George U. “Gus” Sauter will retire the end of this year after 25 years with Vanguard Funds. In Part 1 of our Q&A on Monday, Sauter reviewed execution standards. Today, he discusses his views of market makers and specialists and how the Vanguard trading desk works. {IMGCAP(1)]
Traders Magazine: Is it fair to say that, over the years, you have been a critic of market makers and specialists?
Gus Sauter: No, they perform a valuable function. But the structure today makes it a much more fairer game than it used to be. Let’s say if we’re trading a very liquid stock, say Exxon-Mobil, typically we can find the other side, the other natural side, in electronic exchange and we don’t need any intermediary to create a market for us. In that situation we don’t want to pay for someone to create a market when there’s no need for it.
Traders Magazine: But that doesn’t happen every time
Gus Sauter: Clearly, there are times when we need someone to provide liquidity for us and market makers and specialists have a useful function.
Traders Magazine: However, the ability to choose has changed?
Gus Sauter: I think 20 years ago, you really didn’t have much of an opportunity to get inside the spread of an OTC stock. Now you can get certainly get inside that spread when there’s liquidity. I think the way the structure of the market has evolved has been very beneficial to investors.
Traders Magazine: Still, even as late as this past summer, you and your company were opposing calls on the Big Board for market maker incentives
Gus Sauter: Yes, we view that as very much like paying for distribution. We like to think that market makers will create the best markets without being paid to create that best market; that it is within their own interests to do it.
Traders Magazine: What if market makers can’t make a profit on a level of spreads…
Gus Sauter: Then widen the spreads. There are some stocks and some ETFs where, if there’s not enough liquidity, maybe society is saying we don’t need this product. Our view is that it shouldn’t really be allowed to live on life support forever.
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Traders Magazine: Back in 2004, in a comment letter to the SEC, you called limit orders the backbone of a liquid market.
Gus Sauter: Limit orders do make the market.
Traders Magazine:And market orders?
Gus Sauter: Market orders take liquidity out of the market. Limit orders create liquidity. And 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.
Traders Magazine: How?
Gus Sauter: Ideally, what we would like to do as investors or traders, is to be able to trade as much of a stock or a security at the current price. To do that you need almost bottomless liquidity. And that is provided by limit orders.
Traders Magazine: Could we discuss how you desk works?
Gus Sauter: We have about 12 people here in the United States and we have additional people who are trading for us in London and Melbourne, Australia.
Traders Magazine: So how do people trade?
Gus Sauter: 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.
Traders Magazine: Why do you use this kind of system?
Gus Sauter: The reason for it is a large part of running an index fund is driven by a computer program. Another major piece is determining how to trade when the computer wants you to trade.
Traders Magazine: And so?
Gus Sauter: The portfolio manager 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 hand it off to someone, risking losing some slippage.
Traders Magazine: How do you characterize these people?
Gus Sauter: They are portfolio managers who also trade.
Traders Magazine: You, Mr. Sauter, are overseeing this. But as a CIO, you’re not trading or predicting markets. You’re a different kind of CIO.
Gus Sauter: Yes, I’m just kind of an orchestra leader. I have a risk management area in watching over things and being sure that everything is being well executed.
Traders Magazine: If you could summarize your trading philosophy what would you say?
Gus Sauter: I would say keeping control of your trades; 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. Look to trade stocks appropriately for the environment you’re in.
Traders Magazine: And appropriately means?
Gus Sauter: That means that something that’s running away from you have to trade very differently from something that is coming at you.
Please stayed tuned for Part 3, which will be published next week, when Sauter discusses how Vanguard finds its brokers.
