Bond investors, beware

As Chief Investment Officer of Vanguard, George U. "Gus" Sauter, 58, is responsible for a staggering amount of fund investors' money -- some $1.9 trillion.

More important, he's saved a lot of investors' money. Almost 60% of Vanguard's assets are in passively managed index funds, so Sauter's biggest job has been to pare costs so shareholders keep more of their return. (It may not be glamorous, but it has paid off in performance.)

Along the way, Sauter guided the company into a booming market for exchange-traded funds, the portfolios that can be traded like stocks.

His perch as top investor at the country's largest fund manager has also given him a sharp view of the big picture. And part of that picture today is that bond investors -- who added $27 billion to Vanguard funds alone so far this year -- may be in for a bumpy ride.

Sauter retires from Vanguard at the end of the year. He spoke with Money senior writer Kim Clark; their conversation has been edited.

In the past five years, we've had a crisis on Wall Street, wild volatility, and outflows from equity funds. Are investors losing faith?

We're worried about that. But we do not think the markets are broken. I can't recall too many periods in my 25 years here where we didn't experience volatility. The market was down 21% on Oct. 19, 1987. And then the Asian contagion in the fall of '97, the Russian debt crisis, the tech bubble bursting.

Now we've got European debt, and we've got the fiscal cliff. Still, that does not convince us at all that you won't get normal returns going forward.

Why? Seems like there's a lot of economic danger ahead.

It turns out equity returns are not related to economic growth. The best predictor of future returns over the long term -- over, let's say, a five-or 10-year horizon -- tends to be current valuations. The market is priced at about 13 times [expected] earnings, and that is a little bit cheaper than normal.

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What about bonds?

The best predictor of bond returns is the yield to maturity of the 10-year bond. The 10-year Treasury is at less than 2%, so returns would probably be 2%, maybe 3%. Historically bonds have returned about 6%. It's difficult to see how we could get that.

You've seen big inflows into your bond funds. Are you concerned investors are overdoing it?

Yeah. We're trying to educate clients to be aware of the risks. A rise in rates will negatively impact their principal. At the same time, we do believe that even with lower expected returns, bonds play an important part in the portfolio: diversification. You want to have that anchor.

Vanguard founder Jack Bogle has criticized overuse of exchange-traded funds. You've created dozens of them.

We think that ETFs are just a different way to distribute an index fund. You can invest in our Total Stock Market Index fund either through the conventional share class or you can invest in the ETF.

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It comes down to investor choice. Jack is concerned that people become market timers with ETFs. We have some research that is contrary to his view. Our ETF investors [in broad-based funds] do not have substantially different time horizons than our conventional shareholders.

I think Bogle's concern is about all the ETFs that focus on just a narrow slice of the market. Aren't those likely to be used by market timers?

I certainly share the concern with the proliferation of ETFs in the marketplace. We have data that show that with narrowly defined investments, investors are not invested in them on the way up. They pile in at the top and then ride them on the way down.

But you created funds for sectors like energy and health care.

We have funds for broad sectors, but we don't have industry funds or single-country funds. There's a level where you have to call it quits.

I was telling somebody I was going to interview the guy in charge of the big index funds, and he asked, "How can that be a full-time job?"

You want to see the number of people we have? [Laughs.] Indexes change more often than you might imagine. There's a lot of trading involved. On a given day, we'll do 5,000, maybe 10,000 trades.

Your last hurrah has been to change the indexes tracked by many Vanguard funds, including Total Stock Market. What exactly did you do and why?

We changed index providers. Index licensing fees have been a very rapidly growing component of costs, and we found a way to reduce that by switching. It will save hundreds of millions of dollars [for our clients] over time.

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How does it change the funds?

For example, the index provider we will use for international funds classifies South Korea as a developed market, whereas the current index considers it an emerging market. Every person I know who knows anything about South Korea says it's a developed country. As a result, our developed markets index funds will now include South Korean stocks.

Are there any changes with the funds that follow U.S. stocks?

The Center for Research in Security Prices, which created the new U.S. indexes, have a process they call "packeting." Say a stock is transitioning from being a small- cap stock to midcap. Normally, Vanguard Small Cap Index would have to sell the stock, and then Mid-Cap Index would have to buy it.

With packeting, only half of the weight moves into that new classification. In the next quarter, if the stock remains above that band, only then does the remainder move. When you're at the border, you don't want to flip-flop back and forth. This cuts turnover by about 25%, and that means lower transaction costs.

Last question: Why retire so young?

As they say, it's the miles, not the years. And I wanted to have time to do other things.