Jack Bogle Was Wrong About ETFs

The King Does Not Approve Vanguard founder Jack Bogle rarely erred. He was spot-on when popularizing indexing; bringing institutional pricing to retail investments; avoiding trendy fund launches; and recognizing that positive press would eventually benefit Vanguard more than hiring an expensive salesforce. He was even correct when arguing that U.S. investors didn't need to own overseas equities. (Perhaps he was merely lucky there, given that American stocks have performed so well, but right is right.)

However, one of his strongly held beliefs--that exchange-traded funds were poor investments--has failed the test of time. Per Jeff Cox of CNBC, Bogle once called ETF investors "fruitcakes, nut cases, and the lunatic fringe." Regrettably, he was more circumspect when speaking to me, but his view never changed. ETFs endangered their investors, and Vanguard should not have adopted them.

Considering Bloodlines Mutual funds were invented by bank-trust departments and money-management partnerships as convenient investment packages for long-standing clients. Early mutual funds carried low expense ratios, turned over their portfolios only slowly, and were intended to be held for decades. For the most part, the mutual fund pioneers viewed themselves as stewards for their shareholders. They wished to serve their customers not only for the current generation, but also the next.

Such was the relatively idyllic picture when Bogle first studied the mutual fund business as a Princeton undergraduate. Over time, asserted Bogle, the industry’s caliber eroded, because its success attracted nontraditional entrants who lacked their predecessors’ breeding. Running mutual funds therefore became less about building strong relationships and more about increasing annual cash flows. Nevertheless, the industry’s heritage continued to exert its influence. As financial services companies went, most mutual fund firms were forthright.

In contrast, the first ETFs were created by stock exchanges, to compete with futures exchanges. ETFs represented a new way for investors to trade bundles of stocks. The American Stock Exchange launched a forerunner of ETFs in 1989. That product was soon shuttered by a lawsuit from Chicago Mercantile Exchange, which argued that AMEX’s product too closely resembled a futures contract. The next year, the Toronto Stock Exchange debuted a better-designed ETF, and the U.S. followed suit in 1993, with SPDR S&P 500 ETF SPY.

Bogle disliked ETFs’ birthplace. The underlying investment seemed to be fine, being indistinguishable from index mutual funds, but the motivation was terrible. Attempting to capture business from futures exchanges by creating a product that would increase a stock exchange’s trading volume? That couldn’t possibly be good for investors. Effectively, ETFs would transfer wealth from shareholders to the stock exchanges, as each dollar that investors wasted when making trades would flow to the exchanges’ top line.

Getting Better All the Time When analyzing his mutual fund rivals, Bogle's appreciation of the importance of investment heritage had served him well. Thirty years ago, he regarded Fidelity, American Funds, and T. Rowe Price as being legitimate competitors for Vanguard, on account of those companies' backgrounds, while blithely dismissing the prospects for every Wall Street brokerage firm. Today, those three organizations have the second-, third-, and fourth-highest assets among mutual fund providers, while the full-service brokerages have dropped entirely off the list. Score 100% for Bogle.

But the ETF marketplace evolved, and Bogle’s views did not. Some investors, mostly institutional, continue to use ETFs as they were initially intended. However, others have found additional grounds to own ETFs--reasons that Bogle should have embraced. Chief among them has been the role that ETFs have played in breaking down distribution barriers.

As an exchange-listed security, ETFs can be employed by commission-based financial advisors. Previously, if such advisors wished to index their clients’ monies, they could choose only from no-load mutual funds (which paid them nothing) or from load index funds (which carried uncompetitively high costs). Consequently, commission-based advisors did not use index funds. Now they do. That, surely, qualifies as a major investor benefit.

Admittedly, this feature has become less important, as financial advisors increasingly have switched from charging commissions to levying asset-based fees. However, ETFs also confer an advantage to asset-based advisors. Whereas financial advisors’ trading platforms sometimes restrict their mutual fund choices, because the platforms don’t create selling arrangements with all fund companies, ETFs do not face the same limitation. If an ETF is listed on an exchange, and the trading platform links to that exchange (highly likely), then advisors have access.

Breaking Down Distribution Barriers This freedom, of course, extends to retail investors. ETFs make a mockery of the traditional load/no-load divide among mutual funds, which placed funds into two broad categories: 1) those that were used only by financial professionals ("load" funds) or 2) those that could either be bought directly by investors or employed by asset-based advisors. No such barriers exist for ETFs. They can be bought by individuals as readily as they may be owned by advisors.

This has expanded the investment possibilities for retail buyers, because some companies that make their mutual funds available only for financial professionals have expanded their lineups by adding ETFs. The latest is DFA (the fifth-largest mutual fund provider), which announced last week that it will be supplementing its advisor-only mutual funds with three ETFs. Your chance to buy DFA directly, should you so desire.

This is a decidedly positive trend. From an investor’s perspective, fund companies should not prosper (or fail) because of their distribution models. What matters is how they treat their shareholders. Ironically, ETFs come closer than the mutual fund industry to fulfilling Jack Bogle’s vision. Bogle staked Vanguard’s future on the belief that, ultimately, how funds were marketed and distributed was less important than the quality of the funds. He was correct in that prediction--but not in perceiving how ETFs advanced, rather than hindered, his cause.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.