To paraphrase Vanguard Group founder Jack Bogle, we now know what many have suspected for a long time: indexing has changed the world of investing. Withall of the developments in the indexing world, and in particular the ETF industry, it is easy to get caught up in the excitement, focusing exclusively on the positive developments and observing the industry through rose-colored glasses. But ETFs, for all their advantages and popularity, remain a work in process with a few “kinks” that still need to be worked out. During a recent webinar hosted by IndexUniverse, the legendary Bogle shared his thoughts, both positive and negative, on the state of the ETF industry.
“Truly Great” Business Model
Bogle, regarded by many as the father of indexing and sensible asset allocation for average investors, believes that the ETF industry is based on a sound business model. Bound by what he calls the “relentless rules of humble arithmetic,” active asset managers cannot consistently beat the market over any extended period of time. In reality, equal amounts overperform and underperform their benchmark each year. When costs enter into the equation, returns generated by active management, whether positive or negative relative to the benchmark, are further eroded. Putting some hard data behind this argument for passive indexing, Bogle notes that indexed equity funds outperformed 65% of active managers during 2008. Performance for indexed bond funds was even stronger, falling in the 85th percentile.
The lower cost structure of ETFs make them an ideal investment vehicle for long-term buy-and-hold investors, allowing them to enjoy the benefits of compounded returns while avoiding the “tyranny of compounded costs.” Further, ETFs allow investors to focus on long-term objectives without getting swept up in seeking out the next big trend or frequently shifting positions. Although many investors disagree, there is a great deal of evidence indicating that investors often chase short term alphas to the detriment of long term returns. Bogle himself puts it best, quipping “the stock market is a giant distraction to the business of investing.”
“Flawed” Investment Model?
Bogle’s beef with ETFs is that while they are ideal for long-term investing, they have become the favorite tools of short-term traders, exhibiting annual turnover rates that seem hard to believe at first glance (those aren’t decimal points in the following table!). So while ETFs are a powerful tool for investors looking to gain long-term, cost efficient exposure to a broad universe of assets, they are actually being used to pursue short-term gains by tiliting various portfolio weightings, such as asset class and style, country weights, and durations.
|iShares Real Estate||IYR||23,977%|
|iShares Russell 2000||IWB||7,763%|
Bogle’s second concern with ETFs is that many investors are engaging in “performance chasing,” pumping money into funds that have recently outperformed instead of sticking to their investment strategy. This results in a phenomenon known as “investor lag” in which the return on actual investor dollars trails returns on the actual funds, in some cases by a wide margin. Suppose, for example, a particular ETF with total assets of $100 million increased 10% to $110, at which point investors created $90 worth of additional units of the ETF, bringing the total amount of assets to $200 (but leaving the price unchanged). If the fund then lost 5%, it’s share price would still be up 4.5% over the period, but in dollar terms, investor returns would be zero (with a 4.5% gain on the original $100 offsetting a 5% decline in the additional $90). Some of Bogle’s data supporting this phenomenon for various equity categories is summarized below.
|Fund Type||Investor Lag|
|Europe / Pacific||-2.6%|
So Bogle essentially believes that ETFs are based on an excellent business model, and, if used correctly, can be a powerful tool for long-term buy-and-hold investors, allowing them to maximize their net return. But his claim (and I don’t think anyone can argue with this) is that ETFs have become favorite tools of active traders, providing those with a short-term focus a means to efficiently make bets on broad markets and sectors rather than individual securities.
A few other of the admittedly blunt Bogel’s thoughts:
- On Exotic ETF products: Bogle believes many of the ETF products on the market today “verge on insanity” including leveraged ETFs and ETNs
- On the Role of Inverse ETFs in a Long-Term Portfolio: “None”
- On Benefits of Diversification: While “international diversification lets us down just when we need it most” the diversification benefits of multiple asset classes were proven to be valuable during the recent downturn
- On Government Bailouts: “They had to so something” and while the elected path was not necessarily the best in hindsight, it was preferable to no action at all
- On BlackRock’s Acquisition of iShares: BlackRock “paid a pretty good price for a fairly low-margin business”