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TABLE OF CONTENTS
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1. Home
2. Rekenthaler Report
3. Jack Bogle Was Not Entirely Wrong About ETFs
JACK BOGLE WAS NOT ENTIRELY WRONG ABOUT ETFS
While ETFs aren’t perfect, their virtues clearly outweigh their sins.
John Rekenthaler Mar 23, 2023
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Securities In This Article
Vanguard Total Stock Mkt Idx Inv
(VTSMX)
ProShares UltraShort 20+ Year Treasury
(TBT)
TOO EASILY EXCHANGED?
Jack Bogle, infamously, detested exchange-traded funds. In 2012, for example, he
thundered that ETFs were “what happens when you have marketing people instead of
investment fiduciaries running money. The ETF is the magic word of the day, the
greatest marketing innovation of the 21st century. [Hey, he was on a roll.] They
are absolutely speculation, and they have hurt a lot of people.”
I write “infamously” because even those who typically agreed with Bogle shunned
his attack on ETFs. Vanguard itself had no such qualms about the new fund
structure, launching its first exchange-traded shares in 2001. The firm has
since become the industry’s second-largest ETF provider, slightly trailing
iShares. Nor were other index-fund proponents fazed by the invention.
The marketplace concurs that Bogle was wrong. Last year, U.S. ETFs received $600
billion of net new assets, while conventional mutual funds endured almost $1
trillion in net redemptions. As my colleague Syl Flood reminds me, that latter
figure can be interpreted positively, as it includes withdrawals from retirees
who have profited massively from their mutual fund accounts over the years.
Still, there’s no doubt that ETFs have become the nation’s investment of choice.
Bogle’s error was understandable. When ETFs were launched, promoters touted
their liquidity. Unlike mutual funds, which price daily, after the markets
close, ETFs can be constantly traded, as with individual stocks. Bogle countered
that this benefit was merely putative. Nothing good happens after 2 a.m., or
with fund transactions made by those who can’t wait until the day’s end.
True enough. What Bogle missed, however, was that retail investors would refuse
the bait. Most investors bought ETFs not for their liquidity (or transparency,
another ETF feature that received early attention), but for their convenience
and tax efficiency. ETFs could be purchased from any brokerage firm, as opposed
to only those that had relationships with the fund sponsor, and they made even
fewer capital gains distributions than did indexed mutual funds.
RISKY BUSINESSES
But Bogle was correct in his secondary attack on ETFs: Their taste for
high-volatility strategies. In the same interview that began this column, Bogle
also criticized ETFs’ investment strategies, which, he argued, provoked
shareholders’ baser instincts. By indexing specific segments of the stock
market, or even—God forbid—owning commodities, ETFs tempted investors to
speculate.
The attraction of specialized ETFs is obvious. When the sun shines, they can
make a whole lot of hay. In 2022, the 10 best-performing U.S. funds, headed by
the suitably esoterically named MicroSectors U.S. Big Oil 3x Leveraged
Exchange-Traded Note NRGU, were all either ETFs or their relatives,
exchange-traded notes. They notched great profits even during an otherwise bad
year. Big Oil returned 202%, while the 10th fund on the list, ProShares
UltraShort 20+ Year Treasury TBT, returned 94% (by betting heavily against long
Treasury bonds).
Stripping the leaders’ list of leveraged funds, which are mostly
exchange-traded, reduces ETFs’ dominance of the leaders’ list but does not
eliminate it. As shown by the chart below, which illustrates how many ETFs and
mutual funds have been top-10 performers over the past decade, ETFs blitz the
field when leveraged funds are included. Even when not, they still account for
81% of the winners.
(As the chart’s labels can be difficult to read, I will briefly explain. The
blue bars represent ETFs and the purple bars mutual funds. The first set of bars
includes leveraged funds in the count, while the second set omits them.)
All fine and good—but we realize the corollary. What volatility giveth,
volatility taketh away. Sure enough, that triple-leveraged Big Oil note lost
almost 94% of its value two years previously. Which means that the combination
of its 165% rebound during the succeeding year and even larger 2022 gain has
enabled the ETN to recoup only half its losses. It now sells at 50 cents on its
original dollar.
Unsurprisingly, the losers’ list also dramatically favors ETFs.
GOING TO ZERO
Such highly volatile funds pose two problems. One is that shareholders use them
badly. They buy high, sell low. Consequently, specialized funds consistently
record poor investor returns, as discussed in this article from Morningstar’s
Amy Arnott.
The other is that performance does not always revert to the mean.
Sometimes—especially with leveraged funds—returns keep spiraling downward until
they descend too far to ever recover. Since 1980, 78 funds have posted
cumulative total returns of less than negative 99%. (Yes, really.) Most of them
have been ETFs. Indeed, 1% of all ETFs that ever existed have suffered that
fate. Ouch!
It will be protested that the riskiest ETFs pose little practical threat, since
they possess few shareholders. Yes and no. It is true that retail buyers
typically shun such funds, which, if used at all, tend to be institutional
trading vehicles. But, in aggregate, ETFs are invested much more speculatively
than are mutual funds.
The blue slices in the charts below represent assets in funds that have been
riskier than U.S. equities, as measured by the trailing three-year standard
deviation of Vanguard Total Stock Market Index VTSMX. Only 26% of mutual fund
shares qualify. However, 49% of ETF moneys surpass the mark. An
investment-management constituent that holds half its assets in funds that are
more volatile than a 100% equity portfolio is an aggressive constituent indeed.
CONCLUSION
There’s no question that ETFs were a happy invention. They have assisted in the
index fund revolution, which has benefited investors (although not fund
companies) by reducing costs, minimizing taxable distributions, and encouraging
shareholder patience. Most ETF owners use their investments appropriately.
That said, ETFs also qualify for a less prestigious honor: the home of the
industry’s riskiest funds. Mutual funds occasionally hit walls that ETFs cannot,
by owning private-placement securities that are off limits to ETFs (because of
their pricing mechanisms). In general, though, speculators prefer ETFs, as Bogle
feared. Fortunately, there also been far fewer speculators than he anticipated.
In this case, he surely would be pleased with his mistake.
The author or authors own shares in one or more securities mentioned in this
article. Find out about Morningstar’s editorial policies.
The opinions expressed here are the author’s. Morningstar values diversity of
thought and publishes a broad range of viewpoints.
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ABOUT THE AUTHOR
View All Authors
JOHN REKENTHALER
Vice President, Research
More from Author
John Rekenthaler is vice president, research for Morningstar Research Services
LLC, a wholly owned subsidiary of Morningstar, Inc.
Rekenthaler joined Morningstar in 1988 and has served in several capacities. He
has overseen Morningstar's research methodologies, led thought leadership
initiatives such as the Global Investor Experience report that assesses the
experiences of mutual fund investors globally, and been involved in a variety of
new development efforts. He currently writes regular columns for Morningstar.com
and Morningstar magazine.
Rekenthaler previously served as president of Morningstar Associates, LLC, a
registered investment advisor and wholly owned subsidiary of Morningstar, Inc.
During his tenure, he has also led the company’s retirement advice business,
building it from a start-up operation to one of the largest independent advice
and guidance providers in the retirement industry.
Before his role at Morningstar Associates, he was the firm's director of
research, where he helped to develop Morningstar's quantitative methodologies,
such as the Morningstar Rating for funds, the Morningstar Style Box, and
industry sector classifications. He also served as editor of Morningstar Mutual
Funds and Morningstar FundInvestor.
Rekenthaler holds a bachelor's degree in English from the University of
Pennsylvania and a Master of Business Administration from the University of
Chicago Booth School of Business, from which he graduated with high honors as a
Wallman Scholar.
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* WAS JACK BOGLE RIGHT ABOUT SMART BETA ALL ALONG?
John Rekenthaler Sep 25, 2024
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