John Bogle is the country’s most vocal critic of exchange-traded funds (ETFs). The founder of Vanguard and the father of index funds has called them everything from suicidal to handing an arsonist a match. Yet, despite Mr. Bogle’s distain for ETFs, they have probably done more to popularize his investment philosophy than anything else in the past ten years.
“An ETF is like handing an arsonist a match,” Mr. Bogle said back in 2001 when only a handful of funds existed. His chief complaint is that ETFs trade intraday and this tempts people to do more trading, which is exactly what they shouldn’t do. Mr. Bogle admits that most short-term ETF trading is done by large institutions that have different objectives than individuals.
Ron DeLegge, editor of ETFguide and host of The Index Investing Show thinks that Mr. Bogle is overstating the problem, “Blaming ETFs for tempting investors isn’t in line with what we’ve seen in the marketplace. The ability to trade ETFs anytime has had little impact on how a majority of individual investors have used the product in their portfolios.”
Ironically, the company that Mr. Bogle founded agrees with DeLegge. A 2012 Vanguard report titled ETFs: For the better or bettor? states, “It is not valid to assume that the so-called ETF temptation effect explains the higher-observed trading in ETFs relative to mutual funds, nor is it a reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio.”
Figure 1 is from the Vanguard research report. It shows that a majority of both traditional mutual fund and ETF assets in Vanguard funds exhibit buy-and-hold characteristics (83% and 62%, respectively).
Figure 1: The turnover rate of Vanguard index products is low
Source: Vanguard research July, 2012, ETFs: For the better or bettor?
Mr. Bogle may have issues with people who trade ETFs, but there is no question that this product has help promote his investment philosophy over the years. The interest in ETFs has catapulted the idea of owning a portfolio of low-cost index tracking funds.
Even brokers at the large national firms are using index-based ETFs as core holdings in client accounts. This was unheard of when I was in the brokerage industry during the 1990s.
Clients of fee-only advisers have also benefited. The growth in ETFs has resulted in a large shift in the way many advisers manage money. Rather than using all actively managed funds, many advisers today use strategies that include at least some buy-and-hold index-tracking ETFs.
The shift in money out of actively managed funds and into low-cost indexing products has been widely documented and has correlated closely with the increased ETF popularity. Flow of funds studies by Vanguard and the Investment Company Institute (ICI) clearly show this shift in investor preference.
Figure 2 highlights ICI Data that shows the accelerated growth in index investing that began in 2006. This corresponds closely to the growth in ETFs and ETF assets, according to industry data from iShares.
Figure 2: The shift to index funds has accelerated in recent years
Source: 2013 Investment Company Fact Book, Page 38
“There is no doubt that the popularity of ETFs has accelerated the trend toward index funds well beyond what would have occurred otherwise,” said DeLegge. “Companies such as Vanguard have attracted billions of dollars to their index products through ETFs from new sources such as traditional brokerage firms. Vanguard could not have had the same success if they didn’t enter the ETF business.”
I sympathize with Mr. Bogle’s view that ETFs may entice some people to trade more, but I’ve also witnessed firsthand the huge increase in long-term money that has flowed into low-cost index funds as a direct result of ETF acceptance. The industry hasn’t been given enough credit for this. In my view, the benefits from popularizing Mr. Bogle’s investment philosophy overwhelm any blemishes that the ETF industry may have acquired along the way.