In its April 30, 2007, issue, BusinessWeek excerpted a few hundred words from The Little Book of Common Sense Investing, Jack Bogle's latest contribution to the world of personal finance and money management. As many of you know, Bogle founded Vanguard Group in 1974 and is often regarded as "the father of the index fund" (as BusinessWeek puts it).
In the BusinessWeek excerpt, Bogle blasts the exchange-traded fund (ETF) as "a wolf in sheep's clothing" and an invitation to excessive trading by naive investors. We can't do justice to Bogle's entire argument here, we have tremendous respect for him and his investor-friendly efforts over the years, and we've written about excess in the ETF marketplace here and here. But we think he gets a few important things wrong in his criticism of ETFs.
First, his complaint about excessive trading is only as true as a given investor allows it to be. There's nothing inherent in the structure of an ETF that compels trading activity. By facilitating timely, flexible trading (through intraday pricing and the opportunity to sell shares short, for example), ETFs add a level of flexibility investors should welcome--as long as they don't abuse the privilege! But, again, that's a function of the investor, not the investment vehicle.
Second, he writes that ETFs' "tax efficiency should be higher, [but] actual practice so far has failed to confirm theory." We're not sure what actual practice Bogle is referring to here, as our experience has been that ETFs are exceptionally (often completely) tax-efficient. This advantage is a function of the process by which ETF shares are created by institutions and traded between investors (as opposed to the mutual fund process of creation and redemption by the fund company, followed by the distribution of realized net gains to all shareholders, even those who have held shares throughout the year).
Third, Bogle blasts sector-based ETFs...because investors buy and sell them too rapidly. "Could there be speculation going on here?" Bogle asks. Yes, there could be speculation going on here. Welcome to the financial markets! Surely Mr. Bogle knows that the speculative behavior of millions of individual and institutional investors is one reason index funds tend to outperform big, diversified, actively-managed mutual funds.
Fourth, Bogle writes that "sector ETFs as a group are virtually certain to earn returns that fall well short of those delivered by the stock market." But what sane investor would seek to replicate the broad market using sector funds? That isn't the point of these vehicles. The point is to make a bet (or hedge a bet) on a specific part of the broad market. To take one obvious example: Investors who have owned energy and utility ETFs for the last three or four years have done quite nicely. That said, Bogle is right to warn investors not to pile into the best-performing sectors after they've had big runs. That's good advice, and it applies equally to mutual funds, ETFs, and individual securities.
Jack Bogle has done investors many favors over the years. But his latest effort misses the mark in several important ways. There are nuggets of solid advice in this excerpt, but Bogle's broader argument against ETFs is weak. His problem isn't--or shouldn't be--with these excellent investment tools; it's with those who misuse them.
John C. Bogle, "What's Wrong With ETFs?" BusinessWeek, April 30, 2007