A Day in the Life: Vanguard Traders03.08.2018
This Q&A appeared on Vanguard.com on March 7, 2018
Have you ever wondered what it’s like to do the actual investing at one of the world’s largest investment firms?
To find out, we spoke with two principals in Vanguard Equity Investment Group. Mike Buek is head of U.S. trading, and Gerry O’Reilly leads a team of index portfolio managers. They gave us an inside look at a day in the life of a Vanguard trader.
Our conversation has been edited for length and clarity.
What is the role of a trader at Vanguard?
Mike Buek: Our trading desk acts as a combination portfolio manager and trader for Vanguard’s index funds. So we understand the entire investment process. We seek to minimize tracking error to the benchmark while at the same time minimizing the fund’s transaction costs.
We want an index fund to be 100% invested to its benchmark. We monitor any changes to each fund’s benchmark and match them in our trading.
Gerry O’Reilly: At the same time, our traders manage the trade-off between tracking error and impact. We employ proprietary trading strategies to try to minimize the impact our trading has on the overall market.
So if we have a large inflow to a fund on a given day, we have to decide whether we have market impact and still track the benchmark or if we can minimize impact by trading this inflow over multiple days. It’s important to look at each trade relative to the market so we can understand what the market can absorb.
Every trader on the desk employs strategies we’ve developed over the years. For example, we’re fans of using limit orders as a way to minimize impact.
How do you prepare before the market opens in the morning?
Mike Buek: We typically come in around 7, 7:30. We check what the international desks in London and Melbourne have done so far.
Then we go right to reconciling each fund to make sure we’re 100% invested. For example, we may have expected to receive $50 million on a given fund the previous day, so that’s what we invested. But then the next morning, it turns out the fund received $55 million. We need to get that $5 million invested as soon as possible. In this case, we’d invest in futures to get the fund fully invested because the market isn’t open yet.
Gerry O’Reilly: Each trader also has to sign off on each of their funds in the morning, saying they agree with each fund’s status. Someone from investment risk also signs off, as well as the desk supervisor. So there are three different sets of eyes looking at the funds each day, making sure the starting line makes sense.
Each fund, based on its size, has a certain tolerance. For example, Total Stock Market Index is an enormous fund. If it starts the day with $10 million in cash, that isn’t a huge deal proportionally. It’s not even a basis point. But $10 million cash in one of our smaller funds could be a huge deal. Our investment risk group monitors those tolerances.
Knowing that you have someone keeping an eye on the performance of the fund and the benchmark is a big source of comfort. As much as we’d like to try to eliminate any potential tracking error, it’s probably unrealistic to think it will always be that way. We closely monitor what little tracking error there is.
If a fund is off, the portfolio manager works with the desk supervisor to determine why and make sure the fund is made whole. If you’re sitting on some cash, you’re probably going to buy futures before the market opens. If you’re overinvested, you’ll probably sell futures to get yourself flat.
Mike Buek: We also look at the performance from yesterday. We’ll look at every fund’s performance versus its index. If there’s anything off, we want to know why. If there’s a reason we knew about and it makes sense that we outperformed by 3/10 of a basis point—and that’s how deep it gets, explaining fractions of a basis point—we investigate so we can adjust and get the fund tracking as close to perfect as we can.
How does the experience change throughout the day?
Gerry O’Reilly: Our data group is notified of the index changes coming at that day’s close. Once you know an index change is coming, a fund tracking that index has to adjust.
On a given day, you could have 10 to 20 different corporate actions going on, such as a company issuing more shares. Each trader is assigned a corporate action and takes point on that stock. They will figure out what each fund needs to do to ensure the index weights are correct.
Trading can get really busy when indexes add or remove names. Say, for example, XYZ Company has outgrown a small-cap index and is being added to a mid-cap index. We’d need to mirror that move in the funds tracking those indexes.
We can often accomplish a lot by moving shares between funds. The small-cap fund may need to sell a million shares of XYZ, while the mid-cap fund will need to buy 700,000. We can move 700,000 shares from the small-cap fund to the mid-cap fund at the closing price with no impact. Then we just have 300,000 shares of XYZ to sell on the market.
What does the desk do as market close approaches?
Gerry O’Reilly: That’s the really important time of the day. Most of our cash flows are benchmarked to the closing price. So having a good handle on those flows is really important to tight tracking.
Mike Buek: One challenge we face is that fund shareholders can transact up until 4 p.m. If someone puts in a large order at, say, 3:55, our traders have to maneuver quickly to invest it properly.
Gerry O’Reilly: That can mean trading futures. The bulk of our trading goes through the New York Stock Exchange or Nasdaq. We have to get our orders down by 3:45 for the NYSE and 3:50 for Nasdaq.
If we get an order at 3:55, we’ve missed the cutoff, but we can trade futures until about 4:15.
How does Vanguard manage the global nature of the market? What specific difficulties come up?
Mike Buek: When we go global, we’re passing trades to Vanguard’s European and Australian-Asian desks to execute. And they pass us trades to execute for their funds. The communication has to be good between the three desks so the traders executing each trade understand the objective.
That’s challenging because of the different hours, but with improved technology and our expanded team, we’re able to make sure our portfolio management is globally consistent.
If you look at pure size, our U.S. mandates are bigger, so we have more impact on the U.S. markets. Some international markets, especially emerging markets, are more difficult to trade. Sometimes they have different closing mechanisms that present special challenges. So we have to understand those markets and work around it.
Gerry O’Reilly: International trading can often involve more markets. In the U.S., we mainly deal with the NYSE and Nasdaq. In other regions, you might have 10, 15 different markets closing at different times with different rules. In Europe, you’re looking at “When’s Norway closing? What about Germany?” You have to make sure you get your orders down in time because if you miss it, you miss it.
The other obvious difference is currency. U.S. investors are giving us dollars, which we have to convert into local currency when we buy international stocks. So in addition to the equity trade, our teams need to address the currency piece in order to keep the cost of the trade to a minimum.
Without getting proprietary, what would you say sets Vanguard’s trading desk apart?
Gerry O’Reilly: At a high level, one of the things that differentiates our desk is the level of experience. Mike has 30 years at Vanguard, and most of that is on the trading desk. I’m at 25 years and almost 23 on the desk. I’d say the average tenure for our traders is probably 12 to 13 years.
On this desk, we have people who specialize in different areas. When we get information from our brokers about what’s going on with a name, we can funnel that to the appropriate person to address that information.
You learn from experience. None of us are set in our ways. You have to be willing to change and learn from past experience.
How does your group add value beyond seeking to track the index?
Gerry O’Reilly: Vanguard is often one of the first calls whenever a company issues new shares of stock.
If the stock issue is big enough, there will be an index change the following day. So we’ll know we have to buy shares. If the stock issue has a price we think is appropriate, we’ll participate in that issue. Any time we make one of these purchases at a discount from the next day’s close, that’s a little bit of value added to the fund.
Mike Buek: That goes back to understanding the index methodology. When you buy the shares a day in advance through the secondary offering, you introduce some tracking error but save some transaction cost. And because you expect to buy at a discount, you might add value.
You’re constantly weighing those two things.
What does the desk do to prepare for the next day’s trading after the market closes?
Gerry O’Reilly: We have a role on the desk called the desk supervisor. That person makes sure that all of the day’s tasks were carried out.
So in addition to each trader signing off on their portfolios saying, “This number that I have on the fund makes sense to me,” the desk supervisor is going to sign off as well, saying, “I agree.” You want to be confident when you leave this floor that your funds are fully invested.
Mike Buek: The international side of the desk generates trade lists to pass to the other regions. It’s morning in Australia when we’re leaving, so we try to touch base with them to explain the list, especially if it’s a complicated one.
If there are issues, we all have each other’s cell number. If Europe comes in early in the morning and they don’t understand an instruction, they’ll reach out to the team that generated the trade to make sure they have it right.
Gerry O’Reilly: It doesn’t happen often, but if there is a situation in one of the markets at one of the international desks that requires input from our U.S. team, they know they can get in touch with us at any point. We’ve had people come in at 3 in the morning because of something that happened overseas. Our team knows they can always contact someone at any site if necessary.
If nothing comes up in the night, you come in the next morning and start over.
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