At the 2017 Inside ETFs Conference, we gained insights from Rich Powers, Head of ETF Product Management at Vanguard. During our conversation, Richard discussed ETF due diligence, smart beta, fixed income, and the recent ETF expense ratio cuts by major ETF issuers. We also discuss investment strategies for navigating the financial markets in 2017.
ETFdb.com (ETFdb): Please tell us about yourself and your role at Vanguard.
Richard Powers (R.P.): My name is Rich Powers. I lead our ETF Product Management function. Our focus is on Vanguard’s ETF business in the United States. There are three primary functions to what we do. The first is to educate investors on our product offerings so they have a better sense of where our product lineup fits into the broader schematic of ETFs. Secondly, we evaluate what our competitors are doing so that we are aware what products they are rolling out, how they are making changes to their products, and how they are thinking about product pricing. Finally, we try to piece together the first two components and evolve our offerings.
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ETF Due Diligence Is Important
ETFdb: What would you say are three best practices that investors should keep in mind?
R.P.: The first is to not trade at the open or the close because the markets aren’t very deep during these times. Secondly, avoid market orders at all costs. Finally, investors need to keep their risk/return profile and expectations in mind. A retail investor will have a different set of parameters and risks that they are willing and able to bear, compared to an institutional investor, when selecting a product.
ETFdb: Most investors understand the benefits of ETFs: low cost, transparency, tax efficiency and so on. What would you say are the risks associated with ETFs?
R.P.: The more decisions investors make, the greater the risk they will encounter in achieving their long-term objectives. For the subset of investors who are professionals, we don’t need to tell them what to do. But retail or individual investors probably do not benefit from being able to trade an ETF throughout the day.
Having more niche products coming into the marketplace may potentially increase the risk to any individual or advisor using them for a client portfolio. It requires a higher level of due diligence when you are contemplating products that step away from your classic market cap–weighted index ETFs.
Being aware of risks and costs are important regardless of your ETF investing strategy. Read The Hidden Risks and Costs of ETFs to find out more.
The Evolution of Smart Beta
ETFdb: How do you define smart beta?
R.P.: Smart beta is factor investing. Factors describe the risk and return profile of stocks or a group of stocks.
I believe we are still in early stages of the adoption and use of factor portfolios. Firstly, very few investors use these types of strategies. Secondly, we view smart beta as a different version of active. It is “active” anytime you depart from the market cap–weighted portfolio; there are different risks and rewards that come with that.
Read Smart Beta ETFs Can Help You Navigate the Market Cycle to find out about the individual factors within smart beta ETFs.
ETFdb: There are two major types of factor strategies: single-factor and multi-factor. Are they being used differently by investors? Are they being used differently by each type of investor, such as baby boomers or millennials?
R.P.: I think they are different products and they serve different investor needs, maybe even at different times in their investing life cycle. The classic view on single-factors is that they would be trading vehicles. However, they can also play the role of a strategic allocation in a portfolio where an investor may wish to have a long-term overweight to value or momentum strategies. Single-factor exposures can also serve as a transition investment; if you decide to part ways with a traditional active value manager, but haven’t made a decision as to where to reallocate those assets, you might use single-factor value ETFs to help fill that need in your portfolio while you assess your options.
I think multi-factors are more of a core type of exposure that an investor can build a total portfolio around in a risk-controlled active strategy. They can also be a complement to a traditional market cap–weighted index fund where the investor wants to bear active risk in a transparent, low-cost manner.
The Future of Fixed Income in Smart Beta
ETFdb: How do you see the fixed-income smart beta space evolving?
R.P.: Firstly, we have seen a dramatic uptick in fixed-income interest amongst investors over the past few years. Fund flows into fixed-income ETFs is proof of that.
I think investors are getting more comfortable with fixed income in the ETF wrapper. Initially, there was skepticism of how a bond inside an equity security (ETF wrapper) was going to work. Having a long history of fixed-income ETFs suggests that it does work. We are in the early stages of fixed-income ETF adoption. Investors are now probably looking at fixed-income ETFs as another tool in their toolkit, whereby they can hold thousands of bonds within a wrapper that is low cost and has greater liquidity than any individual bond within it.
As for fixed-income smart beta, there are lots of conversations in the marketplace and new products are being rolled out on a regular basis, but to date, these new concepts have not been broadly embraced. In reality, one could argue that fixed-income smart beta, or factor investing, has been available in the ETF vehicle for a very long time. For instance, there are numerous cap-weighted strategies that focus on credit or on a particular part of the yield curve. These strategies tilt an investor away from the broad market-cap weighted portfolio to specific factors, but in a passive and very low-cost manner. We would expect these types of strategies to remain the preference of investors for the foreseeable future until the newer factor strategies prove their mettle.
Utilize ETFdb.com’s ETF Screener tool to filter through the entire ETF universe and compare fixed-income ETFs by dozens of criteria such as bond duration, bond type, dividends, expenses and historical performance.
Financial Markets in 2017
ETFdb: How should investors and advisors navigate geopolitical risk events in 2017?
R.P.: I think geopolitical risk is a permanent part of investing; it’s nothing new. We could have had the same conversation more than 15 years ago, leading up to Y2K. I don’t know that today is any different than the past in terms of the volume of geopolitical events. Certainly, there is more awareness given the free flow of information that we have on a variety of different mediums. But I don’t know that that would cast today’s environment in any different light; it’s just a different set of players in different locations. I think investors are probably best served by blocking out the noise, setting a long-term plan and sticking to it, while being conscientious about cost.
ETFdb: How should investors play the rising U.S. Dollar within the context of rising interest rates?
R.P.: Investors will likely have to look at a few key factors to form their return expectations for equity and fixed income over the long run. For equities it’s valuation. Price-to-earnings is a good starting point for equities. We think equity returns over the next 10 years may be mid–single digits.
For fixed income, the starting point is yield-to-maturity (YTM). We think fixed-income returns are probably in the low single digits. Having said that, higher interest rates will be great for fixed-income investors. Fixed-income investors typically care about income that they are receiving from their investment. As interest rates rise, they will get higher income streams, which ultimately will enhance their returns.
As for making predictions on currencies – it’s a fool’s errand. Many brilliant investors attempt such calls but few, if any, have demonstrated long-term, enduring efficacy in the endeavor.
I would say that tempering return expectations would be the best way to think about what the future holds.
ETFdb: How should investors go about investing in emerging markets in 2017?
R.P.: If you look across different geographies, you have different forward-looking return expectations based upon valuations. Vanguard’s approach is one where diversification is actually the only free launch that you have. In the models we use with our advisors, as well as in some of our packaged products that are full of our advice, we have a broad set of exposure across U.S. equities, developed equities, and emerging markets equities, with no tactical allocation element to them. That is the starting point to the extent someone wants to articulate a view on the relative value of a specific region or geography. In terms of the relative attractiveness of emerging markets versus the U.S., there are products in the markets that investors can use to do that. But I think a good starting point would be the global market cap portfolio.
ETFdb: ETF issuers have reduced fees for several broad-exposure focused ETFs in recent months. Where do you see this fierce price competition among ETF issuers heading?
R.P.: It’s pretty gratifying actually. Many of our competitors have finally seen the value in lowering costs for investors. We know that the less you pay in investment fees, the more you get back as an investor. So it’s a great thing that there’s competition from a price standpoint for investors because they’re going to be the winners as a consequence of that. We’ve been doing this forever. We are owned by our investors and, therefore, we’re going to charge what it costs us to actually run the organization, and return everything else back to investors in the form of a lower expense ratio. We have a long history of reducing costs. In December 2016, we released the first round of fee reductions across our lineup for this fiscal year.
It’s not a reaction to what others are doing; it’s simply what it costs us to run XYZ fund. So over the coming months, we’ll continue to release prospectus updates on a variety of funds. You should expect that Vanguard will continue to return value to shareholders in the form of a lower expense ratio.
Find out the top 100 Lowest Expense Ratio ETFs here.
Revisiting the Active vs. Passive Debate
ETFdb: There has been almost a one trillion dollar shift from active management into passive management over the last year. Why do you think that is the case? Is it purely because of the benefits that the ETF wrapper provides? Have investors lost faith in a lot of these active managers?
R.P.: A couple things apply here that have been tailwinds for index investing – whether it be via an ETF or an index mutual fund – over the last decade or so, and have created some challenges for active. Firstly, investors have become much more attuned to cost and how important it is in terms of the returns they get. This is largely a function of the availability of information today. Secondly, many active managers have not held up their end of the deal. They promise to deliver better performance or deliver lower risk than the market.
Unfortunately, most active managers have simply not delivered on their promise. I think it largely comes back to the high hurdle they have to overcome in terms of the high costs of their active mutual funds. So investors are saying, “I don’t need to take this manager risk anymore. I’m paying 100 basis points for this active manager who hasn’t outperformed. There’s a key person risk here, potentially. How about I reallocate this portfolio and assets to an index fund where I can buy it for five basis points, not really have any key person risk, and participate in the market returns, whatever they may be.”
However, let’s not write off active. Active is alive and remains a huge part of the overall market. About two-thirds of industry assets remain in active strategies. What we argue is that for active to work it needs to be in a low-cost form and you need to have skilled managers in place. So the real issue is high-cost active. That will likely be dead. The rise of ETFs and index funds in general help signal that. That is the challenge and I think many active managers are grappling with that. Some are looking at the ETF as the vehicle that is going to help save them and right the ship. It may or may not be, but one of the key things they could simply do would be to take some of the cost out of the equation. That gives them a fighting chance of actually outperforming. We can say this and feel very comfortable about it because we believe in both. We have a trillion dollars of active assets, so as much as people like to paint Vanguard as this massive index-only shop, our start as an organization was as an active shop – our oldest fund being the Wellington Fund. A trillion dollars of investor assets puts us as one of the largest active managers in the industry.
ETFdb: ETFs have proliferated in the financial markets in recent years. What makes an ETF succeed or fail?
R.P.: There are three reasons why an ETF succeeds. Firstly, it has to be low cost. Secondly, it has to have a sound investment case. Thirdly, it has to be simple. The more complicated the ETF, the more challenging the hurdle is for an advisor, an institution or an individual to put their capital at risk in the ETF.
ETFdb: What are two trends you see playing out in the ETF industry over the next five years?
R.P.: Firstly, I think you will see costs coming down further. Second, I would expect greater adoption of ETF products, especially broad, diversified market cap–weighted ETF portfolios.
The Bottom Line
ETF due diligence continues to be important given the wide variety of ETFs investors can choose from. Vanguard suggests that investors block out the noise, set a long-term plan, stick to the plan and be conscientious about cost. This will help them navigate the ups and downs of financial markets over the long run.
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