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Q&A with Gus Sauter
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August 28, 2001: 6:41 p.m. ET
The manager of Vanguard's S&P 500 index fund speaks
By Annelena Lobb
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NEW YORK (CNNfn) - As portfolio manager of the Vanguard 500 Index Fund, George U. ("Gus") Sauter oversees more than $90 billion in assets, arguably making him the most powerful fund manager in the world. Having run the fund since 1987, Sauter is a staunch defender of indexing -- the idea that individuals can't beat the market, so they should just try to match it. But Sauter also tries his hand at actively picking winners, managing portions of four other Vanguard funds -- Explorer, Morgan Growth, Strategic Equity and Windsor II.
Why index? Does it always work? And what does the manager of an index fund do all day? That's what staff writer Annelena Lobb sought to find out in a recent interview with Sauter.
AL: What's the case for indexing? Maybe you had a few bad picks in your past?
GS: The attempt to outperform the market is a zero-sum game, meaning that for every winner there has to be a loser. If someone is selling a stock at an undervalued price and someone buys it at that price, the buyer wins on that trade -- and the seller loses.
Some investors can outperform the market, but they have to be offset by investors underperforming the market. So the average investor gets the average rate of return -- that's why owning the whole market makes sense. When you factor costs into the equation, it just tips the scale a little further: It means that more than half of investors underperform the market, and fewer than half outperform it.
AL: Do you think there are specific areas of the market where investors should be indexing? Or, for that matter, specific areas where it doesn't make sense?
GS: I think investors should be indexing in segments or markets that have high-costs. If there is a financial asset that is low-cost, then the advantage of indexing tends to disappear. It doesn't make sense to index money markets, for example, because expense ratios are pretty low anyway.
I think a lot of people underestimate the cost of gaining exposure to the stock market. It's very easy to see what a mutual fund's expense ratio is, and a lot of people think that a 1 percent annual fee isn't that high. But it's a pretty big hurdle for an active manager to consistently overcome on a long-term basis.
Then there are also transaction costs. The average fund turns over 90 percent a year, adding another 1 percent or even 2 percent in transaction costs. You start adding all those costs together, and you're eroding your returns.
AL: And yet Vanguard has quite a stable of actively managed funds -- and you yourself help run several of them. Isn't there a little hypocrisy going on here?
GS: The advantage we have in active management is that Vanguard don't saddle fund managers with tremendous costs, so the hurdle to overcome is much smaller.
Like every mutual fund company, we expect that our managers will be in the select minority that will be able to outperform the market. It doesn't always work, obviously, but we try not to handicap our managers with high costs as well.
AL: Can you describe what you do all day? I hear these nasty rumors that index managers just sit around and watch the computer do all the work...
GS: Yeah, you hear there's nothing going on, right? I mean, primarily what I do involves running software that we've developed...
AL: So it's all true...
GS: ...and making sure the software is giving me results I think are appropriate. There may be instances where I want to override the software. A large part of indexing is actually a trading function. I've never heard anybody say how easy it is to be a trader, but a
large part of indexing is being a trader.
There can be plenty of things going on where you want to override a computer. For example, it may or may not know how liquid a security is, it might tell you to buy 100,000 shares of an illiquid share. You know it's not a great idea, but the computer doesn't.
AL: As a matter of fact, my computer just did something very strange...
GS: Thank God it's not managing my money.
AL: When picking your first index investment, would you pick a Wilshire 5000 fund, which owns the vast majority of stocks on the three major exchanges, or an S&P 500 fund?
GS: I think the Wilshire 5000 is the more appropriate benchmark. When it comes to indexing and investing in general, you should gain exposure to the whole market, not just the large-cap sector, which is what you get mostly with the S&P 500. The Wilshire 5000 provides
broad exposure to the entire U.S. market, so it's a better one-stop shopping investment than the S&P 500.
AL: If someone were choosing between buying an index fund, or exchange-traded shares (ETFs), which would you tell them to buy?
GS: I think they're both appropriate -- for different investors with different needs. The biggest differentiating factor is the flexibility offered by exchange-traded funds, which an investor with a shorter time horizon would probably be attracted to. ETFs are for someone who might want to trade their shares in the middle of the day.
If someone is investing for a 5- or 10-year time horizon, then they'll probably be satisfied with a basic index fund. A conventional index fund will also win out for someone who's dollar-cost averaging.
AL: Good to hear. You've actually got about half of my own assets in there. I'm glad you're confident they're in a place where they'll grow.
GS: Oh, they will. Just give them some time to do so. But they will. 
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