In 1987, George U. “Gus” Sauter was an obscure investment trust officer with little trading experience. He had just joined the crew of an investment company with a piddling $1 billion in assets under management.
Twenty-five years later, the Vanguard Funds have $1.6 trillion in assets. It’s the largest mutual fund complex extant, surpassing Fidelity Investments two years ago.
Sauter is about to leave his post as its chief investment officer, which he took in 2003. In the quarter century he’s been with Vanguard, the trading industry’s market structure has dramatically changed. Where 300 million shares used to be traded on three national exchanges each day, 4 billion a day get traded now, on 10. More than half of trading is automated. Roughly 40 dark pools and alternate trading systems now operate. And the cost of a trade has, in the last decade alone, fallen by 70 percent.
That’s where Sauter, with the support of his fanatically cost-conscious employer, has been a driver of the change.
In filings with the Securities and Exchange Commission and in public comments, he has consistently argued for publicly displayed markets in which investors can see the costs of their orders.
He also believes that limit orders, unlike market orders, expand liquidity. He has held to these principles so consistently over the years that some in the industry have taken to calling him “Mr. Limit Order.”
“I don’t have any objection to that. I believe limit orders do make the market,” said Sauter, who will leave his CIO position at the end of the year.
Cutting Costs
Displayed limit orders, Sauter said, drive down costs by allowing asset managers to put a ceiling or floor on the price they will pay in a transaction. The use of thresholds limits financial risks, and as a result, more orders come to rest in the market.
The expanded order book creates more liquid markets, almost by definition, and provides reassurance to investors that they will obtain better prices on the execution of their trades.
Limit orders, in effect, beget more limit orders. As a corollary, the liquidity creates more liquidity. And the increased competition for orders leads … to more orders.
“If you are an investor who wants to trade immediately, you have a great option that has been granted to you by that limit order. You know you can trade against that limit order. So that is a good service that has been provided to you. And that’s why I think we need to entice the creation of limit orders,” Sauter said.
The byproduct? Lower costs.
“Competition among limit orders creates narrower spreads and additional depth of book, both of which contribute to a reduction in transaction costs for all investors,” Sauter wrote in an April 2010 comment letter to the SEC.
Limit orders are critical in keeping transaction costs under control, Sauter contends, for several reasons: They can protect orders from the danger posed by brokers front-running their customers’ orders or, more straightforwardly, from the market moving against the direction in which orders are placed.
“The flash crash,” Sauter explained, “was a perfect example. If you had placed market orders, you could have been dragged all over the place. If you had limit orders, you were safe.”
To that point, only investors who had placed market orders would have ended up with penny transactions on the “stub quotes” in Procter & Gamble or Accenture. Limit orders would have kept their users near the going market price, when the Dow Jones Industrial Average plunged 600 points in a matter of minutes and liquidity effectively left the market.
Limit orders, along with several market structure changes over the last 20 years including changes in order-handling rules and the passage of Regulation National Market System, have dramatically reduced transaction costs, he says.
How?
Requiring orders to seek the best prices across all national markets created more competition. Pure and simple. This has produced intense combat between exchanges for business. And it brought in new trading venues that have won market share by lowering fees and offering rebates on the commissions paid to brokers, to attract business. And liquidity.
“Vanguard and its investors have benefited from the competition that today’s market structure facilitates,” Sauter said.
How much?
Vanguard points to the work of David Xiao, formerly with Citi Global Portfolio Trading Strategies.
For a $1 billion basket of Standard & Poor’s 500 stocks, Xiao found that the cost of trading a share of stock fell 70.5 percent, from 1999 to 2009, because of such competition.
Spreads equated to a fee of 70 basis points on each share of stock traded in 1999 and just 3.5 basis points in 2009. The liquidity cost, or the impact on the price of putting an order into a market and seeing the price move away from the original target, equated to a cost of 42 basis points in 1999 and 29.5 points in 2009.
Taking Control
“I think the way the structure of the market has evolved has been very beneficial to investors,” Sauter said.
The reforms may have accelerated the lowering of costs. But Vanguard’s approach to mutual funds was to avoid “active” management of funds and instead simply put stocks in funds according to an index. That basic principle lowered the amount of churn in a portfolio and the average cost of a trade.
But Vanguard also took more control of orders, as a means of lowering cost. Enter Mr. Limit Order. By protecting customers and protecting portfolios with limits on the prices they paid for shares, he lessened, in effect, the “slippage” in the price that got paid.
Sauter said that the trade-through rule helped. Rule 611, a part of Reg NMS formally known as the Order Protection Rule, requires brokers to compares quotes on multiple exchanges. This ensures that institutional and retail investors get the best possible price for a given trade.
Also becoming more cost-conscious were investors themselves, in the wake of the credit crisis that erupted in September 2008. If investors couldn’t profit from stocks, they at least wanted to limit their losses, and pay less in the process of overhauling their investments in shares or moving out of shares altogether.
But much of this cost-lowering has been result of the giant investment company relentlessly lobbying regulators and industry players.
Vanguard, for example, successfully advocated to retain the trade-through rule during the Reg NMS debate, forcing traders to find the best prices for investors. The rule has also forced more trading venues to provide more displayed liquidity, Sauter believes. And he has also pushed to lessen the role of specialists and market makers, saying asset managers should be able to handle trades between themselves directly.
The Vanguard institutional desk, he said, is run on the premise that portfolio managers should handle their own trades as much as possible. (Separately, Vanguard also has a brokerage unit to handle retail orders. See sidebar: “How Do the Vanguard’s Different Desks Function?”)
“We combine the trading and portfolio management functions together in our index funds. So if you’re managing an index fund for us, you’re doing the portfolio management and then also trading it,” he explained.
Typical of this advocacy was a Sauter comment letter to the SEC seven years ago, challenging the specialist/market maker system.
“Why can’t we just do it ourselves?” he asked. Indeed, at his company, portfolio managers not only pick the stocks, but also help execute the trades.
Sauter contends that Vanguard’s portfolio managers, who also have the ability to trade, should be allowed to do it themselves because they can often find the other side of a trade. So these managers also trade work with low-cost brokers or brokers who carry out other parts of their agenda.
They also oversee a group of agency brokerages, such as ITG, that will give them low costs. Besides cheap executions, Vanguard also expects these brokers to provide opportunities to get shares in initial public offerings and to maintain a willingness to commit capital for trades, Sauter said.
Today, he believes specialists and market makers, while sometimes needed, can be used much less frequently because of various market structure reforms. And that, he said, is a reason his transaction costs have dropped steadily over 20 years.
“We really don’t like turning our trades over to a broker for discretion or any other market maker to the extent we don’t have to. We have always wanted to keep our trades as anonymous as possible,” Sauter said. But he still relies on his brokers for some things.
Sauter uses the algos of his brokerages and will also sometimes use dark pools. Vanguard will also sometimes record internal crosses. “If one fund is a natural seller of a security and another is a natural buyer, we cross those trades,” he said.
He said keeping control of trades is the key to his trading philosophy: “Always be cautious and mindful that there are people out there who would love to know what you’re up to. Always remain anonymous by using limit orders.”
Apparently, this reliance on anonymity is a widely held buyside sentiment. Indeed, 81 percent of 103 equity fund managers surveyed by Greenwich Associates described anonymity as a “very important” attribute.
The reason for this kind of trading system, Sauter said, is that a large part of running an index fund is allowing trading to be run by a computer program. Another major piece is determining how to trade and when the system actually wants you to trade. These are judgments, he said, best made by his managers.
The portfolio manager, Sauter said, “is figuring out the best way to trade something, so it just made sense for us for a portfolio manager to trade it instead of handing it off to someone, risking losing some slippage.”
Trading Conductor
So Sauter is overseeing portfolio managers who also trade. “I’m just kind of an orchestra leader,” he said.
For him, Vanguard’s trading conductor, that has meant finding tools for his managers, such as working dark pools and using trading strategies embodied in algorithms. These tools ensure costs are as close to nothing as possible. That in turn leads to limit orders, Sauter said.
Ultimately, he believes limit orders protect against excessive transaction costs. High transaction costs are a drag on performance in a time when good long-term performance is difficult to obtain. The problem, he said, is that many in the industry are not sensitive to costs.
The recent five-year return on the Standard & Poor’s 500 is 1.25 percent a year, and the 10-year number is a so-so 6.92 percent, according to fund evaluation service Morningstar.
When returns are 6.92 percent, costs may not matter that much. But when they’re 1.25 percent a year, they certainly do.
“Historically, people have never had respect for the magnitude of transaction costs,” Sauter said.
Indeed, back in the halcyon days of the late 1990s, he added, there was a greater tolerance of transaction costs. That’s when the market was rolling along with five straight years of 20 percent returns.
It was also a golden age for the fund industry. It was a period when investors couldn’t pour dollars into equity funds fast enough. They also generally shunned bond funds. That is the reverse of last few years.
Sauter warns that the problem of transaction costs today is a performance drag that is often not fully understood. One constant, he cautioned, is they are almost always a higher cost than many fund companies think.
That’s because transactions costs are not always measurable. Market impact costs can’t always be measured, he said.
Sauter believes most fund companies don’t have the extensive in-house tools to measure the damage they do. Even demanding clients have difficulty exactly figuring out transaction costs, he said.
The exact trading costs, Sauter said, aren’t included in a fund’s expense ratio, prospectus or even the statement of additional information.
Low-cost investing, a concept once ridiculed, has led Vanguard Funds to the top rank in investment fund companies.
Back in 2005, when Sauter testified before Congress, Vanguard’s assets were $600 billion. Seven years later, in a period when many fund companies have lost assets, Vanguard’s assets have risen to 166 percent to $1.6 trillion, according to Morningstar.
When Sauter came aboard and assets were just $1 billion, he developed a quantitative model to actually manage equities at the bank. Vanguard was looking for someone to build out its quantitative capabilities, both in indexing and active quantitative equity.
“We had one person in the department. And I was the second, and I was brought in to run the department. We had a trader, and I was basically in charge of building that business,” Sauter said.
Sauter, named Vanguard’s first chief investment officer in 2003, is possibly the most unique CIO in the business. That’s because he doesn’t pick stocks. He doesn’t predict the economy.
His job is to create index products and ensure those products are tracking indices accurately. He also verifies that those funds obtain dirt-cheap executions, since the lowest costs are the essential element of every Vanguard fund.
Vanguard equity funds have an average expense ratio of 0.23 percent compared with an industry stock fund average of 1.25 percent, according to fund evaluation service Lipper Inc.
The need to keep those average costs as low as possible, and to ensure that Vanguard retains a cost advantage, is why Sauter is vitally interested in market structure issues and an advocate of the benefits of limit orders, which are essential to low-cost investing.
Reeling in the costs of transactions, in fact, is the strategy he contends put Vanguard at the top of the fund business.
“The future of low-expense funds,” said Mr. Limit Order, “is bright.”
SIDEBARS
How Do Vanguard’s Different Desks Function?
CIO Gus Sauter explains how Vanguard’s two trading operations work, in this Q&A with Traders Magazine.
Traders Magazine: Can you describe the division of labor between your trading unit and the brokerage unit?
Gus Sauter: They’re totally independent. The brokerage unit takes on retail orders. These are individual clients who use us for their brokerage needs, and that group is in the unit that runs our retail investor group.
Traders Magazine: But I remember when your brokerage desk for your retail customers announced a few years ago that it was going to self-clearing. Vanguard officials said it was about more than saving; it was about control over the trade.
Gus Sauter: Yes, that brokerage is for the individual investor. We actually don’t trade through that business in our money management efforts.
Traders Magazine: But it’s still the same idea?
Gus Sauter: Yes, self-clearing was to control quality and to keep costs low for our investors.
Traders Magazine: And what do you do on the institutional money management side?
Gus Sauter: We interact directly with institutional traders. We deal directly with the street and go directly to exchanges. So we don’t use Vanguard Brokerages Services.
Traders Magazine: So 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 that will 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 lowest 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? So we weigh 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 that 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 brokerages. 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 those 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.
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