April 24, 2023
Dan Pozen, a senior managing director and equity portfolio manager at Wellington Management Company, oversees the equity sleeve of Vanguard Wellington Fund. He and his team are responsible for approximately $65 billion in Vanguard assets, as of March 31, 2023.
In this Q&A, Pozen reflects on his three-year anniversary as lead portfolio manager of the fund, discusses the downside protection that this value creation approach strives to provide, and looks ahead to how the fund is positioned for a changing economic landscape.1
We’re pretty intentional about the objectives of the equity sleeve of the fund. In order, they are: Downside protection for the fund shareholders during difficult economic or market environments; to outperform the Standard & Poor’s 500 Index over the long term—our target is to outperform by 100 basis points of annualized alpha over the long term; and to provide fund shareholders with a level of current income that is equal to or greater than that of the equity index. [A basis point is one-hundredth of a percentage point.]
From a philosophy perspective, we employ a straightforward approach. First, we aim to own a set of businesses that achieve a superior level of value creation versus the market over the long term. The following equation depicts how we measure the value creation of the companies we own on behalf of our shareholders:
Second, we want the fund to create value that is equal to or greater than the value creation of the businesses that we own. On a simplistic level, to do that, we need to avoid buying high while also not selling low. If we pay reasonable prices for the businesses we own, the long-term returns of the fund should be equal to but ideally a bit higher than that of the underlying businesses.
The final piece is that we care about the fund shareholders' experience over the long term. We don’t want shareholders to buy us high and sell us low. Of course, we don’t control shareholder decisions, but one of the pieces of the puzzle is to provide downside protection in difficult market environments. Intuitively, if you outperform in a down market, then shareholders are less likely to redeem.
We think we do two things well: First, we connect insights about long-term rates of growth of the business to what we should pay for it—in other words, valuation—and second, we think we can be good, patient, and disciplined owners of businesses.
Patient and disciplined mean two different things to me. Patient means sticking with a business during difficult time periods. In my long history of managing money on behalf of clients, I don’t think I have owned a single stock that’s been a pleasant experience throughout, so we want to be sure that we’re patient through the difficult times so we can experience the benefit of the good times. At the same time, we want to be disciplined and to acknowledge when we’re wrong.
One investment lesson that has been of focus recently is the use of stock-based compensation, or SBC, in the technology sector. Companies that lean heavily into SBC face a significant risk of a negative self-reinforcing cycle if economic/market dynamics turn negative. Therefore, we believe investors should treat SBC as a cash expense when assessing business models and valuing firms and should engage with management teams on this topic. Critically, companies that lean heavily into SBC may not be as great or cheap as meets the eye. In addition, we think companies should limit the extent of SBC in their compensation mix as they mature to mitigate exposure to exogenous risks. In our view, the benefits of SBC can be achieved with moderate share issuance and/or ownership requirements funded through cash compensation.
Finally, we believe boards should evaluate and compensate management teams based on financial metrics that treat SBC as a cash expense, because it is a more accurate measure of economic value creation over the long term. In our view, these factors are crucial for tech investors to consider, particularly given today’s rapidly evolving market environment.
Looking out over the next three to five years, I think that we’re shifting away from an environment of free money. The past few decades have been marked by massive unprecedented fiscal and monetary expansion where inflation was benign. In that environment, it’s been fairly straightforward for companies to grow revenues and profits.
Going forward, we’re shifting to an environment where the relationship between economic growth and inflation is more positively correlated, and that should create a cost of money for the first time in a long time. It should create more volatility, and it should create an environment where companies have an opportunity to differentiate themselves both positively and negatively in terms of their idiosyncratic performance. I expect it will be an environment where risk awareness, risk mitigation, and valuation will matter.
For this fund, that environment should act as a positive backdrop for us.
Note: This interview was edited for length and clarity.
1 Subadvisor opinions don’t necessarily reflect those of Vanguard.
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Meet the expert
Daniel J. Pozen