John Bogle is a living legend of the investing world. The founder of Vanguard spent decades fighting against high investment management fees and clashing with active managers who claimed they could beat the market for their clients. Bogle fought to popularize mutual fund products that would track market indexes, delivering the market return for ever-slimmer fees.
For a long time, active managers scoffed at Bogle’s efforts. But a number of stock market downturns in the past couple decades have resulted in a flood of capital out of actively managed mutual funds, hedge funds and various alternative investment vehicles into Vanguard’s funds and those of its imitators. Vanguard now manages more than $5 trillion.
But Bogle is not completely happy with the revolution he started. In particular, he has come out aggressively against a particular kind of index-tracking product: The exchange-traded fund. ETFs are different from traditional mutual funds because they are publicly traded in their own right. Investors can buy and sell ETF shares with the same ease as individual securities.
While index-tracking ETFs may seem like a natural outgrowth of the index-tracking mutual funds, Bogle is not convinced. In this research note, we take a look at Bogle’s issues with ETFs.
Bogle hates ETF speculators
Bogle has made his distaste for ETFs quite clear over the years, but in recent months he has ratcheted up the vitriol. He has described them as speculative instruments that have “bastardized” his idea of the index mutual fund.
The accusation of speculation comes from the observation that turnover within ETFs tends to be far higher than the turnover in individual stocks. While the hundred largest stocks see turnover of about 144%, the hundred largest ETFs see a staggering 785% turnover. Much of this turnover is the product of institutional, rather than individual trader, behavior, but it is still indicative of speculative action that might run contrary to the very idea of an index fund, i.e., it tracks the index in relative lockstep.
High volume is not necessarily evil
We can see that volume and turnover among ETFs is very high, but does that really matter? One might argue that speculation has always been around. One might also argue that the various shareholders of ETFs can hold the same positions but for different reasons; and these different reasons do not necessarily conflict. For example, a short-term speculator might move an index marginally through heavy trading action, but this would end up little more than a blip to a long-term holder that intends to use it as a tracker of the underlying index or market.
Furthermore, it could be argued that the high volume driven by speculative activity creates knock-on benefits for all ETF holders. One such benefit comes from lowered transaction fees. With extremely high volume and liquid markets, the cost of trading is reduced progressively.
But too much speculation could cause trouble
If ETFs were to become genuine vehicles for speculation, however, it could endanger their value as tools for locking in the market return. In other words, high incidence of speculation over a sustained period could throw the ETF’s value out of alignment with the underlying assets or benchmark for a sustained period. That could spell trouble, considering there has been a mass migration of large institutions and allocators into the perceived safety of index funds.
And this is the real danger Bogle sees. As more institutions pile into ETFs and use the instruments to speculate and move the market, rather than simply trying to lock in an approximation of the market return, then holders of those ETFs will no longer be able to rely on their assets to deliver the promised return. Of course, the nature of ETFs as a composite of underlying securities means there will eventually be reversion to the mean (or a return to normalcy), but the irrationality could well last much longer than current ETF investors think possible. In the event of a downturn, for example, speculative action or panic might throw ETFs (especially thinly-traded and exotic ETFs) into disarray.
Are mutual funds the answer?
Vanguard’s mutual funds were designed to be low-cost index trackers. So are ETFs. But a mutual fund product cannot be traded or dispensed with so easily as an ETF. This obviously has the negative effect of reducing liquidity. But it has the benefit of providing an investment product that is not itself susceptible to pressures exogenous to the movements of the underlying index.
As a defensive, and ultimately highly conservative, product, index tracking funds probably should remove (or at least mute) the sorts of exogenous variables that could disrupt the return profile.
It’s good enough for Buffett
Why are we taking the time to compare index mutual funds to ETFs when this forum is meant to be about finding opportunities for beating the market and delivering consistently higher returns? The answer is simple: Even as we pursue abnormal returns through value investing strategies, we should also consider supplementary strategies and techniques. This allows investors to hedge themselves and potentially smooth out returns.
Right now, with the market so high, buying the top might look risky. But it is still worth acknowledging the market return has beaten most active managers out there. Furthermore, it is wise to realize that most individuals have neither the time nor inclination to work out and manage more active investment strategies. In their case, an index fund can be the best option.
Even Warren Buffett (Trades, Portfolio), perhaps the greatest value investor in history, sees the wisdom of index funds. He has stated on more than one occasion that, when he dies, the money set aside for the benefit of his widow would be placed in index funds.
Buffett’s vehicle of choice? Vanguard mutual funds.
Disclosure: I/We own no stocks discussed in this article.
