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How Vanguard Hires Its Managers

By Motley Fool Staff and Tom Gardner – Mar 14, 2014 at 3:06AM

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How can you tell whether a fund is being mismanaged or is just going through the inevitable ups and downs.

John C. Bogle is the founder and retired CEO of The Vanguard Group, the largest mutual fund organization in the world, comprising more than 160 mutual funds with current assets totaling more than $1.4 trillion. Since his retirement from Vanguard in 1996, Bogle has spent his time studying, writing, and speaking on the financial markets and mutual funds. He is president of the Bogle Financial Markets Research Center, created in 2000 to support his ongoing work on behalf of investors.

Even successful funds underperform some of the time; how can you tell whether a fund is poorly managed, or just going through a rough spot? In this video segment Bogle explains Vanguard's approach to assembling management teams for its funds.

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Tom Gardner: Even the most successful, actively traded funds at Vanguard have a period of three years -- sometimes even five years -- where they underperform, but net-net they've outperformed.

In the case of outperforming actively managed funds, let's just say they have a few qualities that we probably both love: very low turnover, tenured leadership, a very fundamental business-analytical approach.

But even in those cases where the fund is very well run -- even Warren Buffett and Charlie Munger -- are going to have a year or a period of a couple of years, potentially, where they lose to the market. What's the appropriate amount of time to hold something before saying, "This team doesn't really know what they're doing?"

Jack Bogle: Well, let me start off by explaining Vanguard's philosophy as I implemented it -- not as they necessarily do today.

That is very early after we closed Windsor Fund back in 1985 --- it was getting too big -- and we started Windsor II. Everybody said it would never do nearly as well as Windsor, and of course it's done better, a little. They track each other very closely, so I don't want to make an issue about that.

Then we had U.S. Growth, and that was run by Wellington. We decided we needed a new manager, and I wasn't so sure about them, so I did what set the standard for everything I did since then, and that is bring in another manager, and then another manager, and then another.

We have a lot of equity funds that have five managers. It's not that it's easy to pick five managers, but if you're comparing yourself with the universe of -- let me say -- large-cap value funds, and there are 50 funds in that universe, five is going to have the same return. It's a law of large numbers thing.

Most of our equity funds have five to seven managers, so there's not much premium on manager selection. You hope they will do well. We happen to be having a good year this year, but we'll have a bad one because that's the nature of the business.

What you don't want is something that departs so far from the market -- particularly on the upside -- I mean, you don't like it on the downside, but on the upside it draws money in. It brings in these investors who are looking for the next big thing, the next hot thing.

We win by about a point and a half a year, on average, not because we pick better managers, but because we have very low operating costs; our expense ratio. We negotiate the fees way down with the advisors -- the fee rates -- because the advisors are not starving to death in terms of the dollar fees.

Then we've looked, as you said, for long-term managers with lower turnover, and then we have no loads. If you look at all those numbers if we're good enough to be average -- or lucky enough to be average -- we win by about a point and a half a year, which is 20% over 10 years, and I always thought that was quite good enough.

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