Try as they might, few money managers are able to consistently beat the market. It’s even trickier for Gus Sauter.
By Hal Lux
August 2001
Institutional Investor Magazine
He is the market.
Sauter runs Vanguard Group’s massive stock indexing operation. At last count the Valley Forge, Pennsylvania-based mutual fund giant managed some $211 billion spread across 29 stock index offerings, ranging from the country’s biggest mutual fund, the Vanguard 500 Index Fund, to the obscure Pacific Stock Index Fund, which invests in the stocks contained in the Morgan Stanley Capital International Pacific free index. Sauter’s goal in overseeing these funds is to track the performance of the underlying index, even after accounting for trading and other administrative costs.
As a manager, he has done a pretty good job: He leads all Standard & Poor’s 500 index fund managers over the past five years, according to Morningstar. And as an investor familiar with efficient-markets theory, Sauter puts most of his own money into these indexes. “I always hope,” he says, “that investors in active funds realize that the odds are stacked against them.”
Here’s where it gets tricky. The fact is, Sauter also happens to be an active money manager. He runs $3.8 billion in four funds, trying to beat various benchmarks - in other words, indexes. In other words, himself.
Inconsistent? Not necessarily, say investing experts. “I could see how it would strike people as being paradoxical,” says Morningstar mutual funds analyst Scott Cooley. “But I don’t think there’s a contradiction. You don’t have to believe in total market efficiency to believe in indexing.” And Sauter doesn’t. “I don’t believe that markets are perfectly efficient,” he says. “If I did and I was doing active management, I would be a total farce.”
Farce, he is not. As an index manager, Sauter is brilliant - he has actually outperformed some of the underlying indexes that his portfolios mirror - but as an active manager, the jury is still out. To be sure, it’s hard to judge Sauter’s record fully because he runs pieces of three multimanager funds - Windsor II, Morgan Growth Fund and the Explorer Fund - that don’t report individual manager results. (He says he is beating his benchmark on two funds and trailing on the other.) As the sole manager of the $800 million Vanguard Strategic Equity Fund, Sauter has racked up annual returns of 14.16 percent over the past five years, good enough to beat the fund’s self-selected benchmark, the Russell 2800, an index of small- and midcap stocks. After trailing the more visible benchmark, the S&P 500 index, for most of the past five years, Strategic Equity is now neck-and-neck with the index for the five-year period, thanks to a 3 percent return this year compared with the S&P 500’s 9.8 percent decline.
Still, Sauter, who follows a rigorously quantitative investing style, resides in the middle of the performance pack for all midcap value managers, the category Morningstar considers Strategic Equity’s peer group. “I think his fund is okay,” says Morningstar’s Cooley. “I wouldn’t mind owning it if it were in my 401(k). But I would be hard-pressed to say buy it compared to other midcap funds like Oakmark.”
Nevertheless, with Strategic Equity solidly beating its benchmark, Sauter is quite pleased. People who know the low-key Midwesterner only as the king of indexing might be surprised to learn how much he loves playing the market. “I’m more intellectually stimulated by the active side,” confesses Sauter, who spends about 25 percent of his time on stock picking. “When we’re hitting on all cylinders, it’s a pretty big thrill.”
Sauter’s double life reflects the mixed blessing of being a passive money manager. The style is unquestionably successful, but it’s rather dry.
For the past 20 years, only 13.25 percent of surviving U.S. mutual funds have beaten the cumulative returns of the S&P 500 index, according to mutual fund data company Lipper. This dismal performance has turned passive investing into the ascendant philosophy of money management. About 25 percent of all U.S. pension stock investments are now indexed, versus 19 percent in 1995, according to Greenwich Associates. And about 12 percent of all U.S. stock mutual fund money now sits in index products, up from just 5.5 percent in 1995, according to Lipper. The steady growth of index mutual funds - especially Vanguard index funds, which account for about 60 percent of the market - has played a major role in the 1,000 percent increase over the past decade in Vanguard’s assets under management.
On the active side of his business - and brain - Sauter adheres to a quant style that, surprisingly, shares some roots with passive investing. Wells Fargo Bank pioneered the concept of indexing in 1971, when it began running a small amount of institutional money based on a broad index of New York Stock Exchange listings. Batterymarch Financial entered the institutional indexing business around the same time, and in 1976 Vanguard founder Jack Bogle launched the first indexed mutual fund. Some in the financial services industry mocked these early efforts, which threatened to undermine their lucrative active money management businesses, but indexing drew important intellectual support from emerging academic theories of portfolio diversification and efficient markets.
These theories, which allowed investors to think rigorously and mathematically about risk and return, as well as the development of options pricing models, ignited the early interest in quantitative active investing strategies. Quants build intelligent models and systems that pick stocks and identify profitable trading strategies. Not surprisingly, Wells Fargo and Batterymarch were also pioneers in institutional quant investing, and Vanguard launched one of the first quant mutual fund products, Vanguard Quantitative Portfolios, in 1986. “Indexing and quant strategies came out of the same movement in the 1970s to take advantage of new academic ideas in investing,” says Donald Luskin, former vice chairman of Barclays Global Investors, which was once known as Wells Fargo Nikko Investment Advisors. Luskin, who runs an actively managed New Economy mutual fund called OpenFund (down 52 percent for the 12 months ended June 30), adds that the risk management techniques of indexing are especially applicable to active investing.
Indexing has proved more successful than active quant strategies, but is as boring as it is sensible. Index fund evangelist Bogle has described such investing as being as much fun as “watching paint dry.” Many sober index investors, including even some passive managers like Sauter, still yearn to take a crack at beating the market, even if they believe it unlikely. Call them, well, passive-aggressive.
“There’s no question that it’s an uphill climb,” says Sauter. “But the right side of my brain would be disappointed if I couldn’t do it.”
Vanguard has long juggled the same potential contradiction, selling actively managed funds while trumpeting the superiority of indexing. The fund giant urges investors to index the core of their portfolios and warns them that it’s nearly impossible to predict the short-term performance of active managers. But it still runs the third-largest family of active funds. How does Sauter resolve such contrary impulses? He believes that, in fact, a few active managers have the skill to beat index funds over the long run.
“If markets are perfectly efficient, then nothing makes sense besides index funds,” says Sauter. But markets, he believes, are not so pure as once thought. In fact, in recent years finance theorists have softened somewhat from what once was a very rigid definition of market efficiency - known as “strong form” efficiency - to a consensus view that the skills of a very small number of active managers will allow them to surpass their benchmarks. “You find more and more academics willing to concede that the market doesn’t look as efficient as they once thought,” says University of Chicago finance professor Tobias Moskowitz. Still, many academics believe that the number of market-beating managers will be so small that investors are unlikely to find them in a cost-effective manner. Sauter just happens to think he’s one of those managers.
The fact that an indexer such as Sauter uses a quantitative approach in his active investing is not surprising. While indexing and quant stock picking are very different, even somewhat contradictory practices, they tend to attract the same types of investors and managers. Both quant investing and indexing require heavy quantitative and computer skills, and they are a natural fit for people with scientific or quantitative finance backgrounds. Also, while there is little hard evidence to support the notion, many indexing proponents seem to intuitively believe that quant investing is the most sensible of the actively managed approaches.
“When indexers grow up,” says Sauter, “they want to be quant managers.”
Before he grew up and joined the world of money managers, George (Gus) Sauter spent three years panning for gold. A native of Mansfield, Ohio, and the son of two lawyers, Sauter earned a BA in economics from Dartmouth College in 1976 and an MBA from the University of Chicago in 1980. After graduating, the fledgling goldbug headed west to the Mojave Desert, 50 miles south of Las Vegas, to work an acquaintance’s gold-mining claims. Gold prices were the 1980 equivalent of Nasdaq 5,000. Inflation fears and speculative frenzy sent the precious metal to a high of $875 an ounce in January 1980, up from $200 the previous year. Pundits were predicting that the metal’s price might spike to more than $1,000. Sauter hoped to strike it rich with a new process for extracting small amounts of the precious metal, but the Piute Minerals Co. was an unalloyed bust. Gold plunged to about $400 by 1981.
“We were never able to extract the gold from the ore,” Sauter says. Throwing in the trowel, he worked for the next three years as a trust investment officer with the First National Bank of Ohio, where he devoted part of his time to developing a quantitative investment system.
Sauter got his job at Vanguard by accident. In 1987, while attending a Dartmouth reunion, Sauter ran into then-Vanguard president Jack Brennan, who had lived on the same dormitory floor freshman year. Vanguard happened to be looking for someone to develop an internal quantitative investment program.
Although Sauter joined Vanguard to work on actively managed quant investing, he almost immediately was switched to run index investing after the head of that unit resigned. Though he had never run an index fund in his life, he turned out to be a natural at juggling the systems planning and day-to-day trading chores involved in indexing huge sums. “We were extremely lucky,” says Brennan, now Vanguard’s chairman and CEO. “You don’t find too many people who can talk about investment theory, are perfectly happy to work an order on a trading desk and, ‘by the way,’ they can write the software that you need to run the business.”
Today, Sauter handles his money management activities out of a cluttered corner office at Vanguard’s headquarters. Propped up on his desk is a poster reproduction of an anti-indexing advertisement - “Help Stamp Out Index Funds” - run by a money management firm in Institutional Investor magazine in the 1970s. Packed boxes are still stacked on the floor, even though Sauter moved in more than a year ago.
Little else about Sauter’s life at Vanguard is disorganized, and by any measure, he has run the company’s index funds brilliantly. Stock index funds typically trail the benchmarks they track by a small amount because of transaction costs and the inevitable delay in putting some money to work, but Sauter’s giant S&P 500 fund has actually beaten the index by 2 basis points over the past three years, according to Morningstar. Sauter does what seems theoretically impossible by conducting some riskless trades with his massive asset base that add incremental returns. “The guy clearly blows the doors off the competition,” says William Bernstein, a portfolio manager and analyst who has studied index fund performance for Efficient Frontier Advisors, a North Bend, Oregon-based money management firm. “Sauter is the master of transactional skill in indexing. I think he’s one of the most underappreciated people in the investment business.”
An indexer’s performance depends on investing all new money before the stock market closes each day while minimizing transactions costs in putting those funds to use. Working out of a tiny trading room, Sauter’s traders handle an average of $50 million to $100 million, and sometimes as much as $300 million, each day. Unpredictable money flows from millions of small investors, nearly infinite choices about how to process the order and the occasional trading market disruption - such as June’s Nasdaq system crash - make indexing an extremely challenging trading competition.
The margin of victory or defeat for indexers is small. Every Friday the 17-person quantitative equity group, which works on the indexes and Sauter’s active funds, compares its performance with those of other giant index fund managers, such as Barclays Global Investors and Dimensional Fund Advisors, and often the top firm leads its closest competitor in annual return by just 1 basis point. “It’s absolutely a game of inches,” says Sauter. “Being off by 2 basis points on the institutional side in the S&P 500 can lose you a mandate.”
Running Vanguard’s indexing group requires an intense focus on details and an unending competitiveness about arguably the most unglamorous battle in the money management business. “Indexing is about blocking and tackling,” says Sauter. “You have to get the processes right and then you have to execute flawlessly.” Even if the building catches fire. In case of an emergency, Sauter and his traders have made plans to dash to a “hot site” that is an exact duplicate of the regular index trading room, in a Vanguard complex ten minutes away. Should they get stuck in traffic on the way, Sauter is prepared to buy and sell futures by cell phone. “We spend a lot of time planning for things like fire,” he says.
Sauter took a patient approach to launching his active business at Vanguard. For four years he managed only index funds, while slowly researching the quantitative models that he would use to help run his actively managed funds. In 1991 he finally took over a small portion of the assets in the actively managed Windsor Fund. In 1994 he became one of several managers of the Morgan Fund, when he took on responsibility for a small piece. The following year he launched his own quant fund, Vanguard Strategic Equity, and in 1997 he began managing a slice of Explorer. Today Sauter runs about $3 billion in Windsor II, Morgan and Explorer, and some $800 million in Strategic Equity.
As an active manager, Sauter basically builds quantitative models that pick stocks based on multiple factors, such as relative valuations and expected earnings. Sauter is betting that his computerized selection system can process a lot more information, study many more stocks and discern patterns in historical price movements that the judgment of competing managers will miss. Sauter holds fewer than 200 stocks in Strategic Equity and turns over that relatively narrow portfolio less than once a year - extraordinarily restrained trading in the quant world. He isn’t exactly swinging for the fences. After one model picks the sectors and stocks that he hopes will outperform the market, Sauter takes a bit of a step back into the passive world and uses a piece of software of his own design, called an optimizer, to put together a portfolio no riskier than the Russell 2800. After all this work Sauter hopes to have built a portfolio that will modestly outperform the market, a strategy that limits the fund’s risk but makes it unlikely to top the ranks of value managers in the short run. Even in the long run, Sauter cautions investors not to hope for too much. “Outperforming by 1 percentage point would be great, outperforming by 2 percentage points per year would be a grand-slam home run,” he says.
Thanks partly to the tech bubble collapse, Sauter’s recent performance has been impressive. Vanguard Strategic Equity has topped its benchmark in four of the past six years. Last year it returned 7.46 percent, compared with 5.45 percent for the Russell 2800. This year through late July, thanks to stock picks such as grain processor Archer-Daniels-Midland and brokerage firm Bear Stearns Cos., the fund has returns of 3 percent compared with the index’s -5.6 percent.
Though Sauter’s returns are solid, he readily concedes that five years aren’t enough to prove statistically if his benchmark beating numbers are skill or luck. Whether he can overcome his beloved indexes over the long term remains to be seen. Passive Gus wouldn’t expect it to happen. Active Gus is cautiously optimistic. Says the man who combines both styles, “Hope springs eternal.”
