Vanguard founder and passive investing champion John Bogle sparked controversy recently when he warned investors to "beware" of exchange-traded funds (ETFs). In a Financial Times editorial, he dismissed them as the "greatest marketing innovation of the 21st century".
ETFs, like conventional index funds, offer investors the ability to assemble a low-cost, diversified portfolio. However, Bogle says their convenience – ETFs can be bought and sold like an ordinary stock – is a double-edged sword, tempting investors to partake in the trading game in which the “only sure winners are the brokers and dealers of Wall Street”.
Concerns
Bogle’s concerns are not new. In 1993, Vanguard rejected a proposal that it start the first
ETF
based on its Vanguard 500 index fund. Bogle said the idea that the fund would become a vehicle for frequent trading was “anathema” to his buy-and-hold investment philosophy.
The idea was instead taken to State Street Global Advisors, whose S&P 500 ETF is now the world’s largest, with assets of $185 billion.
Vanguard eventually changed its mind, launching its own series of ETFs in 2001, two years after Bogle retired from an active role in the company. Although Bogle remains a legendary figure at Vanguard, current chief executive Bill McNabb has rejected his latest criticisms, describing ETFs as a “great investment innovation” that lowers the cost of investing for “millions of individuals around the globe”.
Other ETF providers were blunter, telling the Financial Times that Bogle's critique was "confused", "self-serving" and "utter nonsense".
ETFs come in all shapes and sizes, and are used by investors and traders alike. Controversy has typically focused on the world of leveraged ETFs, where the "fruitcakes, nutcases and lunatic fringe" tend to congregate, as Bogle once put it. Last year, BlackRock chief executive Larry Fink warned that leveraged ETFs had the potential to "blow up the whole industry".
Long-term investors can, of course, steer clear of speculative ETFs and simply leave the "lunatic fringe" to its own devices. According to a recent survey carried out by BlackRock and Fidelity, 88 per cent of investors think of ETFs as part of their long-term investing strategies.
Even Bogle admits that ETFs in themselves “are fine, as long as investors do not trade them”.
Studies
Do they? Not really, says Vanguard. In a 2012 study entitled
ETFs: For the better or bettor?
, it examined the behaviour of investors who owned Vanguard index funds and ETFs. Those who owned ETFs were more active, but there was “little evidence of speculative behaviour”.
On average, investors held Vanguard ETFs for 34 months, compared to 42 months for Vanguard index funds. Various factors accounted for the differences in investing behaviour, said Vanguard, which concluded that the so-called “temptation effect” was “not a significant reason for long-term individual investors to avoid using appropriate ETF investments”.
Clearly, ETFs are not so tempting that they turn long-term investors into day traders. Nevertheless, other data suggests Bogle is right to be cautious about ETFs.
In 2009, Bogle analysed Morningstar data tracking the average returns of investors in 79 ETFs across different asset categories. In 68 cases, the average investor underperformed the actual fund due to poor market timing.
Investors did worst in the most volatile sectors. For example, investors in financial ETFs lost 28.6 per cent over the period, even though financial ETFs fell by just 10.5 per cent.
Overall, across the 79 funds, the average ETF gained by 6 per cent, but the average investor made only 3.5 per cent, effectively a cumulative loss of 12 per cent.
“When you combine those, you’re talking about 18 per cent of investor capital that’s been lost by all this trading,” Bogle said.
Typically, investors in funds also underperformed the funds themselves, but the discrepancy was not nearly as large, Bogle found, with Vanguard fund investors consistently outperforming Vanguard ETF investors. Again, this doesn’t prove that ETFs tempt investors to indulge in questionable market-timing activity. One could argue that the ETFs simply attracted more speculative investors in the first place – hence the underperformance.
The dark side
However, a 2013 study, titled
The Dark Side of ETFs
, indicates there is indeed a damaging temptation effect. The authors analysed the investing records of nearly 8,000 clients of an online German brokerage, tracking their performance before and after their first ETF purchase.
The results weren’t pretty. Investors who began investing in ETFs performed much more poorly than those who steered clear. The ETFs they bought did worse than those they sold. Investor returns suffered after they began investing in ETFs.
Furthermore, it was purely the ETF portion of their portfolio that caused the falloff in returns, with no deterioration evident in the non-ETF portion of their portfolio.
In other words, the obvious benefits provided by ETFs were “frittered away by bad market timing”.
The irony of the situation is hammered home by the researchers in a follow-up paper, Abusing ETFs. Passive ETFs, they say, are a "wonderful innovation" with "enormous potential to act as a low-cost and liquid vehicle for diversification". However, "the low cost and high liquidity of these ETFs seem to encourage their trading, and this aggravates an individual's temptation to engage in some sort of timing", a fact that "should make regulators, consumer protection agencies . . . and financial economists more cautious when recommending ETF use".
Sit tight
The research is a reminder that the biggest problem faced by investors is their own psychology and the seemingly instinctive desire to tinker with portfolios. Generally, the best course of action is to do nothing, as shown in an anecdote told by US money manager James O’Shaughnessy. An employee who joined his firm told him of a study by fund firm Fidelity relating to the best-performing client accounts.
The winners? “They were the accounts of people who forgot they had an account at Fidelity.”
The Fidelity study brings to mind the “don’t do something, stand there” mantra preached by Bogle. It would be wrong to say that buy-and-hold investors should automatically steer clear of ETFs; after all, one can assemble a low-cost ETF portfolio and then sit tight for the next few decades, just as Bogle advises.
However, many investors find it hard to ignore the stomach-churning twists and turns of stock markets, causing them to meddle with their portfolio when it’s least opportune to do so. ETFs are cheap and easy to trade – for some investors, perhaps too much so.
