How Vanguard Manages Its Outside Money Managers

Most of its funds are run by multiple managers, who are held to tight allocation targets to get optimal results

Investors know Vanguard for its low-cost index funds. But the company's $1 trillion in assets includes $580 billion of actively managed assets, and of that, $250 billion is run by outsiders. "I believe we are the largest hirer of managers in the world," says Joe Brennan, who heads Vanguard's portfolio-review team.

Today 27 money managers run 68 different funds or portions of funds for Vanguard. Baillie Gifford, which manages nearly $7 billion (as of Sept. 30) spread across four funds, is one of Vanguard's larger managers, although it falls far short of the size and scope of Wellington Management—which has advised the $38 billion Vanguard Wellington Fund (VWELX) since its 1929 inception—and of Barrow, Hanley, Mewhiney & Strauss, lead manager of the $31 billion Vanguard Windsor II Fund.

To find managers, Vanguard's 30-member portfolio-review team constantly meets with potential hires. It's not uncommon for Brennan and his team to talk with a potential manager for years before proposing the firm to Vanguard's board of directors. "Vanguard being the painstaking organization that it is, our relationship was the result of endless visits and detailed examinations," says Edward Hocknell, a partner at Baillie Gifford, which Vanguard first hired in 2003.

Once Vanguard settles on a manager, it faces a second challenge: divvying up assets of large funds among several managers to get optimal results. The majority of its outsider-run funds rely on multiple managers. Vanguard's theory is that combining different managers with different styles—pairing a value manager with a growth one, say—will balance performance when the market favors one type of stock or another. That should create a fund with a higher return and lower risk.

Vanguard rebalances managers the way individual investors do their portfolios. Each manager gets a target allocation, say 20%. Then Brennan and his team continually rebalance each fund to keep it in line. Do well, and money will be taken away; do poorly, and you'll get more money. "If you have equal confidence in both managers, that is absolutely what you should do," says Brennan.

    Before it's here, it's on the Bloomberg Terminal.