Vanguard’s New Bond Chief Is Going on the Offensive
(Bloomberg Opinion) -- Given how frequently Sara Devereux emphasizes the importance of “alpha,” the last place you might expect she works is Vanguard Group Inc. After all, the $7.9 trillion asset manager founded by Jack Bogle is best known for making passive index funds mainstream — the exact opposite of trying to beat a benchmark.
Yet Devereux makes no secret of her plans to go on the offensive in active management as global head of Vanguard’s fixed-income group, a $2.1 trillion team she took over at the end of June after John Hollyer retired. When I spoke with Hollyer about Vanguard’s ambitions in early 2019, it had $413 billion in active bond funds. That figure has more than doubled to $1 trillion.
Devereux, in her first media interview since taking over as Vanguard’s fixed-income chief, told me she intends to press the firm’s low-cost advantage even further.
“Our goals at Vanguard are to help all investors, not just Vanguard investors,” she said. “So if by entering new active markets, we not only deliver strong performance — which we have — but we also drive fees down across the industry, we consider that a win.”
The prospect of ever-lower fees should make Vanguard’s rivals sweat. In late July, the Valley Forge, Pennsylvania-based money manager revealed plans for two new active fixed-income funds. The Vanguard Core-Plus Bond Fund, which is set to open to new investors next month, has an expense ratio of 0.2% for Admiral shares, compared with 0.48% for peers. The Vanguard Multi-Sector Income Bond Fund will have an expense ratio that’s about a third of its competition. That’s serious margin pressure in an industry where consolidation isn’t a matter of if, but when.
Devereux, a former partner at Goldman Sachs Group Inc., also discussed her outlook for Federal Reserve policy and whether real U.S. interest rates can ever turn positive. The interview has been edited and condensed:
Brian Chappatta: Let’s start with inflation. Is it just transitory or something more permanent?
Sara Devereux: Given the nature of the reopening — increasing demand in the face of supply-chain constraints and base effects — we’re in a period of elevated inflation. But we do believe it’s transitory. Vanguard’s forecast is for core PCE to finish 2021 around 4% but to track back down to the 2% area in the middle of next year.
This slowdown to 2% could be driven by decreases in pandemic-related areas, for example a reversal of price increases in used cars as demand eases and there’s resolution to supply-chain issues. We saw some of that in the latest CPI release. That’s core to our view of it being transitory. But we’re sensitive to upside risk. We’re watching very closely beyond the pandemic-sensitive components. In particular, we’re keeping a close eye on housing.
We’re also keeping an eye on inflation expectations and wages. At the end of the day, we believe longer-term secular trends such as technology will weigh on inflation. But we acknowledge there is medium-term risk to the upside and a lot of uncertainty.
BC: Given those risks, are you surprised to see 10-year real yields below -1%? What would it take to see positive real rates again?
SD: If we were to see unexpected and persistent inflation, we would expect to see real rates lead nominal rates higher. That’s not our base case.
One thing we look at very carefully is where the Fed terminal rate is priced. The market is currently pricing in something like the 1.5% area, which is really low. We understand why, but if they go to 1.5% and have a target of 2% on inflation, that implies -0.5% real rates. That’s lower than it has been historically, but it has been trending lower, so it’s not outside the realm of possibility. But the debate around r-star is a challenging one.
BC: Is it possible for governments and corporations to unwind the leverage they’ve taken on since the 2008 financial crisis? If not, what are the consequences? What’s the endgame?
SD: The incentives created by economic and financial conditions over the past several years have yielded a backdrop whereby the cost of debt is really low. For years, cost of issuance for a sector like utilities was 13% to 14% for AA senior-secured debt. That created less incentive to issue new debt. Nowadays, the incentives are completely reversed. Corporations could unwind the leverage, but the cost of debt on an after-tax basis is so extremely low that there’s no incentive to do so.
When you think about a country and their fiscal space, it’s not just a function of how high the debt-GDP ratio is, it also depends on the relationship between the cost of debt and economic growth. At the highest level, developed-market debt loads are sustainable over the medium term. We don’t foresee them driving large changes in fiscal policy. If they were large and persistent — say, running at 5% over a longer period of time — it would need to be addressed or risk damage to economic and financial-market stabilization.
BC: When will the Fed start tapering and raise rates for the first time?
SD: Our base case for a taper announcement is the November meeting, with the potential to start tapering as early as December. They’ve done a pretty good job telegraphing it, and they don’t want to surprise the market. They weren’t even thinking about tapering, then they were talking about talking about tapering, now they’ve talked about it.
In terms of the pace, they want to be very predictable and orderly. Our expectations are $15 billion a meeting, $10 billion in Treasuries, $5 billion in mortgages. We don’t see any incentive to go in any other proportion than that.
We expect the first hike to occur in mid-2023. If the Fed starts tapering in December or January, they’ll complete it by late 2022 and at that point they’ll look where inflation and employment stand. At Jackson Hole, Powell went out of his way to decouple tapering from hikes. It’s hard to predict where inflation will be that far forward, but based on our outlook, we see mid-2023, with some risk of sooner should inflation prove less than transitory.
BC: You said during a panel on Treasury market functioning and liquidity in September that some primary dealers “closed and were not willing to make markets” in March 2020. Did the pandemic reveal market-structure issues that need to be addressed?
SD: That was a liquidity crisis, not a credit crisis, and the speed and the scale with which things unraveled was truly unprecedented. Even off-the-run Treasuries were experiencing challenges, so that tells you they were extreme circumstances. When the largest, most liquid, enduring market is having troubles, that’s what we call a crisis.
We put a lot of liquidity in our funds so we didn’t have challenges meeting redemptions. Dealers were less willing — maybe less able — to commit balance sheet and warehouse risk for any period of time. Historically, dealers have been the buffer. You look back to the last crisis, where you could balloon up a balance sheet to warehouse some risk and trade out of it over time. The ability to have that flexibility has waned.
BC: What’s behind Vanguard’s big push into active bond mutual funds and ETFs?
SD: People sometimes are surprised when they learn we have over $1 trillion in AUM in active fixed income, across taxable, munis and money-market funds. We have been growing our capabilities, in particular in emerging markets, high yield and mortgage-backed securities. Along with growing our capabilities, we’ve also increased fund offerings. Our Core Bond Fund recently hit the five-year mark with a strong performance record.
We’re now ready and have filed to launch both a Core-Plus Bond Fund, which will be open to new investors in October, and a Multi-Sector Income Bond Fund, which we are running in-house for now but hope to open to investors in the near future.
We’ve also been increasing our presence in ETFs. We recently launched two new ESG-screened corporate bond ETFs, one in the U.S. and one in Europe. In April, we launched an active ultra-short bond ETF that has already crossed the billion-dollar mark.
Our motivation behind all these decisions is just contributing to more complete and stronger product lineups. Our measure of success is related to whether the product is helping investors meet their financial goals. In the case of active, this means generating consistent alpha and great risk-adjusted returns.
I’d also add that our goals at Vanguard are to help all investors, not just Vanguard investors. So if by entering new active markets, we not only deliver strong performance — which we have — but we also drive fees down across the industry, we consider that a win.
BC: Has passive fixed income gone as far as it can go?
SD: There are investors who are inclined to seek alpha and there are some who aren’t. We believe in an actively managed approach because it gives you the flexibility to respond to changing market conditions.
Yields are low — every basis point counts. If we can generate a little extra income, that might be a reason to look at active. In a rising rate environment, active skill can be critical. Or in credit, we’re going through a patchy recovery, selection is key and active allows us to choose the best names.
BC: If you had to take risk, would you rather take duration risk, credit risk or illiquidity risk?
SD: We prefer strategies that have the highest information ratios. Part of our philosophy is to focus on diversified sources of alpha, rather than concentrated macro bets. The theory is that this results in compounding alpha and the best risk-adjusted returns over time.
Credit selection is a really good example of a high information ratio strategy where we have edge. We have outstanding teams of experts, a rigorous process, and it results in alpha generation that’s repeatable and reliable across macro scenarios.
As for illiquidity, there are reliable strategies that capitalize on market inefficiencies, and we have had some success there. The key, as we learned in March 2020, is to keep exposures to a manageable size and ensure that your portfolio is balanced and there’s plenty of liquidity overall. You can’t be too stacked in illiquid areas or you can get caught offsides.
To us right now, valuations are rich across the board. An environment like this is where we can really be differentiated because we have low fees — it gives us breathing room to take risk down when investors aren’t getting sufficiently rewarded. When spreads are tight, we take down risk, we go neutral, we generate dry powder to be deployed at more attractive levels later. We can remain patient while our high-fee competitors can’t afford to do so.
BC: When you were named a partner at Goldman in 2014, 14% of new partners were women. Have you noticed a shift in finance since then?
SD: In my 25 years in financial services, I’ve definitely seen improvement in diversity. Right now there’s really strong momentum. I’m super excited for the future, but I recognize, and we all recognize, it’s a marathon, not a sprint. On a personal level, I try to be visible and accessible as a role model. I feel strongly that it’s important to pay it forward and help others along the path where possible.
It’s been great here at Vanguard. We’re super focused on fostering a diverse and inclusive culture. Our differences strengthen our teams to make better decisions — we believe in the business case.
We’re not yet where we want to be, but we’re excited about our progress. We’ve set some goals: By 2028, we aspire to have female and minority leadership representation at each level be at parity with overall representation.
SD: I did an MBA at Wharton; it was a phenomenal experience. I also received certification as an Associate of the Society of Actuaries, which was valuable. It gave me a strong foundation in quant skills, even though I’m not practicing as an actuary. And I do work with many CFAs who I admire.
I’m a big supporter of constant learning and ongoing development. I don’t think you can go wrong by investing in yourself, whether it be an MBA, the CFA, Associate of the Society of Actuaries or other accreditations. It’s a personal choice based on what’s right for you, your skillset and your career aspirations.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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