From the October 2012 issue of Research Magazine • Subscribe!

September 25, 2012

How John Bogle Really Sees ETFs

The investment visionary, long a skeptic of exchange-traded funds, gives his candid assessment of the fast-growing field.

When  John C. Bogle, the founding father of index funds, takes time to interrupt summering in Lake Placid to talk with Research about exchange-traded funds, it isn’t because he has nothing to say.

“ETFs have become a marketing and promotional game. Those kinds of things are great for marketers but bad for investors,” says Bogle, in an August telephone interview, on vacation in the Adirondack Mountains. 

Bogle created the first stock index mutual fund in 1975, a year after he founded the Vanguard Group, where he served as chair-CEO for 22 years and senior chair until 2000. Today, at 83, Bogle—who has appeared on Time magazine’s list of the world’s “100 most influential people”—is president of the Bogle Financial Markets Research Center, on the Vanguard grounds in Malvern, Pa.

He has long been a critic of exchange-traded funds but seems to be warming to them, provided they are used in accord with his specs. Still, Bogle is far from ETFs’ No. 1 fan.

Indeed, the funds do not suffer from a lack of fans. They are in the thick of a spectacular growth phase, boasting 2011 estimated net asset flow totaling over $120 billion, according to Morningstar. As of August 2012, there were 1,471 ETFs on the market versus 1,369 at the end of 2011. Traditional mutual funds have been losing market share to ETFs; consequently, mutual fund families are offering them too. Some funds even use ETFs to equitize cash in their own portfolios.

ETFs have become a phenomenon because of their low expenses, tax efficiency, excellence as a prudent diversification tool and last—but certainly not least—because, like stocks and bonds, they can be traded throughout the day.

The ETF is “the most successful marketing idea of the modern age in the securities business. Whether it proves to be the most successful investment idea of the age, however, remains to be seen. I have my doubts,” Bogle writes in his new book The Clash of the Cultures: Investment vs. Speculation (Wiley).

 Twenty years ago, before the first exchange-traded fund was introduced, Bogle was pitched the ETF concept. But the staunch buy-and-hold, stay-the-course advocate refused to be sold. He worried that the product’s extra liquidity would invite excessive trading and therefore speculation. Now, he is all but saying: I told you so. 

“The ETF has become a heavily traded vehicle used for speculation, often on indexes without much claim to fame except that they have new ideas some marketers want to test on unsuspecting investors,” Bogle says. The proliferation of “fringe element ETFs” has resulted in “a quagmire of choices—everybody’s trying to be more creative than the next guy. So there are ETFs of dubious credit quality, leveraged ETFs, people creating their own investment ideas, their own indexes. All that has led to speculation.”

Many ETFs are indeed exotic funds tracking extremely narrow market niches. A substantial number have proven to be of questionable, if not poor, quality.

Notes Edward Jones principal Matt Embleton, who heads mutual fund and ETF research, and is based in St. Louis: “Every day I get a notice that a new ETF has come out. I’m not sure how many are going to survive and be around for the long term.”

Russell Investments in fact announced in August that it was closing all its U.S. passively managed ETFs. The niche funds had failed to generate much interest, possibly because investors needed to drill down deeply to understand them.

Even financial advisors who pioneered ETF investing and remain enamored are quick to point out that the sheer number of ETFs has become troubling.

“There are a lot of ETFs in the smorgasbord of options that are not good. You have to beware of the traps,” says Shelley Bergman, a managing director and senior portfolio manager at Morgan Stanley Smith Barney in New York City, an ETF investor since 2006. The Bergman Group manages assets of $3 billion, about $250 million of which are in ETFs. “As the ETF world grows larger and larger,” says the FA, “there’s mass confusion as to what the underlying securities are.”

Bogle’s advice to advisors: “Be very wary of narrow segments because the narrower you get, the more risk you expose your clients to. Stay out of lunacy.”

He gives ETFs his blessing only when the right funds are used—and used for investing, not speculation. Advisors “should be very selective about ETFs and rely primarily on broad-based-market ETFs. Buy and hold the right ones. Don’t buy and hold a fund that’s giving you triple leverage. That’s a foolish thing to do. It’s rank speculation.”

While many FAs like ETFs because they consider the low-cost funds to run on “autopilot,” others insist they should be watched carefully.

“The average advisor thinks this is a ‘set it-forget it’ strategy. But they are sorely mistaken, especially in the macro environment we’re in,” Bergman says. “There are dangers. We constantly monitor the portfolio. We’re meeting with a lot of wholesalers. It’s a full-time job.”

Bogle, of course, still favors traditional index funds over ETFs. “I don’t think there’s any great magic to ETFs except for low cost and diversification, though you can get that, and do every bit as well, through a garden variety S&P 500 index fund or total stock market index fund, emerging market index fund or international market index fund.”

But he adds: “Anybody who wants to buy a Vanguard S&P 500 ETF and not trade it and hold it forever, more power to them!”

To the extent that ETFs are index funds, Bogle is positive. It is the trading aspect that he claims had led to speculation with which he mainly takes issue. 

The ETF marketplace has turned into a chaotic arena dominated by institutional trading, says Bogle, who estimates that 75% of all ETFs are held by institutional investors and that roughly less than 10% of ETF assets are with long-term investors.

According to the Investment Company Institute, “over the past five years … institutional investors have found ETFs a convenient vehicle for participating in, or hedging against, broad movements in the stock market.”

Notes Bogle: “ETFs probably have a turnover rate of 700% per year. That is staggeringly high by any measure,” he says. “The mutual fund industry, in general, has a turnover rate among shareholders of 30% to 35%, a three-year average holding—which I myself think is amazingly short.”

Bogle is not alone in charging that ETFs played a major role in the stock market “flash crash” on May 6, 2010.

“Sixty percent to 70% of securities that were suspended were ETFs,” he says. “Of course it can happen again! With high frequency trading, we have a system that seems out of control. We’ve created a kind of Frankenstein’s monster.”

Many investors are drawn to ETFs, Bogle suggests, because “they are worried there’ll be a big crisis and that [with ETFs] they’ll be able to get out of the market before the end of the day. But when that bad event happens and you want to get out, you’re probably right at the bottom. So you’re apt to decide at exactly the wrong time.”

FAs enjoying significant success with ETFs choose funds with high trading volumes “so there won’t be a shortage of buyers when we sell,” notes Lawrence Grabenstein, a Raymond James Financial Services branch manager and president of Potomac Financial Group in Calverton, Md.

“The biggest pitfall,” Grabenstein says, is choosing the hot sector—getting into an area that has performed well only to see it disappoint. And many ETFs have special risks, such as commodity ETFs or leveraged ones.”

Edward Jones won’t even permit its clients to purchase leveraged ETFs. Other industry participants are leery of these as well.

“With leveraged ETFs, the ups and downs are magnified,” says Michael Iachini, managing director, ETF research at Charles Schwab Investment Advisory, in Englewood, Colo. “There is basic market risk and also risk because they reset their leverage daily to deliver twice or three times the daily return of whatever index they track. Over six months to a year, the compound effect of that tends to erode returns…. So you set yourself up for failure every time the market reverses direction.”

One of the most controversial issues on the ETF landscape is the introduction of actively managed funds, now available from about 10 providers. Fifty-four such funds have been launched as of August 2012, Morningstar says. For example, last March Pimco unveiled an ETF version of its huge Total Return mutual fund; and Fidelity Investments, among others, have filed with the SEC to also introduce actively managed ETFs. 

However, financial advisors aren’t jumping up and down about actively managed ETFs because the funds, they say, are largely unproven. And, as Bergman points out, “they violate the two main advantages of ETFs: low cost and tax efficiency.”

Adds Grabenstein: “If we’re looking for actively managed, we’ll use either a mutual fund or a separately managed account. We’re going to let somebody else be a beta test.”

For his part, Bogle fiercely opposes actively managed ETFs.

“It’s a bad joke,” he says. “People are trying to capitalize on the ETF fad by bringing in these funds at very high cost. I don’t see any merit to them except marketing or promotional merit.”

He continues: “Actively managed ETFs are basically casino-type things, leveraging three to one. I call that a lunatic strategy. You’re not only gambling about whether the market is going up in [the next half hour], you’re gambling that in that tiny half hour, your manager is going to do better or worse than the market. How does that comport even remotely with any kind of common sense? It’s flagrant stupidity. Do I make myself clear? Active management is a loser’s game.”

The 401(k) plan that is comprised of ETFs is another new wrinkle—which could become a trend. Schwab, among others, is set to offer, in the second half of next year, an all-ETF version of its Schwab Index Advantage retirement solution, which it debuted last January.

“We’re doing this to create better outcomes for employees. We’re looking at the next generation of 401(k) plans,” says Steve Anderson, senior vice president, national head of Schwab Retirement Plan Services, based in Cleveland. “We’re not going into esoteric categories. The real magic is the third-party advice we’ll be providing. We see minimal risk in terms of trading.”

Thumbs-down, unequivocally, to ETFs in 401(k) plans, Bogle stresses.

“It’s very, very foolish. Telling employees that they need investments ‘you can trade all day long in real time’ is nuts. It’s totally counterproductive investment behavior. My impression from working with individual investors over 61 years,” he says, “is that they don’t need any encouragement to trade—they need encouragement to stay the course.”

But ETFs aren’t the only encouragement to what Bogle sees as today’s rampant speculation. “What’s the point of all this trading? Instead of being a vehicle for owning shares in a corporation, the stock market has turned out to be this casino in which people buy shares because they think they can sell them to somebody at a higher price. That’s speculation.”

In his book, the financial services innovator opines that ETFs, “in general, have not served their investors well” because “picking an ETF”—which are tracking more than a thousand indexes—“is just like picking a stock, with all the attendant risks.”

In the interview, though, he notes that ETFs “are less speculative than owning an individual stock. ETFs are a safer approach. I’d rather own a technology ETF than a combination of Microsoft and Apple, say. I don’t know which one will do the best, but the ETF will give me the technology sector’s return.”

Right now, ETFs are in robust growth mode. Once this phase ends, the space will have reached maturity.

“Ultimately,” Bogle forecasts, “the market will clean itself out of the ETFs that don’t work and that run at high cost. They’ll just go away.”

But that doesn’t mean the visionary envisions ETFs becoming “the Holy Grail of Investing,” Bogle writes.

“Once the dust settles,” he tells Research, “I don’t see ETFs ever taking over the industry.”

Vanguard’s ETF Path

Two decades ago, the American Stock Exchange’s head of product development pitched John C. Bogle, then CEO of the Vanguard Group, his brand-new idea of an exchange-traded mutual fund. Bogle, concerned that the extra liquidity would become a magnet for speculation, gave the would-be product a pass.

Nine years later, when Bogle no longer helmed the firm he founded, Vanguard introduced its first exchange-traded fund. Had Bogle still been head, would he have launched an ETF?

“Maybe yes, maybe no. I don’t know which way I would have decided,” he says. ”I’ve been profoundly skeptical about ETFs. And I’ve also found in my long, long, long career that when I did something for marketing reasons, it usually turned out to be a mistake.”

Since Vanguard debuted its first exchange-traded fund in 2001, ETFs have driven about 25% of the Group’s total growth, according to Bogle.

“What Vanguard is trying to do is get into the business in a sounder way than somebody else, and we have done that. There is no reason,” he says, “that a Vanguard S&P 500 ETF, for instance, can’t go on for a long, long time—and it will.”

A Vanguard research study, published in July 2012, examined the trading behavior of the company’s mutual fund and ETF individual investors from 2007 through 2011. Looking at 3.2 million transactions, it concluded that though ETF investors were more active than those in traditional mutual funds, this was because “investors who are inclined to trade, choose ETFs—not that investors who choose ETFs, are induced to trade.”

The study, Bogle says, showed that “Vanguard individual investors traded ETFs significantly more than holders of our regular funds, but that it wasn’t outrageous.” — J.W.R.

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