Editor’s Note: Research Magazine and AdvisorOne contributor Ron DeLegge published (originally on ETFGuide) a strongly worded critique of Vanguard founder John Bogle’s dim view of ETFs. That letter provoked an equally robust reply from Bogle, found below. DeLegge tells AdvisorOne he plans a further response to Bogle’s rebuttal.
The polemic by Ron DeLegge on ETFGuide.com (Feb. 13, 2013) is replete with serious errors about my views on ETFs. I would like to take this opportunity to set the record straight.
First, to repeat the canard that I “hate” ETFs ignores the fact that I’ve never used that word in this (or any other) context. Indeed, I’ve long since learned that it’s pointless to “hate” inanimate objects. My consistent opinion about ETFs was expressed most recently in my 10th book, The Clash of the Cultures:
“ . . . I remain positive on the (ETF) concept, but only when (a) the right kinds of ETFs are used; and (b) used for investment and not speculation. I’m decidedly negative about the remarkable range of foolish extremes that have characterized their implementation.”
I then cite a recent essay in the London Economist that fully supports my conclusion: “Exchange-Traded Funds: A Good Idea in Danger of Going Bad—The Risks Created by Complicating a Simple Idea. . . ETFs have become a means for hedge funds to speculate on the market throughout the trading day . . . Like a hyperactive child, the finance sector can never let a good thing be . . .”
The record is clear that many of the broad-market ETFs (such as those based on the S&P 500 Index) are used—albeit, far too rarely—by individual investors with a long-term horizon. But more than one-half of all ETF assets are held by financial institutions—not individuals—who trade them with alacrity. Those realities explain why I believe (and have publicly stated) that ETFs are like the famous Purdey shotgun: great for big game hunting in Africa, but also great for suicide.
Yet Mr. DeLegge finds it convenient to ignore the huge positions that hedge funds and other large institutional investors hold in virtually all of the major ETFs—and many of the small ones. Financial institutions own 60% of all SPDRs, 59% of iShares and 41% of Vanguard ETFs.
Are these institutions long-term investors, or are they traders, hedgers and speculators? Of course we can’t be sure of the exact ratio of individual and institutional trading in ETFs, but we know that annual share turnover rates (including both individual and institutional transactions) in 2012 were 2,517% for SPDRs, 761% for iShares, and 250% for Vanguard. (Among “traditional” mutual funds, the turnover rate for investors was about 32% last year; for my nickel, disgracefully excessive!) Each day, the SPDR S&P 500 alone is the most widely traded stock in the world. Its shares were turned over at a 4,688% rate in 2012—nearly 5,000 percent! I’m sure that Mr. DeLegge will be “shocked . . . shocked to know that gambling is going on” in the world of ETFs.
The Vanguard Study
While there’s no way to separate the institutional transactions from the transactions by individual investors, Vanguard gives it not only a try, but in fact a statistically sound analysis that compares the “buy and hold” investors in our traditional index funds (TIFs) with those in our ETFs. Mr. DeLegge accurately presents these data, but fails abjectly to analyze them.
Even the most cursory examination of the Vanguard data clearly reflects a pattern in which our individual ETF owners trade their shares far more actively than our individual TIF owners. For example, the study finds that there are 25% fewer buy-and-hold investors in our ETFs as compared to our TIFs, 125% more short-term investors, and 140% more “hands-on-investors,” defined as investors who engage in more than two “reversal” transactions per year. Our ETF owners, therefore, are significantly less likely to be long-term investors, and significantly more likely to be short-term speculators.
So, no, I haven’t ignored the Vanguard study. But while I have the utmost respect for the intellectual ability and personal integrity of the authors of the study, I believe that the paper should have been far clearer in acknowledging that the study excluded institutional holders, and therefore encompassed only 60 percent of our ETF holders.
Ever the editor, I also thought that the paper glossed over the distinction between Vanguard ETFs and the ETF industry as a whole. Given Vanguard’s well-established culture of long-term investing, I’m confident that Vanguard ETF owners exhibit the longest holding periods of any group of ETF investors, and that the levels of speculation in non-Vanguard ETFs are far higher, especially for those focused on narrow market sectors and high-leverage. “Don’t go there” is my message.
And, no, Mr. DeLegge, locking up customers’ money until the end of the day is not “the real tyranny,” and the ability to “buy and sell in real time” is not an improvement. It has been well established that investor behavior is counterproductive. Independent academic studies clearly show, time and again, that the more trading by investors, the worse their returns. But that behavioral flaw is not the only negative for (especially) ETF traders. All that alleged intraday liquidity for ETFs can vanish during market plunges, just when liquidity is needed most. The Economist estimates that in the 2010 Flash Crash, “60-70 percent of the trades that subsequently had to be canceled were ETFs.”
Further, ETFs can trade at significant premiums or discounts from the value of their underlying securities, especially in ETFs that invest in less liquid securities, like junk bonds or real estate. These potentially wide spreads can further erode investor returns (while, admittedly, providing a bonus to those lucky enough to be on the “right” side of the trade). This is not so in TIFs, which always trade at the actual market value of the underlying securities—the fund’s daily closing net asset value (NAV).
To his credit, Mr. DeLegge does not repeat yet another canard about ETFs: that they provide lower cost and greater tax efficiency than TIFs. Yes, nearly all ETFs provide lower costs and greater tax efficiency than actively managed mutual funds, but only a few provide lower costs than TIFs. Vanguard, of course, sets the low-cost standard and the tax efficiency standard. Our major TIFs and ETFs (Admiral Shares, $10,000 minimum) carry identical expense ratios (0.05% for our larger U.S. equity funds, for example). Whichever class of shares they hold, they own identical portfolios and own them at the same low cost.
‘Present at the Creation’
In my 2012 book, The Clash of the Cultures: Investment vs. Speculation, I tell the complete story of the pros and cons of TIFs and ETFs. I also candidly recount the 1992 visit I had with the late Nathan Most, creator of the ETF. This fine gentleman, now deceased, showed me his plan: to enable investors in our pioneering Vanguard 500 Index Fund to trade its shares “all day long, in real time.” We had a wonderful discussion, in which I identified some serious flaws in his concept (which he acknowledged, and would promptly correct). But I turned down his proposal. Vanguard 500 Index Fund, I argued, was designed for long-term investors, not short-term speculators.
Do I have any regrets about that decision? Absolutely not! Do I have any regrets about Vanguard’s decision, nearly a decade later, to leap into the ETF fray? Again, absolutely not. Our legendary Gus Sauter (now retired) virtually demanded we do so, patented a better way to organize ETFs, and took a conservative approach (none of those speculative fringe ETFs). Our firm has done its best to attract long-term-oriented clients, educate investors about the folly of speculation, and leverage our low-cost standard to force our competitors to reduce their own fees—a trend that is easily observable.
I’ve often described the ETF as the “greatest marketing innovation” of the fund industry so far in the 21st century. I stand by that statement. After all, assets in ETFs now total $1.4 trillion, and there are 1,424 ETFs out there today tracking a mind-boggling 1,112 unique indexes (although the vast majority of those indexes are of dubious provenance), challenging investors to pick the one (or two or more) that is right for them. But I’ve always added this caveat: “whether it is the greatest investment innovation remains to be seen.”
For institutional speculators, perhaps it is. But for individual investors, the matter is far from settled. Unfortunately, the early evidence is not encouraging. Investor returns of ETFs have lagged the actual returns of the indexes they track by an average of 13% over the past five years alone (see page 206 of The Clash of the Cultures). The jury is still out, but the results so far are not encouraging for the ETF cause.
Sorry, Mr. DeLegge. I’m not “dead wrong” about ETF investing; and let your followers decide whether or not my comments in this note are “irrational.” This letter, I hope, makes it clear that it is you who are dead wrong—dead wrong about Bogle.
John C. Bogle
February 26, 2013
(published on ETFGuide.com on March 12, 2013)
Read DeLegge: Why Bogle Is Dead Wrong on ETFs on AdvisorOne.
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