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Vanguard Indexing Guru Gus Sauter on ETFs, High-Frequency Trading

Vanguard Chief Investment Officer Gus Sauter is one of the key figures in the history of low-cost index funds and ETFs. He played a big role in developing the trading systems Vanguard uses in its massive index funds and also led the firm’s entry to the ETF market.

Sauter plans to retire at the end of 2012 after a storied 25-year career at Vanguard and says he’s considering teaching as one option after he steps down.

We caught up with Sauter on Thursday in a telephone interview. The Vanguard CIO discussed similarities between Black Monday in 1987 and the 2010 flash crash, how Vanguard index funds trade, high-frequency trading and how ETFs are impacting the market.

Sauter joined Vanguard in October 1987, just two weeks before one of the biggest market crashes in history.

Sauter, 57, directs Vanguard’s global investment management groups, which oversee aggregate assets of $1.6 trillion of Vanguard’s $2.1 trillion in global assets.

Below is an edited transcript of Thursday’s interview:

ETFtrends: Are there any links between Black Monday in 1987 and the more recent flash crash?

Sauter: Both crashes involved macroeconomic concerns. In 1987, interest rates worked higher but the stock market ignored it and skyrocketed. The 2010 flash crash involved concerns over the macro picture, Greece and the debt crisis. In other words, people were really eager to sell. The big difference between the two relates to market structure. In 1987 it was mostly a manual market. Specialists controlled stocks, and if things got crazy they would halt trading. The 2010 flash crash was a liquidity event. Reg NMS [Regulation National Market System] resulted in more links between exchanges and trading. Stocks trading on multiple venues. There was no mechanism to halt trading. In the old says, the specialist would say sorry, but we’re taking a timeout. Now we have circuit breakers that would have prevented the flash crash. We also have “limit up-limit down” coming. During the flash crash there was no one to control liquidity.

Q: Please talk about the development of the programs to trade indexes and benchmark changes at Vanguard funds.

Sauter: We were early adopters of the various electronic communication networks [ECNs] and automatic exchanges. We’ve always taken control of our own trades. We executed our own trades as opposed to giving trades to a broker with discretion. This helps us lower trading costs and avoid being front-run in the index funds. Our adoption of electronic exchanges was very important in the development of our trading programs. The biggest thing was taking control of our own trading and finding pockets of liquidity without the marketplace realizing we were participating.

Q: It doesn’t sound like managing an index fund is “passive.”

Sauter: There is an awful lot of blocking and tackling with passive management. A lot of action in the trenches – more than the average person probably realizes.

Q: What is your take on high-frequency trading [HFT]? Is it helpful or harmful to individual investors?

Sauter: The term high-frequency trading is applied to many different types of participants and strategies in the market. Market makers are high-frequency traders. We need market makers to provide liquidity and for price discovery. High-frequency trading is also used for arbitrage opportunities. We want the derivative markets to be in line with the cash markets. We want futures contracts to be in line with the underlying security. It’s the same with ETFs. Arbitrageurs use high-frequency trading to keep markets in synch with each other. Maybe at the other end of the spectrum there are people abusing the system. The SEC is trying to identify people doing that. It’s a very small percentage of high-frequency trading. Investors have benefitted from changes in the market including HFT. Transaction costs have declined precipitously the past 10 to 15 years. Net-net, we’re better off with HFT than without. Individual investors have benefitted more than institutional money managers. Spreads have narrowed dramatically. The bid and offer are thinner than they used to be; it used to be deeper. But most traders are not trading in enough size to worry about market impact. We benefit from tighter spreads but we still have to be careful.

Q: Have ETFs made the market more volatile or increased systemic risk?

Sauter: We’re in a difficult environment to invest. People are looking for something to blame, and ETFs have been successful. I think it’s unwarranted. Morningstar showed there is no market impact from leveraged ETFs. Leveraged strategies can be implemented in a number of ways. It’s the strategy that important, not the ETF structure. Our own experience indicates ETFs haven’t distorted the marketplace. However, education is very important. A lot of investors didn’t understand what they were getting into with some of these leveraged strategies. There is more education now so they may realize that these are short-term trading vehicles. But there is a need to educate investors so they know what they’re getting into.

Q: Why are Vanguard ETFs structured as separate share classes of existing index funds?

Sauter: The ETF share class helps preserve the integrity of the index funds. Like any mutual fund, we don’t want investors coming and going, which boosts transaction costs. ETFs were a way to provide a place for traders. We always try to screen short-term investors out of the mutual fund share classes. ETFs are another arrow in the quiver. ETFs are also a great way for us to work with the intermediary community. ETFs are an attractive vehicle for financial advisors. It opened up a new market to us. The index funds already had critical mass in the portfolio. This makes the ETF easier to manage and the index funds have a long-term performance record.

Q: What accomplishments are you most proud of at Vanguard?

Sauter: I loved everything I was involved in here. Building an equity team here was the first thing I tackled. It was a tremendous amount of fun and things grew dramatically. The past decade has been building out the fixed-income side. I like new challenges, so that afforded an opportunity. I also liked working with the SEC on initiatives and market structure changes. I’ve been with the senior staff the past 15 years and I’ve enjoyed guiding the direction of Vanguard.

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