John Bogle, the founder of Vanguard, has criticised exchange traded funds as “great, big gambling, speculative instruments that have definitely destabilised the market”.
One of Mr Bogle’s concerns is that the intra-day liquidity offered by ETFs could be encouraging long-term buy-and-hold investors to become short-term traders.
More frequent trading has been shown to lower returns as investors face higher transactions costs and often fail to time their investment decisions correctly.
Mr Bogle’s negative views on ETFs were one of the main reasons why Vanguard made a relatively late entry into the ETF industry. In spite of its history as a pioneer of index investing in the 1970s, it did not launch its first ETF until until 2001.
Now the world’s third largest ETF provider, Vanguard has just published an analysis that counters the negative views of Mr Bogle and other critics who argue that ETFs tempt investors to trade more frequently.
“We found that, contrary to speculation in the media, most investments [with Vanguard] are held in a prudent, buy-and-hold manner, regardless of share class,” said Joel Dickson, senior ETF investment strategist at Vanguard.
To examine this issue, Vanguard looked at 3.2m transactions in the ETF and mutual fund share classes of four Vanguard funds between 2007 and 2011.
The four Vanguard funds analysed were the Total Stock Market Index Fund, Total Bond Market Index Fund, Emerging Markets Stock Index Fund, and REIT Index Fund.
Vanguard is a unique position to evaluate the trading behaviour of retail investors as its ETFs are a share class within the mutual fund structure, so the underlying investment portfolios of the ETF and mutual fund are identical.
“We found little evidence of speculative behaviour in either share class,” said Mr Dickson.
Vanguard found that 83 per cent of its mutual funds were buy-and-hold investments compared with 62 per cent for its ETFs. It defined “buy-and-hold” as investments that were owned for more than a year and did not rebalance more than twice in a rolling 12-month period.
Vanguard categorised 5 per cent of its mutual fund investments and 12 per cent of its ETF investments as “hands-on” – defined as investments held for more than a year but where there were more than two episodes of rebalancing.
Just 12 per cent of its mutual fund investments and 27 per cent of its ETF investments were categorised as “short-term” – defined as any investment that was completely liquidated in one year or less.
Mr Dickson said although Vanguard’s ETFs were more actively traded than its mutual funds, much of the difference could be attributed to variations in the investor base of both instruments.
Examining the investor base of both share classes for the same four funds, Vanguard found the population of its ETF investors had a higher proportion of older, male investors who also logged on to the company’s website frequently to check their balances.
These (older, male) clients tended to trade more often, regardless of whether they were investing in Vanguard’s ETFs or mutual funds.
Vanguard also places restrictions on its mutual funds that generally prevent investors from buying back in for 60 days after making a sale. Some of its mutual funds also have purchase and/or redemption fees but there are no such limitations on its ETFs.
These measures to discourage frequent trading of its mutual funds could encourage some investors to trade the ETF instead to avoid any additional short-term trading fees or dealing restrictions.
“The ETF is not causing investors to trade. Instead, more active investors are seeking out the ETF as their preferred vehicle,” said Mr Dickson.
Mr Dickson also said any shift in active trading from mutual funds into ETFs was “arguably a benefit for all investors”. This is because most ETF trading takes place in the secondary market and does not require any transactions at the portfolio level. Trading in mutual funds can require corresponding transactions in the underlying portfolio and any related costs are borne by all shareholders, including those that only trade infrequently.
Brokerage accounts were found to be another factor explaining different trading patterns. All Vanguard ETFs are held in brokerage accounts but just one-third of Vanguards’ mutual fund investors also have brokerage accounts. Investors with brokerage accounts tended to trade their shares more often than those without.
“The ETF ‘temptation effect’ is not a significant reason for investors to avoid using appropriate ETFs as part of a diversified investment portfolio,” concluded Mr Dickson.