(PUB) Investing 2016

Russell 1000 ETF—which by its nature should be highly tax-efficient and has just barely underperformed T-M Capital Appreciation, before taxes, through the end of August—what’s the real value here? Why do the minimums remain so high ($10,000 versus $3,000 for most index funds and nothing for ETFs)?Why not just invest in an already tax-efficient ETF or index fund? Don’t let the tax tail wag the investment dog, or let a tax- >

other words, Vanguard accepted a lot of tiny stock positions from an inves- tor instead of making that investor sell those stocks to raise cash for the pur- chase of the fund. I expect we’ll see the number of holdings drift back toward that 650 level, unless Vanguard accepts another large in-kind transfer. Of course there’s absolutely noth- ing wrong with trying to minimize taxes. But with the introduction of the

exceptions. In June 2014, the number of holdings went from 654 to 805. The managers gradually worked that down towards the 650 range, but in May of this year the number of holdings jumped from 652 to 1,021. Today, the fund holds 954 stocks. Vanguard says the recent spike is related to an in-kind transaction to facilitate a shareholder purchase, and noted that nearly 300 positions are under $10,000 in size. In

then exchanges. All of those channels have different levels of pricing, so there’s no one price. Medicaid and Medicare get significant discounts from the pharmaceutical industry. Large payers, depending on their strength, get large discounts. So the list price, which has been the focus of all the attention, is very different than the net price, and it’s very differ- ent in different channels. There have been some outliers, but when you look at the net growth of the industry, it has been much more subdued. Why health care? I was visiting a lot of companies in Europe last week, and this is a special time in health care, particularly for the biopharmaceutical sector, which is the vast majority of our opportunity set—this is an unheralded time of scientific discovery. When you think about what in the economy is going to create value, I feel very strongly that these companies are going to create so much value for patient outcomes. All the discoveries that happened in the last five years are just the beginning. We are going to see significant innovation, and that innova- tion will be paid for. That’s where we are trying to tilt the portfolio. Vanguard Health Care investors are getting a portfolio of companies heavily skewed toward high innovation while hopefully avoiding compa- nies that we think will be facing a lot of biosimilar competition or just don’t have the pipelines that will create the value. In the last year and a half, we hired two PhDs to our team because the amount of research we had to do—the science is double or triple what I did over the last 20 years. So we added resources to our team to make sure that we are looking at the science completely. Politics has always played a role in the health sector, but recent- ly the failures of certain parts of the ACA have been particularly evident. Insurers are pulling back, and many of the original non- profit “co-op” health insurers have failed. Is the ACA achieving its objective, and will insurers eventually find a way to make it work, or is it, as one consultant wrote, in a “death spiral”? The ACA can definitely be a functioning market, and many of the health insurers were hoping it would be a functioning market, but it’s definitely at a point where things need to be tweaked—some parts of the law have to be tightened. This is a very large bill, and what normally happens when you have a very large bill like this is that as you go along, you correct things that aren’t functioning right. Think of 2014 and 2015 as years of working out all the kinks, and now we know there are things that need to be changed in the ACA, but those cannot be changed during election years. That’s the main issue. If you can get 20 million people in the risk pool with many different

kinds of risks, it should be a very functioning market, but right now there are too many people coming in with very high risks. What’s unsustainable is for people to be losing so much money. The structure of the ACA is likely to stay, but the question is, will it become more like the exchanges or will it become more like Medicaid? That depends on whether we have a Democrat or a Republican in the White House. We do believe the ACA will stay—you can’t take a benefit away from 20 million people without giving something in return. The portfolio has become more concentrated over the past year, both in terms of fewer holdings and a larger allocation toward the top 10. You mentioned in your recent letter that you consoli- dated “during a time of intense volatility,” but you didn’t say why this would be. From September 2015 through March 2016, everything went down— the companies that are well-positioned and those that were not well- positioned. So that made us more intensely focused. Also, there was more fundamental news in the past year that made the winners more clear. We bought companies where we have the highest conviction in part due to the price movement and partly due to fundamentals moves. Also, if you look back a couple of years, we had bought a basket of medical device and tools companies. That sector has done well, so we sold more individual companies in that sector. There’s so much innovation happening in a lot of companies under $5 billion. As those companies grow, I would suspect that the number of names [in the portfolio] will go back up again. When you can’t sleep, what worries keep you up at night? I have to tell you, I am a notoriously good sleeper. What would make this fund not investable? If you had a U.S. health care system that was a single-payer system, it would not be positive for our investment oppor- tunity because it would materially reduce profitability. So that would be number one. Number two would be if all the innovation was happening only at the small company level, it would be hard [for us] to invest. But the good news is that the large companies have a tremendous amount of innovation. And number three, if companies weren’t able to price innovation in the U.S.—if new drugs coming to market weren’t able to be priced at levels that create blockbuster drugs—that would reduce the opportunity set. So it’s all about what would reduce the opportunity set—you can rest assured, if that happens, we’ll let everyone know.

Glad to hear that. Thank you, Jean.

The Independent Adviser for Vanguard Investors • October 2016 • 13

FOR CUSTOMER SERVICE, PLEASE CALL 800-211-7641