CAHPTER 18

SETTING BOUNDARIES

As long-serving general counsel for Vanguard, Heidi Stam had a peculiar issue with the Securities and Exchange Commission. It was persistent, and there was not much she could do about it; she would have to learn to live with it. Her problem was simple, though ironic. While the SEC staff and commissioners often agreed with Vanguard’s drive to give the ordinary investor a fair break, to be candid in shareholder communications, and to reduce fees, they couldn’t always allow client-owned Vanguard to go forward with new initiatives because of the precedent it might set for other, traditionally organized fund companies. “Because Vanguard is so investor focused,” explained Stam, “its approach aligns very well with the investor protection mission of the SEC. On a series of issues, we’ve been way out ahead of the industry.”

As general counsel, Stam was responsible for giving “see the future” advice to protect Vanguard from future changes in regulations or possible lawsuits. The only sure way was a combination of keeping it simple and always doing the right thing. At a values-based organization like Vanguard, that comes naturally. In working with the SEC or any other regulator, Stam advised, “there is no need to be adversarial. We both want the same thing—what’s best for investors.”¹

Over time, Vanguard found several ways to support regulators in their drive to make steady improvements:

•   SEC chairman Arthur Levitt, concerned that investors were not well informed by the required prospectuses of mutual funds, invited the industry in 1997 to study the matter and make recommendations. The main recommendation was obvious; the long, detailed prospectuses crafted by pre-defensive lawyers were impenetrable. The commission recommended a simplified, informative four-page document with all the really important information clearly presented.

•   In keeping with its plain-speaking practices, Vanguard has supported disclosure improvements with clear fee tables and “call out” boxes to focus readers’ attention on matters of particular importance. Legalese is avoided. Some competitors seem to use it to obfuscate.

•   The regulators pushed governance rules for mutual funds, particularly having a supermajority of independent directors on fund boards. Vanguard has always had only one or two employees on its board. When Bill McNabb became president, he joined the board. Later, when McNabb also took on the title of chairman of the board, Jack Brennan resigned from the board. All the other directors, now nine in number, are independent.

•   Vanguard lowers costs. The so-called Vanguard Effect comes into play: when Vanguard enters a new market with its low fees, competitors promptly reduce their fees. In recent years, increasing numbers of investment managers have done so. Vanguard’s price leadership has saved investors billions.

“If the commission is conducting an examination in preparation for a new rule, it will often go to Vanguard to be sure it makes sense, knowing that Vanguard always does the right thing,” Stam said. “Let me correct that statement slightly. In my 19 years at Vanguard, we had only two small $15,000 FINRA (Financial Industry Regulatory Authority) fines—on minor technical matters of no real consequence. Other firms will budget large sums every year for fines and will see fines for rule violation as just another cost of doing business. The real difference is in attitude, with Vanguard always striving to do the right thing. When Vanguard got those small fines, you should have seen all the long, sad faces! Management took it all so seriously. The major comment was powerful: ‘That’s just not who we are!’”

Vanguard is proactive about compliance. For example, the legal and compliance team weighs in early in the development of a new offering to be sure that, from a compliance perspective, Vanguard has the best design. The firm was an early adopter of the web to distribute useful information in interactive formats to its millions of investors.

One of Heidi Stam’s special moments as general counsel came in 2009, when regulators were examining all money market funds for investments in high-risk securities during the financial crisis. At issue were the use of CDOs (collateralized debt obligations) and subprime mortgage-backed securities in what were supposed to be relatively safe, stable-asset funds. Money market funds were a major part of Vanguard’s business, and none of Vanguard’s money market funds contained CDOs or questionable mortgage-backed securities. When the head of the Fixed Income Group, Robert Auwaerter, was called before the Vanguard board for an update on the money market crisis, a director asked, “Bob, can you explain why no Vanguard fund holds any of these securities?” Auwaerter replied, “I didn’t buy them because I didn’t understand them. I don’t buy anything I don’t understand.”

One evening in September 2003, Stam received an email after a day-long training session with the legal team. The news wasn’t good. New York Attorney General Eliot Spitzer had called a press conference to announce a mass investigation of mutual fund companies. “I ran to see the TV in our PR office,” she remembers, “only to see Spitzer claiming that his investigation would unveil widespread predatory trading practices at the largest mutual fund firms, including Vanguard. That was impossible, so counter to Vanguard values. We were always out ahead when it came to protecting our investors. For years, Vanguard would always do the right thing—close ‘hot’ funds, turn away short-term money that would impair returns, and impose redemption fees to protect long-term investors.”

The two practices Spitzer was investigating were illegal market timing (allowing a hedge fund to time fund trades in exchange for other business) and late trading (allowing the hedge fund to trade after 4 p.m. but receive the 4 p.m. price).

That day in September was the beginning of several very tense months. As Spitzer, and quickly on his heels the SEC, began issuing subpoenas, Stam knew Vanguard had to get out ahead of it—whatever it was. Every fund company was a target. That Vanguard had been mentioned by name in the press conference really rattled Stam. Spitzer had to have some reason to name Vanguard.

Frank Satterthwaite, the head of Internal Audit; Pauline Scalvino, the head of Corporate and Litigation in Legal; and Stam as head of Securities Regulation knew they had to find whatever it was before Spitzer or the SEC did—that way they could at least fix whatever it was before the regulators arrived. “We huddled every day, multiple times a day,” Stam recalled. “We basically turned the entire organization upside down and shook it to see what if anything fell to the floor. Frank and his internal audit team began targeted searches to root out any evidence of wrongdoing. Pauline and her team played point on responding to the subpoenas that had requested hundreds of pages of documents—one from New York and the other from the SEC. The Securities Regulation team was looking at compliance with all the trading rules and speaking with our portfolio managers and front-line crew serving clients.” Every Vanguard attorney and paralegal worked well into the nights reviewing emails that might reveal a connection to the Spitzer allegations.

And then, someone identified an email from a representative in the Retail Division bringing an unusual question to the division head. A potential client, a hedge fund, wanted to put a lot of money into Vanguard funds and was asking whether it might be able to trade more frequently than is normally permitted under Vanguard policies in exchange for committing further investments over time. Upon receiving the email, the head of Retail, clearly suspicious, shot off an email to Gus Sauter, then chief investment officer: “Gus, what do you think of this?” His answer, “Absolutely not, we would never agree to this. This practice would be terrible for the other shareholders in the funds.”

As lawyers, Scalvino and Stam could not have been happier. They had the reverse of a smoking gun! Vanguard put together its subpoena response with this email chain prominently in evidence. Vanguard never heard another thing from the New York attorney general or the SEC on these issues and never got an apology from Spitzer’s office. Apparently, the source on the trading scandals had mentioned Vanguard as “one of the firms.” Yes, the hedge fund had tried to get into Vanguard, but Vanguard shut it out.

As Stam reflected happily years later, “It really was a great day for us. The rep knew the request was questionable, and was not so sales oriented that he would just agree to it. The head of Retail knew immediately it was problematic. And our chief investment officer was more interested in his fiduciary responsibilities to investors than gaining more assets to manage.”²

While many people still call indexing “passive,” for those doing the sophisticated work of continuously replicating the many market indexes that Vanguard matches, indexing is most definitely active. In addition to this operationally active work, as a shareholder Vanguard also takes an active role in good governance.

Half an hour before the end of one proxy voting period, Vanguard got an urgent call from the CEO of a major corporation: “I can’t believe you voted against our directors! What difference can it possibly make to you? You index!” His company had fallen short on a long series of good governance criteria, prompting Vanguard to vote against reelecting its directors. Vanguard was taking seriously its role as a major, virtually perpetual shareowner on behalf of its investor-owners.

The proxy voting process and Vanguard’s open advocacy are designed primarily to encourage corporate directors and managers to pay attention to their actual behavior versus best practices. While Vanguard makes its voting record public, to foster candor it does not disclose the specifics of engagements with individual companies. The focus is on laggards, striving to raise the overall average of corporate practice.

Jack Brennan wrote an early letter on corporate governance and on Vanguard as a corporate steward that went to the CEOs of all companies with shares held by Vanguard, saying the firm believes good governance contributes significantly to favorable long-term returns for shareholders. Vanguard seeks to raise the accepted standards of good governance by focusing on basic principles, making its views known, engaging with interested companies and publicly reporting its policies and its voting record.

Vanguard explains that it divides proxy voting into four categories or pillars of good governance:

•   “Board composition: good governance begins with a great board of directors. Our primary interest is to ensure that the individuals who represent the interests of all shareholders are independent, capable, and appropriately experienced. We also believe that diversity of thought, background, and experience, as well as of personal characteristics (such as gender, race, and age), meaningfully contribute to a board’s ability to serve as effective, engaged stewards of shareholders’ interests.^*

•   “Governance structures: we believe in the importance of governance structures that empower shareholders and ensure accountability of the board and management. We believe that shareholders should be able to hold directors accountable as needed through certain governance and bylaw provisions. Among these preferred provisions are that directors must stand for election by shareholders annually and must secure a majority of the votes in order to join or remain on the board.

•   “Oversight of risk & strategy: boards are responsible for effective oversight and governance of the risks most relevant and material to each company and for governance of the company’s long-term strategy. We believe that boards should take a thorough, integrated, and thoughtful approach to identifying, quantifying, mitigating, and disclosing risks that have the potential to affect shareholder value over the long term. Boards are also responsible for consulting on and overseeing a company’s strategic direction and progress toward its objectives.

•   “Executive compensation: we believe that performance-linked compensation policies and practices are fundamental drivers of sustainable, long-term value. The board plays a central role in determining appropriate executive pay that incentivizes performance relative to peers and competitors and disclosure of these practices and their alignment with company performance.”

As Vanguard explains on its website, “We advocate for executive pay arrangements that are constructed to incentivize relative outperformance over the long term. When shareholders do well, so should executives, and when shareholders don’t do well, executives’ pay should move in the same direction. Performance-linked policies should motivate management to focus on long-term value creation instead of short-term goals. The board should ensure that the company’s policies are appropriate compared with those of peers and the company’s industry, and the details of any pay plan should be clearly disclosed to shareholders.”

Taking the important example of stock-based compensation, Vanguard went deeper to share the 10 factors it would use in evaluating such proposals:

Factors for approval:

•   Company requires senior executives to hold a minimum amount of company stock (frequently expressed as a multiple of salary).

•   Company requires stock acquired through equity awards to be held for a certain period.

•   Compensation program includes performance-vesting awards, indexed options, or other performance-linked grants.

•   Concentration of equity grants to senior executives is limited (indicating that the plan is broad-based).

•   Stock-based compensation is clearly used as a substitute for cash in delivering market-competitive total pay.

Factors against approval:

•   Total potential dilution (including all stock-based plans) exceeds 15 percent of shares outstanding.

•   Annual equity grants have exceeded 2 percent of shares outstanding.

•   Plan permits repricing or replacement of options without shareholder approval.

•   Plan provides for the issuance of “reload” options (that grant executives new options when they exercise the original ones).

•   Plan contains automatic share replenishment (evergreen) feature.

Each of Vanguard’s pillars of good governance can be complex, most are industry and company specific, and few are easy for outsiders to understand fully. But all can be monitored by experienced, diligent, capable board members, particularly if they have the requisite information and the interested cooperation of senior executives who understand and honor the important responsibilities of a governing board. Evidence shows progress: women are now about 30 percent of S&P 500 board members, up from 19 percent in 2014;³ performance-based pay for CEOs has increased significantly; and majority voting for directors has more than doubled.⁴

Since it cannot simply sell a stock when concerned about the long-term policies of a corporation that its index funds invest in, Vanguard is necessarily a perpetual owner of shares so long as they remain in the index, and it seeks to be a constructive shareholder. Glenn Booraem leads a team of over 35 analysts working on good governance and proxy voting, an increase from just six in 2000. They formulate policies and communicate them to senior executives and directors of the companies whose shares are owned in the index funds. Responsibility for proxy voting by Vanguard’s numerous active managers is delegated to those managers since they have more granular information.

Sunlight is the best disinfectant, and “we want to be transparent and proactive,” said Booraem.⁵ The volume and the quality of communication with companies have both risen since the Sarbanes-Oxley Act of 2002, designed to protect investors from fraudulent financial reporting by corporations. Since 2018, Vanguard has had direct contact with 1,500 companies that represent 75 percent of its assets under management. During the 2020 proxy season, it discussed executive compensation in about half its engagements. Engagement has increased, particularly internationally. While nations differ (and the United States is not always the most advanced), corporate practices are converging on global standards of best practice. Vanguard encourages this convergence while recognizing that companies, industries, and nations differ in many ways. As Booraem explained, “We want to focus on the right things, not on everything.”

Vanguard is committed to take a stand for all investors, not just for those who rely on it as their investment manager. “If better governance will make a favorable impact—and the evidence is strong that it does—our work will help move the results for all investors up and to the right,” Booraem said. “We want to leave the woodpile higher as a result of our work.”⁶

Some proxy matters are event driven (such as a merger) or topic driven (such as gender diversity), and some matters are sufficiently complex to warrant a “strategic engagement” between Vanguard and a particular company. Since most proxy votes—168,786 in 2019—are simple, routine items, any differences on the more important or tougher decisions can seem few. Vanguard often votes the same way “public interest” proxy advisory groups like International Shareholder Services vote, but certainly not always. For example, in 2019, 7 percent of the times ISS advocated voting for a proxy item, Vanguard voted against, and 9 percent of the times ISS recommended voting against an item, Vanguard voted for it. Here is how Vanguard reported its proxy votes in two recent periods:

Policies Vanguard recommends to regulators are published, in the hope that other investors will speak up, and all its proxy votes are reported. Moreover, Vanguard governance experts are ready to meet with any corporate leaders who would appreciate a briefing on the recommendations. However, that does not satisfy a cluster of hypothetical academic concerns.

Two schools of concern about index funds and proxy voting have articulated their views that index funds wield excessive power, but the two are in clear disagreement. One is concerned that index fund managers will be excessively deferential to management in their proxy voting, while the other is concerned that index fund managers will excessively exploit the power over managements that comes with their large ownership stakes. Charlie Munger, Warren Buffett’s nonagenarian partner, warned against that power in early 2022 when he said of the CEO of BlackRock: “I think the world of Larry Fink, but I’m not sure I want him to be my emperor.”⁷

Both groups note the past and projected future increase in the percentage of all shares held in index funds. Neither recognizes the intensity of competitive rivalry between the leading index fund organizations: if any one of them behaved even slightly unwisely, the others would pounce, and surely so would the media. More important, neither school recognizes the difference between strategic capacity and strategic intent. Both leap to theoretical possibilities and raise far-fetched suspicions of potential misconduct.

One academic analysis,⁸ apparently confusing correlation with causation and using simplistic data mining as opposed to rigorous statistical analysis, concludes that, as index funds own shares in multiple airlines (as they do in all major industries), this has somehow led to pricing collusion on fares by the airlines. A similarly curious concern is that if the three major index managers somehow got together and tried to pressure corporate managements to take particular business strategy initiatives, they might exert undue power in collusion. In a rare foray into a contested corporate vote, in May 2021 Vanguard voted its ExxonMobil shares in favor of two new activist directors who promised to push the oil giant to speed up its transition to renewable sources of energy. So did other large shareholders, including the two other big indexers.

Vanguard’s unusual vote to influence long-range strategy reflected persuasive arguments that the company’s future was clouded, and of course it required no “collusion” with many others that felt the same. Referring to “the increasing need for ExxonMobil to better align their climate strategy with target setting in line with their global peers and their public policy efforts,” the firm explained, “Importantly, Vanguard does not dictate how companies should run their business; rather, we seek to understand how their boards are governing their strategies and overseeing material risks that could affect companies’ long-term value. . . . [Vanguard’s vote] was intended ultimately to hold the board accountable on their risk oversight processes and to enhance the board’s composition and energy sector experience.” As index funds and ETFs get still larger, Vanguard might be wise to divide the authority to vote on such major corporate decisions as mergers, acquisitions, and strategy reversals among two or three policy decision-making units.

The Federal Trade Commission held hearings on whether concentrated share ownership damps down new product introductions or competition for customers. BlackRock’s long-serving vice-chair, Barbara Novick, wrote, “We do not dictate to companies how they should run their corporate balance sheets, nor do we have the ability to do so.”

Harvard Law School professor John C. Coates became a prominent critic. First, he cited the rapid growth of indexing and “quasi-indexing.” Second, he focused on the concentration of indexing in a few major firms. Third, he created clever terminology, “The Problem of Twelve,” to clarify that in a few years only about a dozen people—members of the small group at each management organization that decides how to vote proxies—would somehow have virtual control over the majority of U.S. public corporations. In dramatic words, he declared this a deeply concerning problem. “A small number of unchecked agents, operating largely behind closed doors, are increasingly impactful to the lives of millions who barely know of the existence much less the identity or intentions of those agents.”

Borrowing from antitrust experience with major industrial corporations engaging in price signaling, Coates wrote, “Index providers can obtain strong signals about other index providers’ views on management performance and strategy. No explicit collusion is required to send highly aligned signals about what they want to each other.” While acknowledging that “index provider managers have very weak [financial] incentives to use their control,” he warned: “An announcement by a major index fund provider that it does, or does not, support a given governance position gives greater clout to those [proxy voting advisory services] who tee-up, debate, and form investment community opinion around those issues.”

Sounds alarming, but is it a false alarm? While thoughtful observers are increasingly expressing concerns about “short termism”—corporate managements’ overemphasis on quarterly results to boost stock price—index fund managers are leading in the opposite direction, advocating long-term thinking. Index fund managers like Vanguard explicitly define their focus: good governance for the long run.

Coates’s central concern is clearly stated on his final page: “Unless law changes, the effect of indexation will be to turn the concept of ‘passive’ investing on its head and produce the greatest concentration of economic control in our lifetimes.” These last 10 words certainly try to command readers’ attention. Coates declares: “The mere threat of an activist supported by index funds can reduce investment” or “lead to layoffs.” He then grandly concludes: “That power creates a legitimacy and accountability challenge.”^*

Another academic provided a wholly different concern and suggested restricting proxy voting by index funds because they have such weak incentives to learn enough about proxy issues that their votes will be underinformed and so will drive proxy voting away from good governance. But that’s why indexers concentrate on broad good governance policies and seldom take positions on other business decisions.

As CEO, Bill McNabb reacted publicly in July 2017 to a similar academic article proposing that index funds should, in effect, give up their voting rights: “The proposal is careless and dangerously misinformed.” He went on to say two things about Vanguard’s role as investment stewards: (1) “We care deeply about governance.” And (2) “We’re good at it.”

When Jack Brennan was asked whether he saw any risk of a conflict between proxy voting and Vanguard’s pension management business, his immediate response was clear: “We’re unbending. Life’s too short to compromise your principles for a piece of business. And we’ve never had [a client] say, ‘If you don’t vote the way we like, goodbye.’ We’ve won a lot of business, and we’ve voted tough votes that management didn’t like. But good companies understand that we’re fiduciaries, just as they are. People who run good companies are too principled to politicize something as important as employees’ retirement savings.”

Another concern, most colorfully expressed in the title—but not in the evidence—of a 2016 paper, “Passive Investing Is Worse than Marxism,”⁹ suggests that when indexing becomes too popular and somehow drives out active investing, “the process of capital allocation in our market and then our economy will wither and die.” Let’s look briefly at the reality: well over 500,000 professionals, perhaps as many as a million, enjoy generous incomes as active participants in active investing. To degrade the market mechanism at all meaningfully, at least half and likely three-quarters of these experts would need to quit one of the highest paid and most interesting, engaging lines of work in the world. Even though 89 percent of mutual funds fail to match the market, the number of people entering each year into active investing continues to exceed those leaving, so it won’t happen soon. (In 2019, US-focused index equity funds made up about 14 percent of the American stock market and contributed about 5 percent of US stock market trading.)¹⁰

When Vanguard went no-load decades ago, a shareholder sued, claiming that since he had paid the sales load, he had been unfairly disadvantaged by that cost. Nobody on the Vanguard board thought the complaint had merit, and the suit was taking an enormous amount of time and energy, many days as much as 90 percent of both Bogle’s and Riepe’s time. Both had far more important things to be doing to advance a then fragile Vanguard. Any simple cost-benefit analysis concluded: Hold your nose and settle with the SOB—even if it costs us $5,000. That amount had been requested by the plaintiff’s attorney.

Bogle was adamant. “No! Never!”

The lawsuit went on for another year and was eventually settled for . . . $5,000.

One July day in 1996, Vanguard refused to accept a $40 million account that had been intended for the Admiral Short Term Portfolio, a $430 million bond fund. That made the Hastings Foundation’s EVP so angry that he sent a message—typed in ALL CAPITAL LETTERS—saying that he would pull all its investments “as soon as possible” and would never again do business with Vanguard.

Why the ruckus? When asked how long the money would be invested in the fund, which was explicitly designed for long-term investment, the answer was “about two months.” For Vanguard, that was way too short: the costs to invest nearly 10 percent of the fund and then withdraw that same investment would drive up the fund’s expense ratio, and this would penalize all the other investors.

Vanguard was supported in the press. The Wall Street Journal ran a story with an arresting headline, “Vanguard Puts Up No-Parking Sign.”¹¹ Bogle was, of course, certain about his decision to reject and had good reasons. If the $40 million were held in the $430 million fund for only two months, it would earn Vanguard some $30,000 in management fees, but buying and selling that amount of Treasury bills—a total of $80 million of transactions—would cost the other investors in the fund about $50,000. When Vanguard offered to help Hastings buy appropriate Treasury securities or invest in a larger money market fund, Hastings refused because that other fund had a lower yield.

The Short Term Portfolio’s prospectus stated, “The Fund is intended as a long-term investment [and], consequently, the Fund reserves the right to reject any specific purchase.” Brennan tried to explain: “By the time you invest and disinvest, all the other shareholders would pay a significant expense in transaction cost for the benefit of a single shareholder.” So Vanguard chose not to accept the account. Jim Riepe, by then at T. Rowe Price, was quoted in the article as saying that putting such a large chunk as $40 million into a $430 million fund for only two months is “just plain nuts.” Once again, Vanguard was watching out for its clients.

Governance at Vanguard has many facets, all based on a simple concept: do the right thing. Stories abound about Vanguard’s closing funds entirely or to new investors. Unapologetically paternalistic, Vanguard will close access to funds that appear to be attracting unsophisticated investors chasing past performance. Issuing warnings on hot sectors of the market—emphasizing risks—originated with Jack Bogle and has become an important part of trust building. Vanguard’s leaders always see it as an investment organization, not a sales or marketing organization.

Most mutual fund organizations, being sales-minded, habitually accentuate the positive. Bogle insisted on reporting to investors the way he would want to be reported to if he were an investor: accurately and candidly. That policy goes way back. In 1991, when health-care stocks were market darlings, Bogle cautioned:

In recent months, the Health Care Portfolio has attracted a good deal of publicity about its excellent past performance. Almost simultaneously, the Portfolio has had substantial cash inflows (totaling $76 million in the past three months) from thousands of new and existing shareholders. As press attention has focused almost exclusively on the strong performance of the Health Care Portfolio (and other mutual funds specializing in this field) we wanted to write this note to ensure that our shareholders and prospective investors have a balanced understanding of the risks and the potential rewards of investing in the Portfolio.

The returns of the Health Care Portfolio have been very strong. Through February 28, 1991, the Portfolio’s annualized returns for the past one, three, and five-year periods were +39.7 percent, +24.5 percent, and +20.4 percent, respectively (compared to +14.7 percent, +15.1 percent, and +13.9 percent for the unmanaged Standard & Poor’s 500 Stock Price Index over the same periods). However, it is highly unlikely that such absolute returns—or even the Portfolio’s relative performance advantage—will be matched in the future. Experience has shown that such periods of superior performance by an industry group do not continue indefinitely. Indeed, periods of outperformance are often followed by periods of underperformance.

Bogle went on to warn against too much concentration in any one industry. Vanguard closed the Health Care Fund again in the spring of 2005 and kept it closed for a dozen years until the autumn of 2017. (Over the years Vanguard also closed the Explorer, Primecap, Capital Opportunity, Precious Metals, and Mining funds.) When it reopened, the Health Care Fund was available only to existing shareholders seeking to increase their holdings. A reason given for reopening was to have enough new investment dollars to meet modest redemptions rather than having to sell the portfolio’s low-cost-basis stocks, incurring capital gains that would be taxable to the funds’ long-term shareholders. Jack Brennan was explicit that the fund opening was not a “buy” signal from Vanguard. “We consider ourselves the conscience of our industry,” said Brennan.

As Jack Bogle had told the Vanguard crew, “There is no mystery about the benefits of candor. Making investors aware of risk is not only ethically essential, it represents wise shareholder relations, and good public relations. In short, miracle of miracles, candor has proved to be a sensational business strategy for Vanguard. We distinguish ourselves by being straightforward rather than strident and understating rather than overstating.”

When the financial crisis hit in 2008 and pulverized the stock market, Vanguard knew that with much lower assets, its at-cost operations would require an offsetting increase in the expense ratios of its funds. Believing it would be wrong not to inform investors, Vanguard pleaded with the SEC for permission to tell investors what was coming. The SEC would not allow “projected” fee information in fund prospectuses. So Vanguard sent the same heads-up message in an informal way, by including a note that expense ratios would be rising in its regular quarterly letter to investors. This met both the letter of SEC regulations and the spirit of candor sought by Vanguard. Helpfully, Morningstar brought attention to Vanguard’s move with a highly favorable article.

In 2015, Bill McNabb wrote “an open letter to all mutual fund investors” that ran as an op-ed in the Wall Street Journal.¹² He began: “In the years since the global financial crisis, lawmakers and regulators have worked to stabilize the markets and economy. They identified risks to the financial system and took steps to ensure that Main Street would not be on the hook—again—for bad bets placed by Wall Street. Now regulators might place that burden squarely back on Main Street mutual-fund investors without any solid evidence that the funds or their managers could bring on another panic.” The U.S. Financial Stability Oversight Council and the global Financial Stability Board considered mutual fund companies as systemically important financial institutions (SIFIs) like the big banks, imposing the same bailout obligations on them and their 90 million investors. This would, McNabb wrote, require fund companies to hold capital reserves of up to 8 percent of fund assets, significantly reducing investors’ long-term returns.

As he explained, mutual funds use zero leverage—they don’t buy securities on margin—while banks and securities dealers could borrow up to 30 times their equity capital. Moreover, even in times of great stress, fund investors “never redeem shares en masse.” Finally, “Even when funds exit the business (and hundreds do each year), the risk is contained. Investors in a fund bear the risk of any losses, just as they stand to benefit from only gains. Since funds operate as separate entities from their managers and other financial institutions, there is no risk of losses elsewhere in the financial system, or any need for a taxpayer bailout. It’s not the size of an institution that determines its risk. It’s the amount of leverage in play. Mutual funds use little or no leverage.” The regulators eventually saw the point.

Vanguard is cautious about seeming holier than thou or strident. As it said in a 2019 report: “Vanguard understands that people have a wide variety of deeply felt humanitarian, ethical, environmental, and social concerns, and that some may want to see their beliefs reflected in their investments. As a fiduciary, Vanguard is required to manage our funds in the best interests of [all] shareholders and obligated to maximize returns in order to help shareholders meet their financial goals. Like other investment management firms, Vanguard understands that some individuals choose investments based exclusively on social matters and personal beliefs. For such investors, we have offered Vanguard FTSE Social Index Fund since 2000. This low-cost, broadly diversified fund seeks to track a benchmark that screens companies on social, human rights, and environmental criteria.”

Sure enough, Vanguard was called out on some of the companies held in this fund for not being sufficiently correct. On first complaint, it turned out that the creator of the index Vanguard was matching had failed to do sufficient due diligence. Both index creator and Vanguard moved quickly to eliminate the problem and get back on the straight and narrow. (As described in the previous chapter, a more individualized approach to social index investing may be ahead.)

Indexing is based on disciplined replication—not creativity or judgment calls—so investors should never be surprised either favorably or unfavorably by actual results, particularly unfavorable results. That’s why a deviation in 2002 challenged Jack Brennan to change bond management leadership.

Dow Jones’s Richard A. Bravo set the stage: “In this year’s second quarter, a period of market volatility in credit and equity markets, index funds reported a wide array of returns, many of them falling below expectations.” His article went on to report that Vanguard’s Total Bond Market Index Fund in just one quarter had fallen short of the index return by 89 basis points—a 3.6 percent annualized shortfall! The article reported that while some deviation might be expected, to miss the mark by so much in an index bond fund was “unheard of.” Bravo noted that the $22 billion Vanguard fund had, over 10 years, earned returns before fees and expenses “right on top” of the index and that credit rating downslides had been unusually high—nearly 5 to 1 versus upgrades—and that WorldCom bonds, with $30 billion outstanding, had plunged by two-thirds. Finally, because the most popular bond index contained 6,873 different bonds—over 13 times as many issues as the S&P 500—“sampling error could become a potential nightmare for bond index fund managers.”¹³

Vanguard was forthcoming about the performance disappointment, attributing the fund’s shortfall to sampling; an overweight in hard-hit sectors like telecommunications and energy; a corporate substitution policy in which high-quality corporates were substituted for US Treasury bonds; and operating expenses. Vanguard’s portfolio exposed the fund to far more credit risk at a time when the bond market was not tolerant of credit risk. While the “corporate substitution” practice had added returns in past years, this time it hurt returns. That was an explanation, but certainly not an excuse. That was not what investors had expected with a bond index fund—and not what Vanguard had promised investors.

Brennan, as CEO, took full responsibility and reached out to clients with Vanguard’s characteristic candor. He initiated a flurry of calls and visits to institutional investors to explain. He told investors he was changing the fund’s portfolio management team and specified how the bond management process would be changed to ensure rigorous replication of the index. Going forward, he would make sure that such “I’m smarter than the market” actions would be forbidden.

Most of the institutions liked being called on by the CEO, understood what had happened, and admired Brennan’s taking “command responsibility.”

^* For an organization truly committed to diversity, a large proportion of the top people 10 years ago came from one college, Dartmouth—Brennan, McNabb, Sauter—and rather few were people of color. On the other hand, many women now hold important positions and, due to Brennan’s and McNabb’s efforts, people of color are clearly visible on the board and in senior leadership positions.

^* Coates spent eight months at the SEC in 2021, four as acting director of the Division of Corporate Finance and four as general counsel.