ETF Expert Corner

Vanguard’s Gerry O’Reilly Offers Inside Look at Managing Index Funds

August 14th, 2018 by ETF Store Staff

There’s much more to managing index funds than meets the eye.  Gerry O’Reilly, who oversees $1 trillion+ in Vanguard funds, provides a behind-the-scenes look.



Transcript

You can listen to our interview with Gerry O'Reilly by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: We are now very pleased to be joined by Gerry O'Reilly, Principal and Portfolio Manager at Vanguard. Gerry is currently responsible for the management of over one trillion dollars in index funds. That's trillion with a “T”. Gerry oversees the world's largest index mutual fund, the third largest ETF and then he's responsible for 16 other Vanguard funds. I think this is a fascinating area because there's the perception out there that index funds are on auto-pilot, that there's nothing really going on behind the scenes. It's just a person pushing a button or computers running these things - and that simply couldn't be further from the case. Gerry is joining us via phone from Malvern, Pennsylvania. Gerry, a pleasure having you on the program today.

Gerry O'Reilly: Thank you very much. It's great to be on.

Nate Geraci: So, Gerry, when you wake up in the morning and you're responsible for one trillion dollars in investor assets, I have to ask you, what does that feel like?

Gerry O'Reilly: Well, I would say this: that there are times when there's a little bit of stress involved. So, for example, if we're having some type of a rebalance or something going on where there's huge dollars that need to be traded later that day, those are days when you want to make sure you have your Wheaties in the morning and you're ready to roll when you get into work. But, you know, for a good portion of the year, even though the assets are huge, one of the nice things about indexing is that the turnover tends to be very low. So, the turnover, for example in that fund that you mentioned which is Total Stock Market, it's in that six to eight percent turnover type a year which means that there's not a ton of trading to be done. Now, I do have to trade the daily cash flows, but in terms of just churning over the portfolio, it's very manageable and especially when it's a fund that has 3,600 different securities in it. So, it's a broad, diversified slice that I'm trading. But, you know, I certainly take my responsibilities seriously and it makes it very rewarding when you're able to put that money to work and track the benchmark and do what investors are expecting us to do.

Nate Geraci: Well, let's get into a little more detail on exactly what goes on behind the scenes. So, you have new investor dollars coming into these index funds, there's money leaving, there are underlying index changes, corporate actions. So, give us a flavor here, walk us through a day in the life of an index fund manager.

Gerry O'Reilly: Yeah, so the first thing every morning is we come in and we have three different sets of eyes that are going to look at each fund. So, there's the portfolio manager - so, in this case, for example, Total Stock Market, I'm going to sign-off in the morning saying the fund is exactly where I think it should be and, if all goes well, I should be sitting on zero dollars or I shouldn't be over invested. In all honesty, that never happens. You either overspent by a little bit or maybe you're sitting on a little bit of cash because. While you have a good handle of what the cash flows are into the fund, it's impossible to know exactly because you have people that are investing all the way up 'til 3:58. They might be sending in checks that come in that are timestamped before 4:00, but they might not be processed until afterwards so there's a lot of moving parts involved. So, I'm going to sign-off on that in the morning. There's also, we have a desk supervisor who's going to check to make sure that my work is good and that the fund is where it should be and it makes sense. And then there's someone from our risk area. So, once that's good, it means that “okay” we're good to start the day and then what do you have to do. So, over the course of the day, there may be multiple corporate actions going on. There are going to be cash flows coming in throughout the day. There will be adds to the index. There will be deletes from the index. And, on top of that, you're going to have just continually institutions who are bringing money into Vanguard. So, we have to tabulate all of that together and then, around three o'clock is when you start figuring out how big of a trade list do we need to run for today's cash flows. And you're kind of netting all those flows together. And that doesn't mean though from when the market opens at 9:30 to 3:00 we do nothing. There are names that are incredibly liquid, names that just don't trade well - and those names, we're going to try to trade those names throughout the day going through different crossing networks, dark pools, anywhere we can find liquidity. So, we're going to be opportunistic to see if we can get into those names. The more liquid names, though, tend to be the ones that you're going to be trading at the end of the day. The Cisco's, the Amazon's of the world, the Apple's of the world, they tend to be the ones that you're running in your trade list for the end of the day. So, in any given day, there's just so many moving parts and of course, on our desk we manage about three trillion dollars and we have about 240 different funds so there's a lot of moving parts. And we have a great team, an experienced team, probably average tenure on the desk about 13, 14 years and we have 24 different traders. So, making sure that everyone is aware of what you're doing because a lot to times it's going to impact other peoples’ funds in terms of adds and deletes. So that's kind of a snapshot of what we do over the course of the day.

Nate Geraci: Gerry, can you talk more about how you handle underlying index changes? So for example, I think Twitter is a good one. Most people are familiar with that - it was added to the S&P 500 index. What's the process?

Gerry O'Reilly: So the process is, so for example, S&P, they use a committee to determine how they're going to add names to the benchmark. Back in June, Monsanto was acquired by Bayer which meant that there were only 499 companies then going to be in the S&P 500 and there was a lot of speculation about what would be the replacement. So, Twitter was the name. So, back in June then, once S&P announced the add, they usually give investment managers two to five days of a heads-up ahead of time to say, “hey guys, we're adding this name to replace Monsanto” and then it's up to us then to calculate exactly how many shares we need to purchase in order for our weight to be identical to the index on the day of the add. And the way we do it on the desk is we have one person that becomes the quarterback for that Twitter trade. Every fund we have that has a S&P 500 benchmark, we are going to calculate how many shares and we're going to do what we call a multi-block. So, we put all those trades together as one block of Twitter to buy and then that trader is going to come up with a strategy and that strategy is going to change. It's changed over the years depending on where Twitter is coming from. So, for example, Twitter is in our Extended Market Fund which is a completion index fund. So, we knew that our Extended Market Fund was going to be selling its entire position so were able to cross that. We had the opportunity to cross that with our 500 funds. Also, shareholders who are long Twitter, active managers, for example, they know that this event is happening. So, it's a super liquid event. So, a lot of times, when you have an add to the index, active managers who are long that, they may decide that this is a great opportunity for me to sell to the indexing demand. So, all of those moving parts would have been baked into the strategy and then we would have set about having our, on the day of the add, setting our limits where we thought it was appropriate, working with our risk area to make sure that if we did leave any residual shares, that it was an acceptable amount understanding this kind of trade-off between tracking error versus impact. And on the day then, you would go ahead and execute those trades based on all the information that was available at that time.

Nate Geraci: Gerry, for your last point regarding market impact from the trading your team conducts, can you talk a little more about that? In index funds, obviously everyone knows when changes are made to the underlying index. So, I guess two questions. One, how do other market participants try to take advantage of that? And then two, how does Vanguard sort of combat those efforts?

Gerry O'Reilly: So, you're right, I mean, it’s public information. It's out there when there's an add to the benchmark. And we understand, you know, if you think about the S&P 500, there's roughly, S&P 500 manages, owns roughly 15, 15.5% of the shares outstanding. So, you know, it doesn't take rocket science to figure out how many shares need to be bought by, not just Vanguard, but by all S&P 500 managers. And so then, you will have some people that are probably trying to take advantage of that. Buy in front of the indexers and I remember when I, you know, I've been on the desk for 24 years and I remember back in the beginning, when a name was added to the S&P 500, it was not unusual for there to be a seven, eight percent run from announce date to inclusion date. And over time, people, investors, and hedge funds looked at that and said, “hey, if I can buy ahead of the indexers and sell it out to them on the close, there's an opportunity”. And over the years, it's actually gotten to a point where sometimes the people who are trying to buy ahead of the indexers, they actually overwhelm the indexing demand, So, as an indexer, the place to buy it was actually on the close because sometimes it actually was at a lower price than it was prior to the announcement. So, any time you were looking at an add to the index, there's not a formula. You have to be willing to change based on the information. There are certain times when companies that are getting added already have a shelf registration where they are anticipating that they're going to get an add to the index and they may sell directly to the indexers themselves. That has been known to happen. And so, we're very aware of what the volume is, what the price action is. So, based on all of that information, we're going to have a strategy that is going to be appropriate for that particular add to the index.

Nate Geraci: Is your job any more difficult for smaller or mid-cap funds or even if we look international where, perhaps, the underlying markets may not be open? Does that make your job more difficult?

Gerry O'Reilly: There are more challenges. I mean, small-cap stocks have always been more difficult to trade. And even though the SEC has looked at pilots to try and help encourage more liquidity, I think the nature of small-caps, they're going to be more difficult to trade than the more liquid names. On the international side, you do run into some issues where cash flows coming in today, those markets are already closed. However, at Vanguard, we fair value price our international funds so that if there is activity that happens here in the U.S., our international funds are going to reflect that at the close today. And so when our international side of the desk is trading, they are going to be interacting closely with our desks in London and also in Australia and passing on the instructions for the fund. And then the traders on the ground there are going to use their expertise to get us the best execution possible.

Nate Geraci: Our guest is Gerry O'Reilly, Principal and Portfolio Manager at Vanguard. Gerry oversees some one trillion dollars in Vanguard index funds. Gerry, there are several Vanguard funds and ETFs where your efforts effectively result in the fund being free to investors through positive tracking error. I believe the Vanguard S&P 500 ETF, VOO, has been an example of that. The Vanguard Total Stock Market ETF, VTI. Can you explain how that occurs?

Gerry O'Reilly: So, there's a couple of reasons for that. I would say, number one, our security lending is a very profitable area for the funds in terms of 100% of the net proceeds from security lending goes to the funds themselves and that can actually add up to some meaningful basis points over the course of a year. So, for example, in Total Stock Market, that has been in the one to two basis points a year in added value to the fund. I would say the other two basis points is probably along the lines of when we have cash flows coming in on a daily basis, we're spending two to three billion dollars a day. There potentially is an opportunity to get prices that are better than the closing price. Or, when we have rebalances which is once a quarter, we've been known to trade 50, 60 billion dollars over the course of a rebalance. And, doing those rebalances, there are also opportunities to pick up nickels and dimes when you're trading that kind of size. So, we also have an opportunity when we are participating in syndicate offerings to potentially add some value. So I think the combination of security lending, plus the trading, plus syndicate kind of can add to three, four basis points worth of performance over the course of a year.

Nate Geraci: Also, in terms of adding value, I know Vanguard has a patent on ETFs as a share class of mutual funds and that can offer some unique advantages. I think, perhaps, most notably on the tax efficiency side of the equation. Can you talk a little bit about that structure and perhaps the importance of managing funds from a tax perspective?

Gerry O'Reilly: Absolutely. So, you're right. I mean, we're very fortunate in that if you think, for example, our index funds, if there's an add to the index, oftentimes we can use cash flow that's coming in that day to fund the add to the benchmark. So, there's no need for us to sell a slice of the benchmark to fund that. So, from a tax efficiency point of view, that's a great plus for us. Also, when we have ETF redeems, I'm sure we have low cost lots in Apple and Amazon in our funds. When we redeem, when an AP comes in and we have to do a redeem, we can redeem the lower cost lots in our fund which benefits all shareholders in the fund. One of the other things that we do is if investors are looking to come into the fund short term, so say, for example, someone fires a manager and they're looking, I just want to park the money for two to three months. We really don't want that money coming into the mutual fund itself because we incur transaction costs, commission costs and potentially impact. So, we'd rather that if someone is coming into our mutual fund, that they're coming in for at least a year. However, having the ETF as an option is something that's available where you can say to an investor, “listen, if you're only looking to come in for two months, you can purchase into the ETF, incur your own transaction costs and that way we're protecting the long-term shareholders in the fund”. And I would say, finally, if you have redemptions from the regular fund, we have the option to sell high cost lots which is going to realize losses which benefits kind of all the shareholders of the fund. So, having the ETF share classes is a great benefit for us.

Nate Geraci: Gerry, we have just a couple of minutes left here. As investors have gravitated to index funds over the past several years, and actually probably since the financial crisis, has that made your job any more difficult? And, I think you began to touch on this a bit earlier, but does the size of index funds ultimately matter? Because, I just think on the active side, it can become more difficult as funds get bigger because, theoretically, an active manager has to go chase down new investment opportunities to add value, right? Those may or may not exist. What about challenges on the passive side?

Gerry O'Reilly: So, on the passive side I think if you look in the U.S., for example, passive ownership is about 25% of the shares outstanding. So, there's still 75% that is non-passive and one of the other things that's kind of unique to passive investing is that turnover in the funds tend to be so low - so, you're talking about single digit turnover. So, even though the assets are large like, so for example, in Total Stock Market, 740 billion in assets in the fund, the turnover is only in that five to six percent range. So, there's not a ton of turnover going on and so it's very manageable especially when I have 3,600 securities to trade. So, on a given day, if I have five or six hundred million coming in today, I'm probably buying 1,200 names. Yes, I'm buying Apple and Amazon and Microsoft, but I'm buying the slice of the benchmark. And I know that none of those names really, you know, even if I'm spending two to three billion, if we think about it, there's roughly 400, 450 billion is going to trade in the market today, I'm less than a half a percent so it's very, very manageable for me to trade that. So I would say, even though indexing is becoming large, it is very, you know, it's absolutely, it's not a problem to trade the cash flows that we're getting into the funds right now.

Nate Geraci: As indexing continues to grow in popularity and we see investors place more emphasis on fund fees and we continue to see the overall cost of index funds come down, do you think roles such as yours are going to garner more attention? I mean, you tell me but, my guess is, five, ten years ago, probably nobody cared about what was going on behind the scenes with things like securities lending, but now it does seem like there's interest there. Is this sort of a new frontier in terms of fund evaluation?

Gerry O'Reilly: Well, I mean it is. I mean, I think one of the real advantages, if you were to ask me what makes Vanguard any different, one of the first things I would say is the experience that we have. You know, Mike Buek has been on our desk for 30 years and understands market structure, understands indexing and certainly, the average tenure, I would say, is probably in that 12 to 13 range as I mentioned earlier. So, just having that level of experience on the desk. Yeah, expense ratios are a very important factor, but they're not everything. I would say understanding index methodology, understanding market structure, how you handle large rebalances, all of these are ways that you can add incremental value to the fund. Understanding what that trade-off is between impact and tracking error and having a good risk group that can oversee this. We also work closely with our transaction cost analysis team to analyze all of our trading. So, all of those are different components which can be the difference between a desk that's doing the job well and maybe one that's not doing so well. So there is greater emphasis on it, but I think we're well positioned going forward to do well on that front.

Nate Geraci: Alright Gerry, before we let you go, on a personal note, I read that you actually represented Ireland in the 1988 Summer Olympics. You ran track, you ran the 1,500 and, as I understand it, you've broken the four-minute barrier multiple times. So, my question is this: what's more difficult, running an index fund or running a sub four minute metric mile?

Gerry O'Reilly: Well, I'll tell you, if I was to try and break a sub four minute mile today, that wouldn't work out so well. But, I mean, back then, there's something, I think I read sometime back, there's only 1,500 people to ever break sub four minute mile so it's a fairly elite club and I'm delighted that I was able to do it back in the day. You know, they are two very different challenges, right? I mean, you go through life, there's certain things that are like, this is something I really want to accomplish. I grew up in Ireland. My goal was to try to get a scholarship to come to the United States. I ended up coming to Villanova which is very well known for its middle-distance running. And, once I got to Villanova, then it was, okay now the more senior people on the team, the thing was, you have to be able to break four minutes. That was kind of the challenge and so that was a goal of mine and I managed to do it my junior year. I ran it 3:54 a mile. And then you move on. So, you're running and then you get these new challenges and then, I would say, at Vanguard, the challenge of managing this much money is a great ... I would say there's a lot of similarities in terms of the satisfaction you get. When we have a huge rebalance and it goes well, that feeling you get is not too unlike the feeling you get when you walk off the track after having a great competition. So, there are similarities, but in a different way.

Nate Geraci: Well Gerry, with that we'll have to leave it there. Really interesting conversation today. We certainly appreciate your time. Thank you.

Gerry O'Reilly: It was a pleasure. Thank you all.

Nate Geraci: That was Gerry O'Reilly, Principal and Portfolio Manager at Vanguard.