The Future of Vanguard

With such panic and uncertainty in the markets, it seems like a rough time to take the reigns of one of the world's largest mutual fund companies. But Vanguard's Bill McNabb—who stepped into his new job as chief executive in August (following veteran executive Jack Brennan's retirement)—isn't breaking a sweat. Recently, U.S. News sat down with McNabb and talked about indexing in a down market, the value of alternative investing strategies, and challenges facing the index giant. Excerpts:

Given that index investing is straightforward and holds few surprises, are you getting many calls from investors?
There has been somewhat of an uptick. Investors are asking the natural questions: How does this affect me? Do I need to worry about it? The good news is with highly diversified portfolios, these events—while traumatic—don't have to be devastating. It'll be some time before people see the full impact of how this plays out...it's going to take some time. Our role is to be straightforward and to make sure that we're giving very clear answers and to take a little noise out of the marketplace.

Any advice for investors right now?
We try to do two things: No. 1, try to put a little perspective around it. If you look at the last 70-plus years of history—close to 80 years—and you look at rolling 10-year periods on a monthly basis, 12 or so percent of those periods have negative real returns. That's obviously not a majority, but it's certainly not uncommon. So what we've been going through in the equity markets in the last decade is not uncommon. Markets tend to revert to their long-term averages. But how you think about long term, I think, has to be stretched further.

What about the almighty power of diversification?
I think that's by far the most important thing.... It seems like motherhood and apple pie to talk about diversification and balance, but it just keeps coming back, over and over. Think about every period for the last 25 years that we've gone through and how much better the diversified investor is than somebody who had all of his or her eggs in one asset class.... It doesn't insulate you totally—when you have a period when stocks and bonds both do poorly, then you're not going to look great—but in the long run, that balance has been really important.

Why is indexing still a good idea in a market like this ?
Almost over any rolling 10-year period, index funds outperform active because of cost. That's the single biggest driver. If you think we're in an environment where single-digit returns might be more prevalent...cost is going to be an even bigger, more distinguishing factor. It's one thing to have a 75 or 100 basis point cost advantage in a market that's up 14 or 15 percent, it's another thing when it's up 7 or 8 percent. It's a huge difference in terms of percentage saved. The other part of it is that we haven't even begun to see power of indexing globally, as trading has becoming a global phenomenon.

Is your new global index fund a response to that?
It is. The cost of managing non-U.S. stuff is still very high. As the global market becomes larger and more efficient, indexing has a tremendous opportunity to be a very important component there.

Do you see any areas of the market for new index funds?
There's an awful lot of proliferation going on right now, especially in the ETF world, where things are being sliced very thinly. We continue to look for basic building blocks that are missing. I don't think there's a lot missing from a capabilities standpoint, but we'll probably selectively have a fund here or there. The non-U.S. side is likely to have more promise in terms of new things we might do.

How about a progress report on the new Managed Payout funds?
They're performing in line with what you'd expect, given the market. It's an interesting concept. In essence, you're creating a miniendowment for a personal investment. In the very short period of time since we introduced them, the markets have been very negative, so performance has been negative. But anytime you invest in stocks and bonds in a diversified portfolio, you run the risk—especially in the short run—of negative returns. That's part of the risk-return payoff.

Going forward, what will be the biggest areas of growth for Vanguard?
Half of our assets are in IRAs or 401(k)'s; retirement is something we're very passionate about. There's a popular notion that it's a market that's very mature: That it's done, and the boomers are all retiring and will take all of their money out of stock market. I was born in the peak year of boomers, and I still have quite a while until I retire. If you look at demographics eight to 10 years out, the number of 50-year-olds will increase dramatically, but 40-year-olds are going to hold steady for the most part. Those are hyper-savings years for people.

Expanding our ETF business is also vital. Well-run ETFs are nothing more than index funds in a slightly different structure. We're taking indexing to a broader group. I'm very optimistic that there's lot more room to go there. Third, I think the non-U.S. part of Vanguard will become more relevant over time. There's no reason why our story shouldn't translate in other areas. And it has: We've made decent progress in Australia, which we consider our launching-off point in the Pacific Rim. Australia is a small country but has one of most highly developed retirement systems. They made the move to defined contributions, and we were there right as that took hold.

What's your biggest challenge going forward?
Going forward my biggest challenge is making sure we stay at the forefront of innovations and keep thinking about new things; always improving One of the things I learned from Jack is that you can't stand still, and you never can settle for status quo. And I think living in that state of perpetual dissatisfaction is pretty important.