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.
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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.