Why ETFs Succeeded
They have been used differently than their inventors envisioned.
Note: This column was originally published on May 7, 2019.
They could easily have failed.
When exchange-traded funds were invented, they were advertised as funds that trade like stocks. (The same could be said of closed-end funds, but those investments came with an asterisk. Sellers of closed-end funds received what buyers would pay, not the calculated value of the underlying assets. ETFs, in contrast, were structured to deliver the full amount.)
Jack Bogle’s response: Why would everyday investors want funds that behave like stocks? That institutions might employ ETFs, rather than futures, to hedge their portfolios was understandable. But there seemed no point in giving retail shareholders additional flexibility. Allowing them to trade immediately would encourage ill-informed, impulsive decisions.
It was a reasonable argument. (Although one could respond by wondering why mutual funds offer liquidity as often as once daily. If shackling investors prevents them from making rash choices, then wouldn’t further restrictions help them even more?) However, it has proved to be incorrect. Despite Bogle’s claim, ETFs have unquestionably helped fund investors.
That is because investors largely ignored the marketing. It is true that ETFs can be swapped on a moment’s notice. But that freedom has been more theoretical than actual. Although there is little direct evidence about how retail investors use ETFs, the indirect indications strongly suggest that most investors regard ETFs as long-term holdings. They treat ETFs not as a diversified version of a stock, but instead as another form of index mutual fund. This has been an unalloyed positive.
Deserving praise are financial advisors, who introduced ETFs to the general public. Whereas advisors have often led their customers astray by selling them complex funds that—as the saying goes—are “sold rather than bought,” they did well with ETFs. By and large, they recommended ETFs strategically, as components of long-term portfolios, rather than as investments to be churned.
It turned out that advisors valued a different ETF attribute than the one that was initially advertised: availability. They could only place their clients into mutual funds that were carried by their investment platform, which, in most cases, included few index options. But they could buy ETFs because they were listed on stock exchanges. This distribution feature was a side issue when ETFs were first launched but became an important part of the security’s allure.
(This situation is changing, as investment platforms have begun to restrict which ETFs they include. Their official explanation is “investment suitability,” which is sometimes true—understandably, home offices do not wish to see their advisors using esoteric ETFs that may implode, spectacularly. Often, though, the real reason is cash. Increasingly, ETF providers are expected to pay for shelf space.)
In short, the marriage between ETFs and financial advisors resembled a Reese’s advertisement, when chocolate bumps into peanut butter and something unanticipated is created. “The initial target for [the first U.S. ETF] was without question institutional trading firms,” stated the State Street executive (James Ross) who headed the project. The product’s developers were commodity traders who knew little, if anything, about retail financial advisors.
(Such is serendipity. In its early days, Morningstar was propelled by demand from independent financial advisors—a clientele that Morningstar’s founder, Joe Mansueto, discovered only after the company began operations.)
Credit to advisors for rejecting the key feature of ETFs, recognizing instead other benefits. Credit also to direct investors, who for the most part have treated ETFs as index mutual funds rather than as day-trading tools. And neither have they embraced the industry’s speculative side. Morningstar has seven categories for leveraged ETFs. All told, those funds account for 1% of industry assets. Eighteen plain-vanilla ETFs are larger than the entire collection of leveraged funds.
If Vanguard’s experience is any indication—and it probably is—ETFs hold particular appeal for millennials. In an article on its customers’ usage of ETFs (the article has since been removed from Vanguard’s site), the company noted that, while 11% of all Vanguard direct investors own ETFs, the percentage rises to 17% for customers who started accounts during the past three years. Those who invest almost exclusively in ETFs (at least 75% of their assets) have a median age of only 36—geriatric for professional athletes but adolescent by investment-management standards.
Unsurprisingly, given their youthfulness, Vanguard’s ETF devotees tend to have modest account balances. However, the story is different for those who blend ETFs with mutual funds. Vanguard’s “diversifiers,” as the firm calls those who put from 1% to 25% of their assets in ETFs, have much larger average accounts than those who do not possess ETFs at all.
The business signs for ETFs would appear to be strongly positive. The wealthiest of Vanguard’s experienced investors—those who were raised in the mutual fund era—use ETFs. Mutual funds are their home base, but they also have accepted ETFs. Meanwhile, the company’s millennials are wholeheartedly embracing the new. Their 401(k) plans may consist of mutual funds, but when they create their own portfolios with brokerage accounts, they favor ETFs.
Finally, praise should also go to ETF providers. They certainly have not been perfect. Leveraged funds have done their shareholders little good, and too many smart-beta funds (strategic beta in Morningstar’s lingo) consist of throwing several back-tested investment strategies against the wall, hoping that some of them stick. However, the industry’s major players have mostly launched sensible, low-cost offerings. Such funds are built to be held for the long haul.
As Bogle knew, high-concept funds generally disappoint. If the innovation can’t be explained by a few short sentences—and I have yet to hear anybody accomplish that feat while describing ETFs’ process of basket creation—then it likely will fail. Particularly if the fund’s main benefit, according to its promoters, is how rapidly it can be traded. That would seem to lead investors down a dark and dangerous path.
That ETFs have fared well, rather than poorly, owes in part to some happy accidents. But credit must also be given to all involved parties—advisors, investors, and the providers themselves. They each participated in making ETFs a more successful retail investment than anybody in the early days would ever have thought was possible.
John Rekenthaler (email@example.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.