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Why Jack Bogle Prefers Index Funds to Index ETFs

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John Bogle, the founder and former CEO of Vanguard, has a message for all those financial advisors and investors who favor ETFs over index mutual funds: Consider traditional index funds instead.

Index funds, have much lower turnover rates than ETFs, which means they have relatively lower costs and comparatively better performance, according to Bogle. it toll on investor

Annual redemption rates for Vanguard’s traditional index funds, are around 8% compared to the 3,000% turnover of assets in State Street’s S&P 500 SPDR ETF, writes Bogle in Monday’s Financial Times newspaper.

This very wide spread reflects the differences between the types of owners of these funds. Banks and financial intermediaries hold almost 90% of the S&P 5000 SPDR while individual investors “are by far the largest holders of the Vanguard TIFs,” writes Bogle.

He goes on to compare the performance of the five largest Vanguard broad market index funds with their comparable ETFs, which invest in the same underlying portfolio and finds the index funds returned an average 1.6% more than the ETF over “past months.” Bogle doesn’t specify the exact time period or the specific funds but they presumably include the S&P 500 index fund and ETF, Total Stock Market Index and Total International Stock Market Index and ETF.

“This anecdotal evidence seems to confirm the consensus that higher trading activity takes its toll on investor wealth,” writes Bogle.

Despite the better performance and slightly faster growth of traditional index funds compared to ETFs, their “remarkable success has been largely ignored,” writes Bogle.

TIFs differ from ETFs in other ways, too. The assets they hold tend to be more plain vanilla and less risky. According to Bogle, 80% of the assets of the 425 traditional index funds in the market, are broadly diversified while 15% are strategic beta and 4% are invested in speculative strategies, concentrated sectors and regions.

In contrast, just 43% of the assets of 1,949 ETFs are broadly diversified, while 31% are strategic beta and 25% are speculative assets or invested in less diversified strategies. Both traditional index funds and ETFs each have about $2.4 trillion in assets. 

Index funds and ETFs also have had different impacts on the investing universe. “ETFs, have revolutionized trading in the stock market; TIFs (and a few ETFs) have revolutionized investing in mutual funds,” writes Bogle.

ETFs account for nearly half the trading in U.S. stocks, according to Bogle. The dollar volume of trading in the 100 largest ETFS total $13 trillion year to-date, almost as much as the $13.9 trillion in stock trades for the 100 largest U.S. corporations. But since the market capitalization of those ETFs is just $1.6 trillion compared to the $12.8 trillion capitalization of those corporate stocks, their turnover is over almost 900% compared to about 120% in the stock market.

“The implications of this rapid trading – call it speculation – have yet to be fully examined,” writes Bogle.

Traditional index mutual funds have also grown in assets and popularity. Since 2007, investors have purchased $1.65 trillion in equity index funds while withdrawing $747 billion from actively managed equity funds, putting pressure on the annual expense ratio of active funds, writes Bogle.

He notes that expense ratios for broad index ETFs and their index fund counterpart are comparable: 15 basis points vs. 16 though 5 basis points is “quickly becoming the going rate.”

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