November 2, 2012

Why Bogle’s Wrong on ETFs

It's worth analyzing three key arguments in the Vanguard founder's thinking on exchange traded funds

John Bogle hates exchange-traded funds (ETFs), and he makes no bones about it -- for example, read what he says in the November cover story of Research Magazine.

As the founder of the Vanguard Group and an index investing pioneer, he remains an influential voice and champion of the individual investor. But are his criticisms of ETFs accurate?

Let’s analyze three arguments. 

1) ETFs Encourage Day Trading

Do ETFs induce investors to become day traders?

A recent Vanguard study, titled “ETFs: For the better or bettor?” debunked this popular claim. 

The chart (below) shows a distribution of investments held for longer than one year sorted by the average annual rate of investment reversals. As illustrated, 99% of traditional mutual fund investments and 95% of ETF investments do not exceed a rate of four reversals per year. Moreover, less than 1% of Vanguard ETF positions averaged more than one investment reversal per month.

 

The report said, “Although behavior in ETFs is more active than behavior in traditional mutual funds, some of that difference is simply due to the fact that investors who are inclined to trade choose ETFs, not that investors who choose ETFs are induced to trade. We conclude that the ETF ‘temptation effect’ is not a significant reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio.”

2) ETF Costs are Rising

ETF critics correctly observe that the average expenses for ETFs are still low, but not as cheap as before. The average expense ratio for ETFs has increased to 0.56% in 2012 from 0.39% in 2005. But straight “averages” are deceptive.

By comparison, asset-weighted averages, where the largest ETFs carry more weight than smaller ones, render a more accurate picture of the actual costs ETF investors are paying. According to Vanguard’s research, the asset-weighted average expense ratio for ETFs is a substantially lower amount: 0.32% versus the simple average of 0.56%.

"We've found that when you take a closer look at the data, the averages are misleading because most of the money is flowing into lower-cost ETFs," says Joel Dickson, a principal and senior investment strategist with Vanguard Investment Strategy Group. "It's sort of the reverse of the Lake Wobegon effect."

In this case, Dickson says, "most investor dollars are below average in terms of the costs they are paying."

What about widening ETF bid/ask spreads? Here, too, straight “averages” are deceptive. The asset-weighted average spread is a negligible 0.04% - a far cry from the 0.31% “average” industry figure cited by critics.

3) ETFs Lack Diversification

It’s true that certain ETFs, especially single-country and industry sector funds, hold just a handful of stocks and lack broad diversification. But that still doesn’t negate the fact that other ETFs do offer the same kind of broad asset coverage that Bogle has long championed.  

Funds like the Vanguard Total Stock Market ETF (VTI), iShares Core Total US Bond Market ETF (AGG) and SPDR MSCI ACWI IMI ETF (ACIM) offer broad securities diversification and that’s why they’ve become popular portfolio building tools. And there are many other excellent ETFs like them.

Diehards of traditional index mutual funds rarely mention how their beloved products are limited to stocks and bonds, whereas ETFs aren’t.

Investors can now obtain broader asset coverage with diversified ETFs that cover commodities (GCC), global TIPS (GTIP), global real estate (RWO) and even precious metals (GLTR). True diversification is not a distorted academic viewpoint that says stocks and bonds give people everything they need to own, but rather, an unobstructed approach that embraces all major asset classes. 

Conclusion: Investor Behavior Is the Real Problem

In reality, Bogle’s complaints against ETFs are misdirected criticisms about the problems associated with investor behavior. The truth is that investors with a propensity to self-destruct will do so regardless of what type of financial product they choose.  

A 2011 study of Bogle’s beloved mutual funds from DALBAR, a Boston-based research firm, confirms this. Their 20-year study showed that mutual fund investors achieved a mere 41.9% of the S&P 500′s performance over the two-decade period that ended on December 31, 2010. Should we interpret this data to mean that all mutual funds are bad, as Bogle does with ETFs? Hardly! Instead, the data clearly proves that fund investors are horrible market timers.  

Likewise, the misapplication of ETFs in portfolio management is a user problem and not the fault of ETFs. Similarly, most automobile accidents are caused by driving errors, not design flaws. Should we return to the era of horses and buggies because there are too many automobile accidents? Only a cave person with a pre-historic mentality would agree.

The fact is that ETFs are an extension of the index investing philosophy Bogle started back in the 1970s. And despite his relentless and mostly irrational arguments against them, it’s hard to dislike John Bogle, even when he’s dead wrong.

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