Is John Bogle Wrong about ETFs?
By Ron DeLegge, Editor
June 26, 2009
SAN DIEGO (ETFguide.com) Ė John Bogle hates exchange-traded funds (ETFs). And he makes no bones about his dislike for these low cost but heavily traded financial products.
In a new research piece just published by the Journal of Indexes and IndexUniverse.com, Bogle argues that ETF investors are self-destructing. His data evaluated 79 ETFs and showed that 68 had investor returns that lagged the actual returns of the funds themselves. Underperformance was particularly pronounced with ETFs following emerging markets and narrow industry sectors.
While many financial professionals and investors (including the author) view ETFs as an extension of his original index fund concept, Bogle has been and continues to be an outspoken critic of ETFs. Are John Bogleís criticisms warranted or is he wrong about ETFs?
Before we evaluate his arguments against ETFs, letís evaluate John Bogle.
Thereís no questioning John Bogleís positive impact on investors. As founder and former CEO of the Vanguard Group, Bogle almost single-handedly turned an entire generation of would be market losers into winners. For decades heís consistently warned the investing public about the hazards of investment costs, taxes and the risks of trying to second guess the market. Heís the Paul Revere of investing.
Bogle is also credited with helping to introduce the first retail index mutual fund, a Vanguard fund benchmarked to the S&P 500 (Nasdaq: VFINX). Today, VFINX is one of the top mutual funds, with around $40 billion in assets. Bogle is also an accomplished author.
ETFs are bought and sold at market prices throughout each trading session, whereas traditional mutual funds are bought and sold at their net asset value (NAV) at the end of each market day. Bogle says this encourages ETF investors to become traders of their investments instead of owners.
Intraday liquidity is an important product feature of ETFs. It gives investors a flexible entry and exit strategy by allowing them to buy and sell shares when the financial markets are open for business.
In recent years, trading in ETF shares has exploded and many funds, such as the SPDR S&P 500 ETF (NYSEArca: SPY) and PowerShares QQQ Trust (tracks the NASDAQ 100) (NasdaqGM: QQQQ) dominate the daily volume on major stock exchanges.
Itís a widely known fact that large institutions account for the bulk of ETF trading volume. Before you believe the false argument that ETFs have transformed an entire generation of investors into hyperactive traders, itís important to have some context. The vast majority of ETF trading volume comes from institutional investors trading large share blocks, not mom and pop investors trading a few hundred shares.
Interestingly, individual stocks also have intraday trading volume just like ETFs. Should we make the case that stocks should be completely avoided because they have daily volume and might induce investors to needlessly trade? Making a similar claim against ETFs is irresponsible.
The Truth about Bid/Ask Spreads
Another point of contention against ETFs is their subtle trading costs. Like stocks, ETFs have differences or spreads between their bid and ask prices. Morningstar recently launched a helpful ETF database that reveals the real trading cost of bid/ask spreads. These costs are expressed in percentage terms. Generally speaking, ETFs with lower trading volume tend to have larger bid/ask spreads and consequently higher trading costs, whereas ETFs with higher trading volume have lower bid/ask spreads and cost. Do bid/ask spreads wipe away the low cost and tax efficiency of ETFs?
Itís imperative to understand the cost impact of bid/ask spreads is not exclusive to ETFs and that all exchange listed securities (stocks, closed-end funds, ETNs, etc.) have this often overlooked cost attached to them. But wait, thereís more.
Itís just as vital to recognize that mutual fund investors are also impacted by the trading cost of bid/ask spreads too. Thatís because fund managers are buying and selling stocks and other exchange listed securities within their portfolios. In the case of mutual funds, bid/ask spreads are an embedded cost thatís not reflected in the fundís expense ratio. It should also be noted that traditional index mutual funds do not escape the cost of bid/ask spreads.
What Does Bogleís ETF Study Really Prove?
Bogleís latest study is less about ETFs and more about the problems associated with investor behavior. The fact is many investors with chronic behavioral problems and a general propensity to self-destruct were that way long before ETFs arrived on the investment scene. Demonizing ETFs is misplacing the blame.
Although Bogleís data argues that index mutual fund investors get better returns compared to their ETF counterparts, mutual fund investors are far from well-behaved. Dalbar reports in its Quantitative Analysis of Investor Behavior that in 2008 stock fund investors lost 41.6% compared to the 37.7% loss for the S&P 500 Index.
Used correctly, ETFs are wonderful investment products. Used incorrectly, ETFs can be deadly. The issue of incorrect usage, however, is not caused by ETFs or even a problem exclusive to ETFs. Along similar lines, should we fault automobiles for car accidents? How about we blame fire for burning people? And while weíre at it, shall we fault knives for cutting people? Likewise, saying that ETFs induce investors to self-destruct is absurd. Investors are the ones responsible for their own financial fate, not ETFs.
Unmoved by all counterarguments, Bogleís crusade against ETFs continues. ďAn ETF is like handing an arsonist a match.Ē
Still, it's hard to dislike John Bogle.
Even when heís wrong.