Jack Bogle: Beware The Meteoric Rise Of ETFs

You know, ETFs aren’t as safe as they may seem.

This became readily apparent in 2015 when Reuters reported – in a piece that was largely ignored – that some of the top ETF providers were seeking to secure lines of credit that would be available in the event liquidity became a problem.

The issue still isn’t well understood. For something like a high yield bond ETF, the underlying securities aren’t liquid. The ETF units are, but only because the flows are still diversifiable. That just means that flows are not unidirectional, and therefore when one manager is experiencing outflows, another is likely experiencing inflows which means the ETF units and other portfolio products can be traded back and forth to meet redemption requests.

The question is this: what happens when flows are unidirectional? That is, what happens when someone yells fire and everyone wants out of the theatre but thanks to the post-crisis regulatory regime, the Street is no longer willing to inventory the underlying? Well, then managers have to sell the actual bonds to meet redemptions and assuming there’s no real market in a pinch (which is a safe assumption for something like junk bonds) what you’ll get is a series of fire sales and plunging prices.

In any event consider the following Op-Ed Vanguard founder Jack Bogle penned for FT:

Each day, the investing public hears news of the latest developments in exchange traded index funds. But rare is the mention of traditional index funds, which I call Tifs, although the acronym has yet to gain acceptance.

In 1976, I created the first Tif. It was named First Index Investment Trust (now Vanguard 500 Index Fund). Its purpose was to provide a long-term investment in the US stock market at rock-bottom cost, compounding its returns over a lifetime and giving investors their fair share of those returns. Its initial public offering was a flop, raising but $11m. But it was the start of something big.

In 1993, Nathan Most created the first ETF. He had earlier proposed using Vanguard’s 500 Index Fund in a new structure, one that would enable investors to trade the index fund, “all day long, in real time”. I could not agree with such a trading mentality. Time and again, clear statistical evidence has confirmed that the more investors trade, the more their returns fall short of the stock market return. I turned down his offer.

Persistent, Mr Most turned to State Street Global Advisors to implement his creation. The result: the SPDR (Standard & Poor’s 500 Depository Receipts), still the largest ETF.

Both Tifs and ETFs have enjoyed remarkable success. Each presently holds assets of about $2.4tn. Since 2008, both have grown at an annual rate of about 18 per cent. In fact, Tifs have grown slightly faster than ETFs, yet their remarkable success has been largely ignored.

Some 80 per cent of the assets of today’s 425 Tifs are represented by broadly diversified US (and non-US) funds, 15 per cent in “strategic beta” funds, and only 4 per cent in speculative strategies and concentrated sectors and regions. The asset mix of the 1,949 ETFs is starkly different. Broadly diversified funds account for the 43 per cent of ETF assets (one-half of the Tif percentage), with 31 per cent in strategic beta (double), and 25 per cent (six times as high) in speculative and less diversified strategies.

The ownership and share turnover rates of Tifs and ETFs are also completely different. Individual investors are by far the largest holders of the Vanguard Tifs, with annual redemption rates in the range of 8 per cent of assets. Banks and financial intermediaries hold almost 90 per cent of SPDR S&P 500, where the dollar value of annual turnover typically runs to some 3,000 per cent of assets.

Vanguard’s patented structure for ETFs – in which both its Tifs and ETFs are shares of the same underlying portfolio – presents a unique test case for evaluating investor outcomes in the two types of index funds. Over the past months, Tif investor returns were a few basis points higher than fund returns in each of the five largest Vanguard broad-market index funds. In contrast, returns earned by the firm’s ETF investors – owning the identical underlying portfolios – trailed the returns of the funds by an average of 1.6 per cent during the same period. This anecdotal evidence seems to confirm the consensus that higher trading activity takes its toll on investor wealth.

All Tifs and almost all ETFs are index funds. Yet the differences in their ownership and share turnover attest to a natural separation between the two, that clearly emerged when I first met Nate Most nearly 25 years ago. In view of what has happened in the index fund marketplace since then, I suppose you could say that we were both right. But their impact has been as divergent as their two contrasting strategies. ETFs have revolutionised trading in the stock market; Tifs (and a few ETFs) have revolutionised investing in mutual funds.

ETFs’ impact on stock trading has reached mammoth proportions. They account for nearly one-half of all trading in US stocks. So far in 2016, the dollar volume of trading in the 100 largest ETFs has totalled $13.0tn. Trading in the stocks of the 100 largest US corporations totalled $13.9tn, only slightly larger.

But the $1.6tn market capitalisation of those ETFs is but a small fraction of the $12.8tn for those corporate stocks. As a result, the annualised turnover rates are different in magnitude: stock turnover, 120 per cent; ETF turnover, 880 per cent. The implications of this rapid trading – call it speculation – have yet to be fully examined.

Equally dramatic is the impact of index mutual funds on the mutual fund industry itself. Over the past decade, investor capital has poured out of actively managed equity funds and poured into passively managed index funds. Since 2007, investors have redeemed $747bn on balance of their holdings of actively managed equity funds and purchased $1.65tn of passively managed equity index funds, a swing of $2.4tn in investor preferences. This trend in the fund industry’s cash flows has continued since 2007. It is not an aberration and its reversal is unlikely in the foreseeable future.

ETFs have had to compete with Tifs (and with one another) on the prices that they charge. More importantly, index fund pricing is putting substantial pressure on the annual expense ratios of active equity mutual funds (0.87 per cent). Further, the annual expense ratios of strategic beta ETFs (0.24 per cent) and more concentrated ETFs (0.33 per cent) run far higher than for broad ETFs (0.15 per cent), and broad Tifs (0.16 per cent), with 0.05 per cent quickly becoming the going rate.

Finally, today’s incipient trend towards “Robo-Advisers” such as Betterment and Wealthfront would not have been possible without ETFs. Changes in strategy and asset allocations by computer-driven models continue to grow. Robo-advisers are but one early aspect – and perhaps not even the most significant aspect – of the disruption that index funds will ultimately bring to traditional finance.