Are Investors Hurting Themselves With ETFs?

by: Vanguard

By Joel Dickson

While ETFs have been around for nearly 25 years, they have really exploded in the past five. Exploded in terms of the assets invested in these half-stock, half-fund hybrids (more than $2.5 trillion among just U.S.-listed ETFs as of December 31, 2016, according to FactSet), the sheer number of products (nearly 2,000 listed on U.S. exchanges), and the trading volume on major markets (about 30% of daily volume in the United States during 2016, according to Credit Suisse).

With growth comes scrutiny. A regular drumbeat of comments from market observers, often highlighted and editorialized in the financial press, has focused on the purported ills of ETFs, claiming the investment product is everything from the progenitor of market instability to the evil permutation of the traditional index fund. These arguments remind me of the first half of Noah "Soggy" Sweat's grand 1952 speech about whiskey in the era of prohibition in Mississippi.

Indeed, if Judge Sweat were alive today, he might opine:

If, when you say ETFs, you mean the wolf in sheep's clothing, designed as trading vehicles to tempt otherwise prudent investors to speculate their way to financial ruin, if you mean the heavily hyped mutation of a product proliferating in the marketplace with questionable, market-disrupting investment strategies, if you mean the cleverly crafted investment hybrid dreamed up by opportunistic financial enterprises conspiring to fatten their coffers through trading commissions and management fees, then, certainly, we are against them.

But Judge Sweat was equally eloquent in the second half of his "If by whiskey" remarks, as they became known, and channeling him here on ETFs:

But … if, when you say ETFs, you mean that low-cost, broadly diversified, potentially tax-efficient investment product that provides all investors a more powerful means of capturing a financial market's return, if you mean that better mousetrap of an index fund that offers the traditional benefits of diversification and market-matching performance with the trading flexibility of an individual stock, if you mean the innovative investment that provides advisors with the blocks to build balanced investment programs for their clients that ensure long-term financial success, then, certainly, we are for them.

The truth lies somewhere between the rhetoric of the bashers and the boosters. At their core, ETFs are index funds, widely known for low costs, low turnover, potentially high tax efficiency, broad diversification, and relative performance predictability. In fact, according to Morningstar, nearly $4 in every $5 entrusted to ETFs is invested in large, mainstream index products hewing to such recognized, time-tested market barometers as the Standard & Poor's 500 Index and the FTSE 100 Index.

Also lost in the debate is that ETFs have lowered investing costs for millions of investors. Most investors purchase investments through financial intermediaries, who have traditionally shunned index funds in favor of individual securities and higher-cost actively managed mutual funds. Enter the ETF, along with a change in the business model of intermediaries from commission-based to asset-based, and a whole generation of investors now has access to broader, lower-cost choices that may improve the odds for long-term investment success.

The markets have also benefited. ETFs have consolidated and increased liquidity for many investment classes; enhanced price discovery, especially in periods of market turmoil; and served to drive down spreads and lower transaction costs.

Are ETFs perfect? No. There are probably too many of them. But the same could be said of traditional mutual funds, even index funds. Do all offer sound and durable investment strategies? Probably not. Neither do mutual funds.

Do they encourage speculative trading? Likely at the margin, but Vanguard research indicates that most of our products are being bought and held by long-term investors. And the high turnover statistics cited as proof of speculation largely ignore that ETFs have legitimate short-term uses, largely by institutional investors seeking to equitize cash, hedge other trading activity, or transition assets between managers.

Do they cause volatility in the underlying markets? Not likely. When the smoke cleared from the August 2015 market volatility, it was evident that structural market issues were largely responsible for the dislocation. ETFs, by their passive exposure, reflect the dynamics of their underlying securities or markets rather than dictate those dynamics.

ETFs, like whiskey, require moderation. Moderation in use and moderation in the views pertaining to them.

Note:

All investing is subject to risk, including the possible loss of money you invest.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Joel Dickson

Joel M. Dickson, Ph.D., is Vanguard's global head of Investment Research and Development and a principal in Vanguard Investment Strategy Group. Previously, Mr. Dickson was a senior ETF strategist, also within Vanguard Investment Strategy Group, where he analyzed trends and developments in the ETF market. He also served as head of Vanguard's Quantitative Equity Group, with oversight responsibility for all research and portfolio management activities associated with Vanguard's internally managed active equity portfolios. Before that, he was responsible for the day-to-day portfolio management of Vanguard’s active quantitative portfolios. He also was a member of Vanguard Portfolio Review Department, where he evaluated potential advisors for the company's subadvised funds. Before joining Vanguard in 1996, he worked as a staff economist at the Federal Reserve Board. Mr. Dickson has testified before Congress on Social Security reform and mutual fund disclosure issues, and he is often quoted in the press regarding the role taxes play in portfolio management and asset allocation decisions. Mr. Dickson earned an A.B. from Washington University in St. Louis and a Ph.D. in economics from Stanford University.

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