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Customary Wall Street practice is to follow the trend, and investment product creation and marketing tends to take the easy road. By focusing on what investors want now, firms figure they will simply change tactics when people want something different.

In the end, however, the investor-client base that bought near the top feels taken advantage of. And, when the new trend is obvious, all the firms that waited have to scramble at the same time, then adopt strong sales efforts to capture market share.

So, what’s up with Vanguard’s new ETFs (exchange traded funds)?

Vanguard’s 9 new ETFs

Vanguard has just issued nine new ETFs investing in US Stocks. They are designed to track the three mainstream Standard & Poor’s (S&P) indexes along with the subsets within each for value and growth stocks.

  • S&P 500 (VOO)
  • S&P 500 Value (VOOV)
  • S&P 500 Growth (VOOG)
  • S&P Mid-Cap 400 (IVOO)
  • S&P Mid-Cap 400 Value (IVOV)
  • S&P Mid-Cap 400 Growth (IVOG)
  • S&P Small-Cap 600 (VIOO)
  • S&P Small-Cap 600 Value (VIOV)
  • S&P Small-Cap 600 Growth (VIOG)

Easy way to remember the new symbols: V, IV and VI represent Roman numerals for 5, 4 and 6. V and G at end are for “value” and “growth.” And Os represent zeroes – almost.

Why would Vanguard issue US stock ETFs now?

Curious. We know that the easiest route to investors’ dollars today is to have bond products. And, with yields low, not just plain vanilla funds, but those with higher risk holdings (i.e., longer maturity and/or lower quality). With borrowing cheap, leverage can be added, too. All of this adds up to larger fee income for the firm, so it would seem to be a double win.

Certainly others are following that strategy. For example, Claymore just announced nine funds of their own. They are target dated (meaning the funds will wind up business on a specific day) – in this case, one fund for each year from 2012 to 2020. Each will invest in high yield (junk) corporate bonds.

Well, these funds may be a good example of why Vanguard appears to be thinking that approach is wrong.

  • First, the ETFs are index funds. While Wall Street has tried to get active management into ETFs, it’s difficult. With the typical non-index fund, the ETF structure to prevent closed-end fund discounts cannot be carried out. Moreover, there are some types of investments, junk bonds being right up there, where the investor needs someone to have active control. After all, “junk” means it’s questionable whether the bond will be paid on time or at all.
  • Second, the target dates add a challenge. Any fund dealing with risky securities is faced with a changing picture through time as the target (maturity) date closes in. Just imagine a recession in 2018, with some problems appearing in the 2020 fund’s holdings. There is no time to recoup a loss or even replace the higher, once longer-term yield.
  • Third, gathering bond assets in a new fund could be a losing strategy. A wise investment manager was once asked if he minded being judged by performance. He said, “No. So long as I get to pick the beginning and ending dates.” Vanguard could well be thinking about that as they look at today’s bond investing popularity. By starting up a bond fund today, any trend change could mean all future returns would begin at a poor starting point.
  • Fourth, not preparing for a trend change can mean missing out. It takes time to design, register and start up new products. So, Vanguard might prefer to have their funds already in place – both to be available when investors are ready and to better carry out a competitive strategy.

Why aren’t others doing the same thing?

As I described at the start, Wall Street is not accustomed to pursuing a new strategy (in product creation and marketing) when another trend is in favor. If more firms did so, we might see fewer investment bubbles. However, there are times when one firm will make an apparently contrary and daring move.

What makes the Vanguard move special?

Let’s say we were running Vanguard. Suppose we felt that bond investing had become overly popular and would likely shift to US stocks, currently underweighted and disliked. Would we willingly commit the firm’s resources, efforts and reputation to create nine new general US equity ETFs at this time?

Here are the facts regarding the current Vanguard ETF lineup:

  • There are 46 ETFs (prior to the 9 new ones): 12 bond funds, 7 international equity funds, 11 sector equity funds and 16 general US equity funds. Adding 9 more to the 16 takes general US equity funds up to 25 – overkill?
  • Looking at performance this year (through September 8): 10.8% average return for the bond funds, (0.4)% return for international equity funds, 3.3% return for sector equity funds and 2.1% return for general US equity funds. Less return for more risk – why would investors be interested?
  • Here are the funds’ expense ratios, from which Vanguard earns its revenues: 0.14% average for bond funds, 0.24% for international equity funds, 0.24% for sector equity funds and 0.14% for general US equity funds. Why not more bond funds if revenues are comparable – or more higher fee funds?

So, the facts leave us wondering if the new funds are the way to go. Especially since the funds’ designs use the S&P indexes, already in use by other, popular ETFs from recognized companies. Moreover, since the new Vanguard funds, in order to retain the firm’s low cost reputation, will have especially low expense ratios – e.g., only 0.06% for the S&P 500 Stock Index fund.

Is Vanguard attempting to time a trend shift?

I believe the answer to the apparent conundrum is Vanguard’s culture of independence: a willingness to take a business risk to benefit investors, thereby benefiting the firm if successful. So, while an analytical approach applied to the firm and the fund’s current characteristics might argue for waiting on the general US equity funds, Vanguard’s reading of the markets and investor actions could be leading them to act now.

One way to test this idea is to look at the performance of all their ETFs since inception, whenever that may have occurred. If Vanguard is, indeed, able to get ahead of a trend, then we should see quite a bit of positive performance since inception. Here’s the record: 8.7% average annual return for bond funds (started from April 2007 to November 2009), 4.2% for international equity funds (March 2005 to April 2009), 3.2% for sector equity funds (January 2004 to September 2004) and (0.9)% for general US equity funds (May 2001 to December 2007).

Another way to look at the results is a simple count of those under water since inception. Of the 46 ETFs, 11 currently have a loss from inception: 0 bond funds, 3 international equity funds, 1 sector equity fund and 7 general US equity funds.

All-in-all, a good record. The different ranges of dates show timing was involved, and the returns show that the timing was good – even for the general US equity funds, knowing that the period we’ve been through has been difficult and that the current ending point (September 8 ) is at the low end of this year’s range.

So… Vanguard deserves praise for its willingness to go against the trend in an attempt to deliver the products investors will need tomorrow, not simply what they want today. Time will tell if their strategy is successful. Their previous, positive experience heightens the probability that it will be so. It also sends us a signal that an investor shift from bonds to US equities could be coming.

Disclosure: Some Vanguard mutual funds (no ETFs) along with custody/brokerage services

Source: Does Vanguard Know Something That the Rest of Us Don't?