How does Vanguard Funds,’ famous for Fred Mertz like trading economy, go about finding the lowest possible costs? The process is detailed in Part Three of Traders Magazine’s Q&A with Vanguard chief investment officer Gus Sauter.
Traders Magazine: Who are your brokers?
Gus Sauter: We use all of the wirehouses and all the big trading firms.
Traders Magazine: How do you find these brokers who presumably give you low-cost executions?
Gus Sauter: We start with a broad universe and we trade with a wide variety of different firms. While we are certainly looking for the low possible commissions, we are looking for some other advantages a broker might offer.
Traders Magazine: Such as?
Gus Sauter: What opportunities will they give us to participate in IPOs. How willing will they be to commit capital if we need them to commit capital for our trade. So we weigh off all our different needs and it turns out that no one broker has all of what we want.
Traders Magazine: So you’re using 40 or 50 brokers
Gus Sauter: Yes, but the bulk of it is concentrated in five or six brokers, but there’s a long tail.
Traders Magazine: You said in an interview that “a large part of indexing is actually being a trader.” Does mean that, as with most traders, you’re using algos and using agency traders like ITG or Instinet. How does it work out for Vanguard?
Gus Sauter: We do most of our trading through agency brokerage. We will use brokers’ algos as well if we think that is appropriate for trading. We monitor the transaction costs on a broker by broker basis.
Traders Magazine: So you’re playing one broker against another?
Gus Sauter: Yes, we determine which brokers are getting good executions with certain traders versus others.
Traders Magazine: Even index fund managers need the same trading skills as though who are actively managing funds?
Gus Sauter: Yes, it really is important that our portfolio managers understand how to trade, how to execute, how to find the right strategies and venues. Should it be an algo or something they are using a dark pool.
Traders Magazine: Does Vanguard develop its own trading software or does it use vendor or broker supplied technology?
Gus Sauter: We use broker supplied technology. So we have access to the exchanges through our brokers. We are not high frequency traders but we have the same tools.
Traders Magazine: Which means?
Gus Sauter: We have immediate access to the exchanges through our brokers, through their systems. And we use their algos. We haven’t designed our own.
Traders Magazine: Do you do internal crosses?
Gus Sauter: Yes, if one fund is a natural seller of a security and another is a natural buyer, we cross those trades.
Traders Magazine: A lot?
Gus Sauter: Not a lot. We are very fortunate because a significant portion of our trading is cash flow into the fund. So we aren’t doing much selling.
Traders Magazine: But what about when you’re rebalancing?
Gus Sauter: Typically we’re doing that once a quarter. And when that happens, when one index fund is buying and another is selling, then we do get a lot of good crossing.
Traders Magazine: Why have you and your company launched this campaign to change what you perceive as an overpriced market structure?
Gus Sauter: I think transaction costs are surprisingly high.
Traders Magazine: Higher than most investors think?
Gus Sauter: Yes, a lot of people don’t realize how much money you could spend on transactions if you’re not careful. In other words, we trade hundreds of billions of dollars a year. If you lose , just a half a percent, you’re losing a billion dollars.
Traders Magazine: The implication of what you’re saying is the industry, especially in good times, is incredibly sloppy. Is it because it is other people’s money?
Gus Sauter: Yea, hard for me to tell you. Historically, people have never had respect for the magnitude of transaction costs. They really felt they provided so much alpha in their actively managed funds that they really didn’t have to worry about transaction costs.
Traders Magazine: Not over the past decade…
Gus Sauter: Yes, in a lower return environment people really recognize how much costs are. And they are devoting more time to how they trade.
Traders Magazine: How do you trade small caps when there is limited liquidity?
Gus Sauter: Use limit orders
Traders Magazine; Why?
Gus Sauter: When you have ill-liquid segments of the market, and you don’t use limit orders, it can really run on you just as we saw in the Flash Crash. You’ll add significant greater market impact if you’re not careful in that segment of the market.
Traders Magazine: Anything else?
Gus Sauter: Trying to remain anonymous is very important. If people see you coming, your trade will get a lot more expensive. And probably taking control of your trade as opposed to handing it off is a way to minimize costs.
Traders Magazine: Did the Flash Crash prove the need for circuit breakers?
Gus Sauter: Yes, that was the one thing missing in Reg NMS. In the old days, when the market was dominated by specialists and markets makers, if things got crazy, if there was an order imbalance, the market would just halt. The specialists would just say “time out. We’re halting trading.
Traders Magazine: And you’re saying there was no provision for that in Reg NMS…
Gus Sauter: Now you have stocks trading on multiple exchanges so there was nothing to halt the whole process. So when the order balance happened on that day (the day of the Flash Crash), there was no one there to stop it. I think the circuit breakers are effective in doing that. I think the proposal limit up, limit down, that the SEC is considering, would be even more effective than the circuit breakers.
Traders Magazine: So limit up, limit down would be an effective replacement for the circuit breakers?
Gus Sauter: Yes.
