Wed, 3 Oct 2012
Vanguard principal and ETF strategist Joel Dickson responds to worries that increased passive investing has led to more market volatility and that ETFs cause investors to gamble with their portfolios.
Jason Stipp: I'm Jason Stipp for Morningstar, reporting from the Morningstar ETF Invest Conference 2012.
I am here today with Joel Dickson from Vanguard. He is a principal and an ETF strategist with the Vanguard Group.
We're going to talk about some of the concerns over ETFs and some of the research Vanguard has done to address those concerns.
Thanks for joining me, Joel.
Joel Dickson: Thanks for having me, Jason.
Stipp: I think ETF investing is in the news a lot because it's got a lot of assets, and we've seen a lot of assets moving to passive investments. What do you think are some of the tailwinds that are causing this move to passive investing among investors of all stripes?
Dickson: Well, I think there are a couple of things. First is the recognition of costs being an important determinant of long-term returns for investors, and it's somewhat unlike many other consumer products, if you will, where often higher price is a signal of quality. In the investment world, what you pay is what you don't get to keep, and so lower price can often be an indicator of higher quality, all else equal. You've seen a move towards lower-cost and in many ways passive approaches.
I think also a real, in many ways, seismic shift within the financial advisor community away from commission-based approaches to providing financial planning and financial advice to a fee-based model has really put a focus on the cost of the advice versus the underlying investments, and I think ETFs and low-cost funds generally are finding a sort of welcome home within fee-based financial planning models.
Stipp: At Vanguard, have you seen the percentage of your assets that comes from financial advisors has grown in that environment that you described?
Dickson: Oh, most definitely.
Now, some of that, too, is that we have been focusing on financial advisors, where historically at Vanguard we had not put as much of our own business attention towards the financial advisor community as a distribution arm, if you will, for our products.
Historically, Vanguard has been direct retail and has been 401(k) defined contribution plan sponsor focus, and while we certainly have had a lot of advisory assets over the years, having a little bit more focus on that area has certainly been a good outcome for our ETFs. By the way, our traditional Vanguard mutual funds, because we don't pay for distribution, have never really had a platform within the financial advisor community, at least in large swaths of the financial advisor community. And ETFs, though, are a way to access Vanguard products and investment manager expertise in that area, but without it having to be in the traditional mutual fund form.
Stipp: I think as with any kind of investment or investment type that gains a lot of popularity and lot of assets, there are also concerns that crop up about that kind of investment.
And I think one of the ones we've seen recently is, with this shift to passive investing and the shift into index products, more and more of the world's assets are kind of investing along these same strategies, and there are concerns that this could cause certain kinds of volatility because there's less money in the strategies where bargain-hunters go out and become the buyers during times of market stress.
When you folks have looked at volatility and indexing and the possible relation between the two, have you found any evidence that more indexing leads to more volatile markets?
Dickson: In short, no. I kind of want to put together a top-10 active manager excuse T-shirt, you know. And number one tends to be volatility; number two, correlations; and number three, ETFs, because they cause one and two.
But in fact, what we've seen over the last several years, while there has been somewhat increased volatility, we've also gone through a huge financial crisis and a lot of macroeconomic volatility at the global level.
In fact, one of the things that we look at as a key indicator of trying to parse out what might be sources of volatility in markets, is if you look at the VIX in the U.S. and compare it to the VIX equivalent in Germany and the VIX equivalent in Japan, they have all been moving in lockstep with each other, going up in more volatile times, going down in less volatile times at the same time. But yet ETF assets, and in fact indexed assets, are very, very different in those different markets. That, to us, is an indication that it's not about the growth of ETFs or passive investing generally, but in fact the macro environment that we have been in, which has just been the risk trade--I hate the term "risk-on, risk-off trade"--but the markets are a little bit more moving in sync based on expectations of the global economic situation.
Stipp: Unfortunately, there's been no shortage of reasons behind some of the volatility that we've seen. But given your argument about the ETFs--and I think it's a very valid one when you are looking at all the things that are happening out there--you still would say, though, that we have seen increased correlation.
So, from an investor's perspective when you're putting a portfolio together, what's the thinking at Vanguard about how do you deal with the fact that assets seem to be moving in lockstep a lot more than maybe they used to? Does it change some of the asset allocation advice that maybe we would have seen 10 or 15 or 20 years ago?
Dickson: Well, I think what it does change is the notion of what it takes to be diversified. So, if assets are more correlated with each other, then it takes a broader group of those assets than what it used to be "diversified," or to be able to capture the diversification effect in bringing different stocks together.
But as we talk about investment principles and investment philosophy, normally our starting point is with very broadly diversified investment vehicles--a total stock market or a total bond market, a total international--and from that context, you do have the broad diversification, the asset class exposure.
What you're worried about in under-diversified portfolios, if you will, is maybe a certain risk factor or a certain concentrated position, and it doesn't have to be a stock, but maybe you've got five stocks, and they all tend to be correlated with each other, so in aggregate you have a concentrated position--that moving the wrong way on you. And I think that's the risk that people think about now is how do I avoid what might now be over-concentration, even though I think I may have more stocks, I'm still relatively concentrated. Again, though, we think the solution to that is, broadly diversified asset class portfolios.
Stipp: And certainly, although folks thought that in 2008 everything was going down, Treasuries actually were not going down in 2008. So, depending on how your portfolio was diversified, investors still could have had at least some ballast in their portfolios depending on where they had their money then.
Last question for you, we've heard also concerns about ETFs, the tradability of ETFs, and I think even Vanguard founder Jack Bogle had these concerns, in the early days anyway, that they would tempt investors to have bad behavior essentially, to make fast trades, to get in and out of hot asset classes.
You recently released a research paper over the summer that looked at some of these factors and kind of took out some of the conflicting issues. What were some of your findings there? Are investors using ETFs poorly because they can?
Dickson: So, let's start with facts, because it's always fun to have facts and then the interpretation of facts.
So, let's start with fact. We looked at a series of Vanguard funds and Vanguard investors in those funds, and Vanguard has a unique structure where the traditional mutual fund and the ETF share the same investment portfolio, and it's through a share class structure. So, we can keep neutral the investment type and just look at the behavior of the mutual fund investors and the ETF investors in the same investment portfolio.
So, fact number one is, ETF investors do trade more often than mutual fund investors. But now the question is, is it because the ETF causes people to trade more, or is it that people who trade more choose the ETF?
And we found substantial evidence that it is the latter--in that, people that have an intent to trade will tend to flock a little bit more to the ETF. So, there is a significant difference in demographics between the ETF shareholder and the mutual fund shareholder.
In particular, the ETF shareholder, at least in our sample, tends to skew a little older, more male, and they tend to log on to their accounts at Vanguard daily much more often. In fact, 36% of the ETF investors logged on daily to check their accounts, as opposed to only 16% of the mutual fund investors. Those characteristics--older, male, log on to your account regularly--actually are indicators of more frequent trading activity.
So, once you account for the difference in the demographics between the two groups, that actually immediately explained 40% of the higher trading that we observed between the ETF and the traditional mutual funds.
Now, the rest of the 60%, through our own analysis, we weren't able to attribute. It could be a combination of things like, maybe a little bit more trading or the fact that a number of Vanguard mutual funds have purchase and redemption fees, and so people may be trying to avoid those by being in the ETF, or other self-selection effects that we just don't have data for.
But by and large, it is not so much that an ETF changes an investor's DNA. Investors are going to behave like they are--this is just a new vehicle. Now, it may give those that want to trade more the ability to do so, but it's not changing who they are as investors.
Stipp: So, you looked at Vanguard investors for this study, and Vanguard, I think, historically has been very responsible in the kinds of investment products you put out, and you don't put out gimmicky funds or fund flavors of the month.
But for other types of more exotic ETFs that maybe investors don't really understand as well or behave differently than they expected, could you see that because some of these are on the market, investors may have a worse experience and may end up doing more trading because they can and because the structure is just kind of poorly understood with these more exotic investments?
Dickson: It's certainly possible. Now, what I would say is that we were very careful in our study to focus on not the absolute trading differences, that is do you trade ETFs frequently, do you trade mutual funds frequently? I mean, all of our investors were generally long-term investors. The average holding period even among the ETF investors was about three years. However, what we were most interested in was the relative trading difference.
So, within the same investment portfolio, do you trade the mutual fund or the ETF more frequently? So, when we think about more exotic instruments, yes, we think more exotic instruments probably are traded more frequently naturally, but it's not clear that if it were in ETF form versus fund form that it would trade … frequently just because it's the ETF. It's those relative differences that we think matter.
Stipp: All right. Joel Dickson thanks for offering some of the research insights on ETFs and usage of ETFs.
Dickson: Well, thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.