CAHPTER 7

ACTIVE INVESTING

Vanguard is committed to encouraging investors to recognize the importance of developing a long-term investment plan and staying with that plan. Vanguard is deliberately conservative about investing and regularly warns investors about paying too much attention to short-run market movements. These tenets are consistent with its dedication to keeping costs low without sacrificing value, quality, or performance.

Seldom does one person, particularly one who is not the founder or the CEO, make the decisive difference in the crucial early decade of a major company, but John Neff certainly did. Without Neff in those difficult early years, Vanguard would not have attracted the favorable attention of savvy investors who moved their money to get access to Neff’s remarkable ability to outperform the market averages—and recommended that their family, friends, and business associates do the same.

Over 31 years, from year-end 1964 through year-end 1995, Neff’s Windsor Fund beat the market 22 times. Each dollar invested in 1964 multiplied over 55 times. Windsor’s total return outpaced the S&P 500 index by more than 2 to 1—$10,000 invested with Neff would have compounded over those years to $564,637. What made his “best in the business” performance so noteworthy was that Neff’s consistent priority was not only to achieve gains, but always to avoid loss and manage risk. On a risk-adjusted basis, his performance achievement was even more remarkable.

As the money poured into Windsor Fund, its assets and earnings surged. For fledgling Vanguard, those earnings were like mother’s milk—vital to living and gaining strength. That’s not all: investors attracted by Neff’s Windsor Fund also noticed Vanguard’s other offerings, particularly its low-cost money market and bond funds. Investors initially attracted by Vanguard’s low fees on its fixed-income products saw Neff’s record and often added an equity investment in Windsor Fund.

John Neff was born on September 19, 1931. His mother and father divorced when he was 4, and he would not see his father again for 14 years. John and his mother moved in with her parents in Grand Rapids, Michigan. Young John was an independent thinker determined to hold to an opinion; on his first-grade report card he was cited as “pugnacious.” His mother claimed he would “argue with a signpost.” In fifth grade, he got a demerit for “poor self-control.” His self-confidence flourished alongside his inclination to flout convention. From age 11, John earned all his own spending money. In the summer of 1944, at 12, he caddied days and delivered newspapers nights to earn $40 a week (over $600 today).¹

After two years as a Navy seaman without ever stepping on board a ship, Neff mustered out and went to the University of Toledo on the GI Bill. As he recalled, “An inventory of my skills on entering college revealed a relentless curiosity, facility with numbers, an ability to express myself and firm discipline. Although I finished high school awash in ordinary grades, college became a lark. My grades rarely fell below A, and I was graduated summa cum laude.”

At Toledo, Neff met professor Sydney Robbins, a disciple of Benjamin Graham and David Dodd, whose book, titled Security Analysis but widely and reverently called “Graham and Dodd,” became the bible of the emerging profession of investment research and management. During two courses with Robbins and with his strong encouragement, Neff got hooked on investing.

Unable to get a position in New York even with Robbins’s endorsement, Neff took an offer from Cleveland’s National City Bank in 1959 as a research analyst at $4,200 a year. As he would observe, “To say I loved my new challenge would understate my enthusiasm. I had hit the jackpot. Every detail fascinated me.” Before long he was also earning a graduate degree at Case Western Reserve and had built up a personal investment account of $100,000.

Noticing that a senior auto analyst at National City drove a dilapidated old car, Neff intuited correctly that analysts at regional bank trust departments were not particularly well paid. He started looking for “another job with better pay” and focused on three mutual fund organizations: Dreyfus, National Investors, and Wellington. As Neff recalled, “The opportunity seemed broad enough and there was nowhere interesting to go at National City Bank . . . so I packed my bags and headed to Philadelphia.”

The situation he found there after joining Wellington Equity Fund, later renamed Windsor Fund, was far from promising. “When I arrived in 1963, the Windsor Fund was in worse shape than I had anticipated,” he remembered. “The team in charge had lost its sense of direction.” In 1962, a tough year for many investors, the S&P 500 had been down 8.7 percent. Windsor was down by nearly three times as much: 25 percent. As the markets recovered with a gain of 22.8 percent, Windsor gained only 10 percent. With shareholders bolting for the exits, more money was flowing out of the small $75 million fund than was coming in. More ominous, Windsor was beginning to tarnish the reputation of the company’s flagship $2 billion Wellington Fund. Having gone public just three years before, Wellington Management was worried about the adverse impact on its share price.

Neff studied Windsor Fund’s record of investing and found several problems. Committee decision-making resulted in missed opportunities. Stocks were purchased at high prices that would plunge if optimistic expectations were not fulfilled. Market prices had become unmoored to the book value of the companies. Far too little fundamental research was being done. Windsor was asking for trouble and getting it. Neff’s analysis won the respect of his seniors and, less than a year after arriving, he was put in charge as Windsor’s first solo portfolio manager.

“Keep it simple” was Neff’s motto. It would never change. But close observers would also celebrate his intricately detailed expertise on individual companies and industries.² Whether the market was up, down, or indifferent, he followed a durable and disciplined checklist of investment requirements:

•   Low price-earnings ratio

•   Fundamental growth in excess of 7 percent

•   Dividend yield protection (and enhancement, in most cases)

•   Superior relationship of total return to price paid

•   No cyclical exposure without a compensating low P/E multiple

•   Solid companies in growing fields

•   Strong fundamental case³

Neff was glad to articulate the logic behind his checklist:

Rather than load up on hot stocks with the crowd, we took the opposite approach. Windsor didn’t engage in the market’s clamor for fashionable stocks; we sought to exploit it. Our strength always depended on coaxing overlooked, out-of-favor stocks to move up from undervalued to fairly valued. We aimed for easier and less risky appreciation, and left “greater fool” investing to others.

This strategy gave Windsor’s performance a twofold edge: (1) excellent upside participation and (2) good protection on the downside. Unlike high-flying growth stocks poised for a fall at the slightest sign of disappointment, low P/E stocks have no favorable expectation built into them. Moreover, indifferent financial performance by low P/E companies seldom exacts a penalty. Hints of improved prospects trigger fresh interest. If you buy stocks when they are out of favor and unloved, and sell them into strength when other investors recognize their merits, you’ll often go home with handsome gains. . . .

Absent stunning growth rates, low P/E stocks can capture the wonders of P/E expansion with less risk than skittish growth stocks. An increase in the P/E ratio, coupled with improved earnings, turbocharges the appreciation potential. Instead of a price gain merely commensurate with earnings, the stock price can appreciate 50 percent to 100 percent.

In Windsor’s neck of the woods, the prospects for increasing an out-of-favor company’s P/E ratio from, say, 8 times to 11 times always proved more promising than lining up in hopes of comparable percentage advances by companies that started with lofty P/E ratios. For a growth stock with a starting P/E ratio of 40 times earnings, comparable expansion would have to propel the P/E to almost 55 times earnings—to say nothing of sustaining it.⁴

Even Neff had below-market returns for two to three years in a row, and he might find today’s market much harder to outperform given the increasing dominance of the stock markets by professionals. But Windsor’s disciplined edge was usually formidable, and particularly powerful over the longer term.

Self-confident and repeatedly successful, Neff liked Vanguard’s incentives for managers. Here’s how he explained how a manager with confidence in his abilities would think: “Fairness to shareholders meant low transaction and investment management fees, coupled with incentives for exceptional performance and penalties for dismal performance. We met these hurdles at Windsor. Unlike funds that received fixed annual percentages of the assets under management, performance governed Windsor’s compensation. Similar incentives and penalties are scarce because most managers lack confidence in their ability to do well.”⁵ Like some other Vanguard managers, Neff’s incentive compensation depended partly on his fund’s performance against a benchmark index.

In 1991, late in Neff’s long run, Windsor Fund had an expense ratio of only 0.37 percent, a full 110 basis points less than the average stock fund. A major competitive advantage was locked in each year.

Neff was unusually well informed. Wherever he was and whatever he had going on, his habit was to read every page of the Wall Street Journal each day—and reread all those same pages on Saturday. He was blessed with a powerful memory. As the years went by and his knowledge accumulated, his expertise on specific companies and industries became an increasingly formidable competitive advantage.

Any student of actively managed equity investing has seen the evidence that the major markets around the world have become increasingly “professionalized” and therefore harder to beat after management costs and trading expenses. The number of people earning their living as analysts, fund managers, economists, market makers, and the like has gone from fewer than 5,000 in 1960 to more than half a million—and perhaps one million—all over the world. Every major firm—and some have 30,000 or more employees—expects everyone in its internal information network to begin and end the day with half an hour of receiving, answering, and sending email and text messages. As network theorists know, as the number of nodes increases arithmetically, the useful value of a network rises geometrically. Time available for making investment decisions that can take advantage of new information has dropped decade by decade from six months to six weeks to six days to six hours to six minutes to six seconds—or even less. Over the same time, derivatives have increased in value traded from zero to even greater than the “cash” market.

As tough as it now is to identify predictably superior investment managers, Vanguard’s Daniel W. Newhall⁶ and his manager search and oversight team have been striving to do exactly that for a long time, and overall they have been successful. Low fees to managers are a big reason.⁷

For any active management firm chosen by Dan Newhall’s team and approved by Vanguard’s global investment committee and the board of directors, being one of Vanguard’s active managers can have important business benefits. The basic attractions are Vanguard’s ability to deliver those enormous sums for a manager to invest, and to take care of all investor servicing and all operational tasks, including shareholder record-keeping, legal and compliance, and shareholder communications. The selected investment managers can focus entirely on managing portfolios with the help of a skilled group of analysts, portfolio managers and traders, and all the advanced information technology that active managers use to compete in today’s demanding market. Investment managers also enjoy the low account turnover of working with Vanguard.

Vanguard knows all this too, so it is a disciplined negotiator of managers’ compensation. The result is that Vanguard’s client-owners get “only for Vanguard” low manager fees.

As Newhall proudly reports, over 60 percent of Vanguard’s actively managed funds have outperformed their peer group, after fees, by an average of 25 basis points per annum. (See the chart below for results over four recent periods.) The selection and monitoring of investment process by Newhall and his teams also benefit investors by protecting them from “flame out” managers, and perhaps from themselves. Studies show that individual investors’ actions wipe out up to one-third of the returns they would have enjoyed if only they had stayed with their managers longer. Vanguard investors stay longer.

Relative to competitors, it helps that Vanguard has enjoyed a substantial expense advantage of 0.59 percent annualized for the past 15 years. If Vanguard funds had had the headwind of its peers’ higher average cost, excess returns would, of course, be less by that amount. Vanguard’s focus on keeping costs low, finding skilled managers, being patient when great managers inevitably go through difficult performance periods and removing managers when confidence is lost has driven performance superior to competitors’ active equity funds.

Another way of evaluating Vanguard’s experience with its active managers is to compare each fund to its benchmark index, which includes no fees. (See the graphic below.) As expected, the results are not as favorable. Still, over 10 years, 43 percent outperform their no-fee benchmarks. And over 15 years, 42 percent outperform. The average superiority is only nine basis points over 10 years and only three basis points over 15 years. The median is a modest negative 18 basis points over 10 years and 21 basis points over 15 years. Ten out of 28 funds have outperformed in each period by more than their negotiated fees. As the table shows, Vanguard’s success in selecting and managing external managers has been good—better than most other managers of managers.

Vanguard actively manages its active managers, sometimes moving assets away from a management firm in whole or in part. When James Barrow of Barrow, Hanley, Mewhinney & Strauss retired in 2015 after years of successfully managing Vanguard’s Windsor II Fund, Vanguard evaluated others at his firm and found none comparable. The assets Barrow had been managing were brought back to Vanguard to be managed internally.⁸

Vanguard goes further. If a fund or type of fund seems to be attracting too much money to be invested effectively, or attracting too many new investors, quite possibly for speculative rather than long-term investment reasons, it will either close that fund entirely to new investors or restrict purchases. Acadian Asset Management had a long, successful record with Vanguard, particularly investing in emerging markets, and had multiplied its assets under management to about $500 million, a size that Vanguard thought might challenge Acadian’s investing. So Vanguard took $100 million back to headquarters where it would be managed quantitatively. Tim Buckley led a Vanguard delegation to Boston to explain the decision and thank the Acadian team for their good work.⁹

During the tech bubble of 1999–2002, the cross-functional team overseeing Vanguard’s investment product development met weekly to discuss funds in the pipeline and new offerings to consider. Every week the sales representatives from each of the client-facing divisions asked Jeff Molitor, then the head of the Portfolio Review Department, when Vanguard would offer a tech fund. Clients were clamoring for one and the retail division complained that large sums were moving out of Vanguard to tech-heavy fund groups. Each week Molitor said no. The pressure built as tech-sector returns flew skyward, but Molitor was steadfast: “I will not bring out a tech fund at the height of the market. It’s not good for our clients.” When the tech bubble burst, Molitor was vindicated and investor assets that had gone rushing out to competitors came rolling back into Vanguard.

Total active equity investment assets are now more than $460 billion, making Vanguard one of the largest and most experienced manager-selection organizations in the world. Newhall and his team of 23 manager analysts have currently selected 26 firms (25 independent of Vanguard and 1 internal quantitative group) employing 45 separate teams of active managers of all types to oversee a line-up of 34 stock and balanced mutual funds. In a typical year, they screen as many as a thousand investment firms, meet with up to 200 of them and conduct in-depth evaluation of 50 managers. Of these finalists, they select as many as 5 managers for Vanguard clients. One benefit of their extensive outreach is that the group is continuously accumulating insights into contemporary best practice in active investing.

Jack Bogle initiated “active quant” investing at Vanguard in the late 1980s. This investment strategy uses computer models to attempt to identify stocks that are undervalued and therefore likely to outperform. The strategy then employs another computer model designed to combine the attractive stocks into a portfolio in such a way that the risk of the fund is reasonable for the type of investment. Bogle hired Franklin Portfolio Associates, run by John Nagorniak, for the first foray into active quantitative investing. Bogle wanted to develop the capability to manage active quant funds within Vanguard, believing that was a natural complement to the indexing capability Vanguard had already built. Gus Sauter had the necessary capabilities and entrepreneurial drive to make it happen.

“By 1991,” Sauter said, “we were managing our first active portfolio, as part of Windsor II. A year later, we took over portfolio management for a portion of the W. L. Morgan Growth Fund, and in 1995, we launched Strategic Equity.” More active quant replication would follow, including small cap blend investing (investing in stocks of small companies where neither growth nor value characteristics predominate).¹⁰

As Sauter explained,

In traditional investment management, industry and company analysts recommend individual stocks based on perceived upside potential. Then the portfolio manager, with a focus on risk, decides how much of each stock to buy. We do pretty much the same in quant investing, but it’s all computer and database driven rather than people based. On a daily basis we rank-order the stocks in each industry based on valuations relative to growth prospects. While many money managers do not want to be referred to as a GARP manager—growth at a reasonable price—it really is pretty descriptive of our quant process.

The key to a good or bad investment is the initial price you pay. To simplify the description of our process, we generally looked for stocks that are reasonably priced for their growth prospects. So, in the energy industry, for example, we would compare various valuations of a stock, say Chevron Texaco, using its current price relative to company fundamentals such as earnings or sales and various measures of expected earnings, to find probable pricing errors. Then we use a computer program called an optimizer to determine the appropriate position size or weight that will maximize the return, subject to not taking more risk relative to the market than we want. We want to provide excess return, or alpha, by old fashioned stock picking, not by placing factor bets, such as overweighting an industry or buying the FAANG stocks^* of the day.¹¹

Sauter recognizes the theoretical opportunity of exploiting various “factors” such as momentum or value in investing. But for most investors, factor investing requires far too much patience. Like deer hunting, most of the time nothing is going on. Then the factor pays off for a while—and then there is another long time with nothing going on. Most investors take too long to believe it when a particular factor is working, so by the time they decide to invest, that particular “factor game” may already be over. Sauter cautioned, “You should always be careful to separate a factor’s effect from true alpha.”

In 1983, an article in Pensions & Investment Age caught Jack Brennan’s attention: two superb investors he had gotten to know and respect, Howard Schow and Mitch Milias, had just left one of the most admired firms in the investment world—Capital Group, manager of the American Funds group of mutual funds—to launch a new firm called Primecap Management Company. Brennan called and asked, “Do you ever come to New York City?” He knew that would be much easier for them than meeting in Philadelphia.

Soon Brennan was sitting down in a wood-paneled private dining room at Christ Cella, then Manhattan’s premier steakhouse. A fortunate ice breaker came when Milias and the waiter serving the table began talking and joking in Croatian, but at first the discussions, while friendly, did not go well. Schow and Milias showed no interest in Vanguard. “We are not interested in the mutual funds business: too much administrative detail, too many regulations that require too many noninvestment people,” they told Brennan. “We intend to focus entirely on investing and intend to build our business based solely on having very large institutional clients so we can do just that, focus on investing.”

Capital was known for outstanding research on companies and industries, and for its exemplary culture and business practices. It was recognized for success in recruiting and developing investment professionals and greatly admired for keeping its people “forever.” Everyone agreed Capital was a great place to work if you were very good. Almost nobody ever left Capital. But now, two of the firm’s seniors were leaving and taking a few stellar young analysts with them to establish a new firm. Primecap’s business strategy was simple: attract 20 jumbo accounts—later increased to 25—from the best and biggest institutions around the country and around the world, maintain top-level communications with clients, and establish a deep shared understanding of Primecap’s way of investing. With this combination, clients would stay with Primecap a long, long time. Instead of having lots of out-of-town, away-from-home travel seeking new business, Schow and Milias could concentrate their skills and energy on what they most wanted to do: provide superior investment results.

Brennan had just the right response: “Great! Vanguard will be one of your clients—and hopefully, in time, your single largest client. Meanwhile, we will do all the admin and shareholder servicing. You’ll have none of the traditional mutual fund responsibilities.” Both sides came quickly to agreement and a splendid partnership was initiated.¹² Over many years, it would work out even better than Brennan had hoped.

His concept was to combine Vanguard’s capabilities in retail distribution with Primecap’s capabilities as investment managers, not far from Bogle’s dream for Wellington’s old merger with the Bostonians but better thought out. The strategic fit was compelling. Vanguard sought attractive investment alternatives to offer clients while Primecap had no retail distribution and no interest in the retail market of serving individual investors via mutual funds. There would be no “opportunity cost” for this exciting new firm if it linked up with Vanguard. If Vanguard linked up with Primecap, it could offer retail investors a proven new investment team with a fire in the belly determination to achieve superior long-term investment results.

Schow had earned a reputation as a great long-term investor with ability to recognize fundamental change in companies and industries at an early stage. There were many examples. Anticipating the paperwork revolution of xerography, he had taken a major position in what was still called Haloid. With Joseph C. Wilson’s inspiring leadership, it would become Xerox, the most profitable growth stock of the early 1960s. When Schow invested in Haloid, the company was still struggling to produce what would later become the fabulous 914 copier, the first successful plain-paper copier. In another example, when oil prices jumped to unheard-of record prices per barrel, Schow understood that price would discourage demand, so the high prices couldn’t last. Producers would ramp up their exploration and most consumers would reduce their consumption and look for alternatives. While it would take many years, supply would inevitably surge and demand would be cut back, so oil prices would surely decline, which they did—for 18 long years. As a percentage of the S&P 500 index’s market capitalization, oil stocks fell from 35 percent to 3 percent. Schow sold off all oil stocks early, giving his investment record a major boost.

The journey from Capital Group to Primecap and Vanguard started in a car. Schow and Milias lived near each other in Pasadena, California, so they agreed to take turns driving to work at their office in Los Angeles. Both were early risers and, inherently competitive, both liked to be in their offices and ready to work each morning before 7 a.m.—the 10 a.m. Eastern time opening bell at the New York Stock Exchange.^* This meant leaving their homes by 6:15. When Capital’s office building began to open at 6:30 a.m., they left home a half hour earlier. Both men instinctively liked being on time, so both liked it that the other also cared about being punctual. More important, they had an uninterrupted half-hour each way every day to exchange information and ideas about investing and investments. They soon developed both a strong friendship and a great respect for each other’s expertise and judgment.

Schow surprised Milias one morning: “I may be leaving Capital. If I do, I’ll want you to come with me.”¹³

Milias was stunned. Schow was clearly one of Capital’s strongest investors and a much-admired leader. Capital was growing rapidly in assets and even more rapidly in earnings. The growth was almost certain to continue and probably accelerate. Milias’s first thought was that Schow, as the second largest shareholder in Capital, would be making a substantial financial sacrifice. Capital’s leader, Jon Lovelace, had worked out a stock ownership program that required any shareholder leaving the private firm to sell back all shares at a substantially and deliberately understated book value. A few months later, after much soul-searching and several long talks with Lovelace, Schow had made his decision. “I’m leaving, Mitch. Let’s go!” Given the professional, personal, and economic attractions of staying with Capital, it took Milias several weeks to decide he would indeed join Schow.

Over the 35 years since that first agreement, Primecap’s capabilities have resulted in such strong retail demand that the three different stock funds it managed for Vanguard were eventually closed to new investors. Primecap now manages over $145 billion for Vanguard. As a lean, small organization, it is superbly profitable.

In today’s world of investing, a large institutional account might total $50 million. By comparison, Vanguard investors’ total investments with Primecap are nearly 3,000 times larger. Vanguard Primecap Fund has a long-term performance premium over its peers of more than 3 percentage points. And Primecap’s concentrated Vanguard Capital Opportunity Fund, with a boost from the FAANG technology stocks, has grown at 12.1 percent versus 5.8 percent for the S&P 500—more than twice the annual return. Of course, the obvious irony of performance records is that while investors make their investment decisions on past results, what they get are the future results.

^* Facebook, now called Meta Platforms (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX), and Google, now called Alphabet (GOOG).

^* The NYSE moved the market open to 9:30 a.m. in 1985.