At the Morningstar ETF Conference, we gained insights from Richard Powers, Head of ETF Product Management at Vanguard. During our conversation, Richard discussed the rapid proliferation of ETFs, Smart Beta, ETF due diligence, retirement strategies and robo-advisors. Richard also stressed the importance of setting strategy first before choosing a product, within the context of low cost.
ETFdb.com (ETFdb): Please introduce yourself and tell us about your career trajectory that ultimately led to you becoming Head of ETF Product Management at Vanguard.
Richard Powers (R.P.): My name is Rich Powers and I’m Head of ETF Product Management. I took on this role in December 2015 and have been at Vanguard for 17 years. For the first few years of my career, I worked closely with our direct retail clients, focusing on mutual funds. About fourteen years ago, I pivoted to work with our Oversight Manager Research team, who were effectively the consulting arm of our leadership team and our board of directors in evaluating existing active managers, active funds and prospective managers.
ETFdb: What would you say is the overall strategy of Vanguard in the ETF space?
R.P.: Our ETF offering is relatively small versus our competitors. We have 70 products in our U.S. ETF lineup. Our philosophy is to provide investors with one-stop shops for their investment solutions and products. And we want to give them building blocks as well; for investors that want exposure to certain sectors or certain regions, we have the tools for them too. The consistent thing you see across the entire Vanguard ETF lineup is low cost. This is different than some of our competitors who are selectively low cost and higher cost in other categories. Every one of our products is low cost, because it rises from our structure as a mutual mutual fund organization where we operate at cost. We pass along the economies of scale we gather to our shareholders, in the form of lower expense ratios.
ETFdb: What are your thoughts on the rapid proliferation of ETFs in recent years?
R.P.: It is a rightful concern that we have. It would be fair to say there is product proliferation in conventional mutual funds as well. Product proliferation is probably a broader asset management issue.
Even though there are 2,000+ ETFs, there are only about 350 to 400 ETFs that account for 95% of the assets. There’s an exceptionally long tail of ETFs in the marketplace that do not have much in the way of a buyer. It’s reassuring, because those largest ETFs tend to be your core portfolio holdings that most investors would want to have in their portfolio. I think, over time, many of these products at the tail may likely close, because there will be a less obvious investment case or the economics won’t work for the sponsor.
ETFdb: Can you discuss or highlight some best practices that investors and advisors should undertake when it comes to doing ETF due diligence with regards to adding broad market exposure in their portfolios?
R.P.: There are several things I would look at each time. The first component would be expense ratio, i.e. low cost. The second component is tracking error – if it is low or within my expectations. The third component is liquidity of the ETF and my ability to transact it. Fourthly, I’d want to know the true exposure provided by the broad market index. Understanding what is going on under the hood is important because there are different ways to define value, growth, quality, etc. Finally, understanding index methodologies is paramount – the product could be market-cap weighted, equal weighted or weighted by value factors. Understanding the exposures that arise as a consequence of that methodology is fundamental for any investor to know.
ETFdb: Let’s move on to smart beta. Everybody has a different definition of Smart Beta. Some call it strategic beta; others call it smart beta. How would you define Smart Beta?
R.P.: We would call it factor-based investing. Research has shown that there are certain investment factors such as quality and low-volatility that explain market returns over time. Smart beta is a great marketing term, but factors are at the core of what it really is.
ETFdb: There are two broad areas of Smart Beta ETFs, namely single-factor and multi-factor ETFs. What advice do you have for investors and advisors on using these products in their portfolios? Would the usage be different if used as a strategic asset allocation as opposed to a tactical bet?
R.P.: We have done a lot of work over the last couple years to better understand different mindsets as it relates to making investment decisions. There’s a camp of advisors (or institutions) who tell us to “give me the solution,” because they do not want to spend an inordinate amount of time kind of recalibrating their exposures; multi-factor products generally appeal to them. On the other hand, another set of investors tell us “I actually like tilting towards one factor or another,” or “I like to be a little more tactical in my allocations over time” from a timing standpoint. To them, single-factor products appeal more. Theoretically, your risks are mitigated and underperformance is limited when using multi-factor ETFs, because they focus on many factors, and you haven’t put all your eggs in one basket. However, knowing what underpins the multi-factor strategy, i.e. under the hood, is paramount; it may be called multi-factor but may actually be slightly tilted towards value or another factor.
ETFdb: In your opinion, how should an investor or advisor go about picking an ETF within the Smart Beta space?
R.P.: First, you have to set your strategy. Perhaps you want to utilize a low volatility strategy. The criteria I outlined earlier will help investors narrow down the number of ETFs they are looking at. Look for inexpensive products that are transparent, have benchmarks and minimal tracking error, and are liquid. Another factor to consider is the size of the ETF. Investors should be skeptical of a really small fund that hasn’t gained size over an extended period of time.
ETFdb: Do you think ETFs and mutual funds in the long-term can play nicely in a portfolio context?
R.P.: ETFs and mutual funds are siblings at their core. They largely follow the same type of regulatory structure of the 1940 Act. For us, it’s not ETFs or funds; it’s ETFs and funds. Investors can choose. Perhaps they want to build a passive core in their portfolio and perhaps ETFs are the vehicle they prefer to use. Perhaps they now want to complement that core allocation. Suppose the investor is a traditional bottom-up stock picker who focuses on large-cap growth stocks. In this instance, they are probably going to utilize a mutual fund. Our view is that they can actually complement one another and coexist in a portfolio quite nicely.
ETFdb: Let’s discuss retirement strategies for both baby boomers and millennials. How can investors in both demographics use ETFs to reach their retirement goals? What role should diversification and international exposure play within their portfolios?
R.P.: When you look at the data, the two adopters for ETFs that stand out are millennials and ultra-high net worth investors.
Let’s start with millennials. If they’re saving for retirement and don’t have much in the way of savings to allocate, an ETF can become very attractive because the entry point into an ETF is the price of a single share. Mutual funds could have minimums investment amounts, which they may not have at the outset. This is one reason millennials are attracted to ETFs. Millennials are also getting to know investing a little better, as ETFs become more ubiquitous.
For the baby boomers who have long used mutual funds, the ETF and/or ETF strategy can become the core of their retirement portfolio. Maybe they want to focus on a high dividend paying ETF or a municipal bond ETF. On the other hand, they can also use ETFs as a satellite position. Maybe they have a view on China; they can express that viewpoint by buying a China-focused ETF. Whether it is a core allocation or a satellite position, I think it really depends on the investor’s level of engagement and what he/she are comfortable with.
ETFdb: As you mentioned, millennials adopting robo-advisors are becoming the trend now. How do you see this trend evolving in the coming years?
R.P.: I think that robos have gotten quite a bit of press and have gathered a good deal of assets in a relatively short period of time. And I think they’re a very viable solution for a subset of investors. At Vanguard, we have a whole cohort of investors who actually value that personal interaction. With an advisor, you have that personal circuit breaker – when you’re about to make the wrong decision with your portfolio, having a person at the other end of the line who is able to talk you off the ledge becomes important. However, several investors don’t necessarily want to engage with an advisor, so that is a scenario where a robo can be interesting.
ETFdb: What are a few trends you see developing and evolving in the ETF industry over the next few years?
R.P.: I think you’ll see more and more niche offerings in the marketplace. I think newer entrants will need to offer products that are a little more on the fringes of the portfolio, to not only gain investor interest but also to capture attractive margins. Whether this development is a positive one or not is a whole different question, but I think you’ll see niche-ier and niche-ier products coming to market.
Investor education is another trend we see developing over the long term. It’s a bit overwhelming for an individual, an advisor or an institution to sort through 2,000+ ETFs. Even if you narrow it down to a given strategy, you are still left with 100s of different strategies.
I think the other big trend that you’ll see is investors continuing to embrace core strategies. Regardless of the time period you look at, it’s these core strategies that end up gathering the most investor attention and the most investor assets, because they represent the core of one’s portfolio.
ETFdb: One final question. What would be your best piece of advice for investors in this current market environment?
R.P.: Investors should set strategy first. Product choice should come after setting strategy. The best bet, when it comes to product choice, is to start with a very, very low cost offering, because cost is the single largest factor that predicts performance over time.