it's turned out that the starting quarterback is not playing, the whole market price is down. So market efficiency to me is really about, are you buying it at second based on all the information and a consensus price that makes sense?

21:50It doesn't have anything to do with the case of will indexing or active work and people try to stretch it there. So that's one of the ones that I see is most misunderstood in the marketplace. The second would be around investor behavior. A lot of people call it irrational behavior. I actually think it's rational behavior. And what I mean by that is almost we did a whole study looking at consumer reports, trip advisors, top doctors, top universities. And what we see in almost every other field is persistence and durability. And what that means of persistence and durability is if you are the top quartile, doctor, hospital, or bottom quartile, you see very little regime switching.

22:39You don't see bottom quartile hospitals, doctors, crash tests moving to the first and vice versa. But in the capital markets, you see all kinds of random cyclicality and no patterns, right? Because I do know a lot of people think that it's better to just be contrarian or buy the worst performing asset class because it's undervalued. That doesn't work either. There's really no pattern that we see, right? People have been betting against this stock market for the last five years. They've been saying growth is overvalued, U.S. is overvalued, and they've gotten their heads handed to them because they think it's going to mean revert.

23:22And so eventually, trees don't grow to the sky, so you may have mean reversion, but there is no trading pattern. And we see a lot of people really getting harmed by believing patterns exist that do not exist. putting that all together is that what that means is doing your due diligence and information, unlike finding a doctor or a university, it doesn't have all that much value in the capital markets because of the cyclicality and the randomness and the amount of skill that we can't even say is skill. It might mostly be luck. That's one thing that I think is very different in the investment world versus the rest of the world, which is if you're a doctor and you don't have great skill, it'll be very obvious and you'll underperform persistently and eventually you'll be out of business.

24:11If you're picking stocks, that doesn't require any skill whatsoever. And there's a lot of randomness in the price because, as you mentioned, it's an efficient market. And not only do events that weren't expected to happen that happen that influence the price, but also expectations of what the future may hold influence the price. And that I think that's another unique aspect of this industry that makes it hard to consistently outperform because there is some randomness interjected in the price. Yeah, and quite a lot of randomness. I follow all of your work. You do great stuff, Alex. And I know you talk about the roulette wheel and how many spins of the roulette wheel and how the roulette wheel is.

24:57And you could get lucky for 20 spins, right? And most would probably think that that's skill. If you have 20 turns and every turn it comes up as the jackpot, and think about how many participants there are, right? One would argue that in how many people are in this field, there should be way more than one Warren Buffett just by sheer luck. You're probably familiar with Michael Nobison, but a big fan of his, and he has the success equation, and he talks about you can really determine skill versus luck if you can lose on purpose. And I actually think that's pretty insightful, right? you probably can't lose on purpose in the roulette wheel.

25:37You could get lucky 20 spins in a row. And so really, if you can lose on purpose, then that is probably like you talked about a doctor. You could actually lose on purpose as a doctor. You probably know how to have a bad outcome. And so you'd say high degree of skill, low luck. If you look about what is the skill luck ratio, I think keeping in mind, can you actually intentionally lose on purpose? If the answer is yes, it's probably a lot of skill. If you can't intentionally lose on purpose, then there's probably a lot more luck than most people believe. And I think the part about that that's really fascinating to me is if you ask the market participants how much is luck versus skill, and you ask them what their personal odds of outperforming in the future are, and you surveyed everybody, you get a lot more than 50%.

26:29Yeah, I think you would have binary answers. The ones who have done well would say skill. The ones that have done poor would say bad luck. That's right. And I guess there's also this perception that if I'm the average investor and I go hire a financial advisor, they should have more skill than me. And therefore, that translates into they should have a higher likelihood of outperforming in the future. Yeah, I think that's right. I think most financial advisors, though, would be well served working on areas of portfolio construction, goals and objectives, eliminating leakage like tax leakage, eliminating behavior leakage.

27:10Because I think the average advisor has so much going on with their clients. I'm not sure if they should be doing much around portfolio management and investment management, the average one, because it's hard enough for hedge funds and high frequency traders. And we work with some of the best managers in the world. And they have huge 300, 400 people teams, CFAs, PhDs, and they're able to squeak out 30 to 50 basis points. So now if I'm an advisor, right, and I have 200 clients or 100 clients, I'm trying to figure out their family dynamics, their goals and objectives. I just don't know if I'm on a level playing field as an advisor to make investment choices that are going to rival the professional asset management business.

27:58Yeah. And regardless of that perspective, which I agree with, that's generally not the case. My experience is clients expect the advisors to outperform. Many of the advisors think they can outperform, whether it's what you described earlier, that when they outperform its skill, when they underperform its bad luck, that's going to turn at some point. But from a behavioral standpoint, that's generally not the landscape that I've observed. Yeah, I do think it's changing, though, Alex. I mean, I think if you look at we opened up with case for indexing, if indexing outperforms, let's just say 70 or 80 percent, and then you add your advisor fee on that, let's just say it's 100 basis points.

28:38I would bet you 99.9 percent of advisors are not going to outperform by 100 basis points. So if you're saying your value proposition is you're going to outperform, I think you're setting your practice up for some pretty big risks. And so I do feel that the industry is moving to a more professionalized value proposition around wealth management, asset allocation, financial planning, and just letting the investments be more systematic, market cap weighted. If you want to do active, hire active managers to do bottom up for you and really try not to be the portfolio manager and the advisor all under one umbrella.

29:20Right. And obviously, the advisors can add a lot more besides just returns, which we'll get to in a second. Before we do that, would you just talk about your observations about how clients slash investors perceived investing and markets and the financial planning process and maybe some of the flaws that you've observed? Yeah, here again, I think there is a little bit of a disconnect because when you look at client surveys of what clients want from their advisor, performance isn't even in the top three or four positions that they list. They want service. They want communication. They want accessibility.

30:02They want their advisor to know about them and their family. And so they list what we call the human aspects a little bit more than the quantitative aspects, which is great to see. And it's probably because most clients coming to a new advisor has probably been with an advisor before and probably was not outperforming. So I think the clients understand and put value more in what I would call the service model, the wealth management, financial planning model. But the advisors, I think, are probably maybe a little bit still stuck to where they were investment manager, portfolio manager, and taking on more and more now.