ETFs: Broadening or Perverting Index Investing?

On February 9, the venerable John Bogle, founder of Vanguard, wrote an op-ed piece in the Wall Street Journal titled "'Value' Strategies", which was sharply critical of the manner in which the ETF industry is developing and how ETFs are changing the model of indexing. Bogle blames profit-driven Wall Street and misguided “performance-chasing” investors for what he perceives as the perversion of the indexing idea by the proliferation of ETFs for every imaginable market segment.

The op-ed should be read in full, but we will quote liberally from it below:

“If long-term investing was the paradigm for the classic index fund, trading ETFs can only be described as short-term speculation. And it was only a matter of time until trading overwhelmed diversification as the driving force in the ETF world. Of the 690 ETFs in existence today (including 343 in registration at the SEC), only 12 represent broad market segments, such as the Standard & Poor's 500, the Dow Jones Wilshire Total (U.S.) Stock Market Index, and the Morgan Stanley EAFE (Europe, Australia and Far East) Index of non-U.S. stocks. With each passing day, the market segments available through ETFs seem to get narrower. (Can you believe that we now have a "HealthShares Emerging Cancer (HHJ)" ETF?)”

“These nouveau index funds starkly contradict each of the principal concepts underlying the original index fund. If the broadest possible diversification was the original paradigm, surely holding small segments of the market offers less diversification and commensurately more risk. If the original paradigm was minimal cost, then holding market-sector index funds that may themselves be low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully...As to the quintessential aspect of the classic index fund -- assuring, indeed guaranteeing, that investors will earn their fair share of the stock market's return -- the fact is that investors who trade ETFs have nothing even resembling such a guarantee. In fact, after all the extra costs, the added taxes, the selection challenges and the timing risks, the typical ETF investor has absolutely no idea what relationship his investment return will bear to the return earned by the stock market.”

There is a lot of truth in Bogle’s criticisms. Certainly the number of ETFs being launched is excessive, and undoubtedly many ETF investors are under-appreciating the risks and costs inherent in many of the newer, narrowly-focused or “enhanced index” ETFs, as well as in the higher-turnover ETF trading strategies that are being promoted. But there are myriad ways of employing ETFs in an investment strategy, and ETFs can be highly effective for a Bogle-type buy-and-hold investor seeking broad market exposure while keeping costs, turnover, and taxes at an absolute minimum.

Bogle does acknowledge this point, and even concedes that the unique, tax-efficient product structure and sometimes lower expense ratios of ETFs may make them preferable to traditional index funds:

“ETFs, simply put, are index funds that can be traded in the financial markets. In fairness, if they are not traded, they can often be the equal of the classic index funds. If they operate at lower expense ratios and provide potentially higher tax efficiency, they may provide the same diversification at even lower costs (provided that the initial brokerage commissions are amortized over a substantial span of years). In this format, used in that way, ETFs are solid competitors to their classic forebears.”

One thing is certain; ETFs have shaken up the formerly sedate world of indexing, in which Bogle was a pioneer and remains a leading advocate. Not only are ETFs taking market share from traditional mutual funds (both active and indexed), the ETF industry has vastly broadened the definition of an “indexed” investment vehicle beyond traditional capitalization-weighted indexes maintained by leading index managers such as S&P and Russell.

Indeed, the very idea of capitalization-weighted indexes has come under attack by proponents of alternative weighting schemes (e.g. fundamental, equal weight, etc). It must be a bit uncomfortable for Vanguard, which was late to embrace the ETF concept and is now playing catch-up, for its founder to be among the most vocal critics of ETFs. In the final analysis, we remain convinced that ETFs were one of the most important financial product innovations in decades, and, when intelligently used, can provide a compelling set of benefits to investors.

Comments

[Malkiel]

I fail to see any significant difference between owning a stock or owning an ETF, and that's the point. The ETF allows you to concentrate on general econometric and economic factors, if that's where your knowledge base lies, rather than company-specific factors, which are too often inscrutable. It seems to be a source of irritation to the conservatives who think individual stocks and mutual funds built around them are the center of the investing universe, but they always considered commodities to be dirty business anyway, so ETF's were bound to make them unhappy. If you aren't "performance-chas... then you belong in a savings account at a bank...

[Paul Meisel]

I think there are several different ways to view the alternatives here:

1. Buy and hold a broad index. Do not try to time the market, play sector rotation, or pick individual stocks. The difference between this and a savings account is a belief that equities will yield more over time. A humble approach, to steal a Templeton phrase.

2. Buy and sell a broad index -- try to time the market but not the sectors. Do not pick individual stocks. This is a belief that the investor has some insight into the economy as a whole, but cannot trust his analysis of individual companies and industries.

3. Buy and sell sectors, based on analysis of the overall economy and industries -- time the sectors and possibly the broad market as well, but do not try to pick companies.

4. Pick individual companies based on their fundamentals and valuations; do not time the market, except in the sense that if there are fewer companies available at attractive valuations then there will be more cash on the sidelines. Pick companies, but do not explicitly time the market.

It seems to me that those with relatively little understanding or financial education may be best off in strategy 1; but increasing knowledge and sophistication should permit effective application of strategy 4 sooner and better than either 2 or 3. There are quite a lot of people that can read a balance sheet and income statement, or understand a Value Line summary.

On the other hand, it seems that even "experts" have a lot of trouble timing the market.

[Marc Gerstein]

I do not see the broadening of ETFs as a problem, mainly becasue I don't think of ETFs as having ever been passive. What's passive about the S&P 500? There's quite a bit of very active thought as to which stocks go in and which go out. It's a managed portfolio -- one that is very widely looked to as a benchmark, but a managed portfolio nonetheless. The only difference between SPY and the index is that in the case of the latter, it's just a paper portfolio.

I like the newer, borader, approach to indexing. Outfits like PowerSahres create their portfolios based on objective algorithm, rather than selection commitee debate. Why is that a perversion?

Either way, when you invest in an ETF, you invest, not in a company and not in the whim-skill of a portfolio manager (as in conventional open-end funds) but in a model. Bravo to the industry for offering us more models and for evolving models away from ciommittees toward disciplined algorithm. Not very nouvele ETF perfectly objective, but as long as the trend moves that way, I think the situation is improving for investors.

[Tristan Yates]

Bogle's not talking about there being too many ETFs. He's talking about the idiocy of day trading something that was designed to be a buy and hold investment. And he's right as usual. Trading makes your broker richer and you poorer. Yet people are irrational and everyone thinks that they can beat the market for long periods of time, when that's just statistically impossible.

Tristan Yates
Index Roll: Indexing On Steroids

[TAMRIS]

What I feel Bogle is talking about is the fact that market timing at a fundamental level is a marginal discipline. If market timing is moving to the mainstream because of index ETFs then we risk wilder swings in markets, greater risks and costs, lower returns and ultimately because of the greater uncertainty a higher cost of capital for the broader economy. I refer to market timing in the context of a switch out of equities into cash or other liquid low risk asset.

Andrew Teasdale

The TAMRIS Consultancy