CAHPTER 9

EXCHANGE-TRADED FUNDS

“Gus!” came a familiar booming, gravelly voice from the top of the stairs above the crowded grand foyer to the company cafeteria. “Gus! What the heck is going on around here?” Fresh back from his annual month-long vacation at Lake Placid, Jack Bogle was clearly upset.

Why? Because Gus Sauter had found a way to “destroy” Vanguard’s indexing with an ETF! Or so Bogle seemed to think; he had opposed ETFs from “before the beginning.”

Ever since the day he rejected Nathan Most’s innovative idea of launching the first ETF,^* Bogle had been opposed to ETFs and in favor of the conventional offering of index mutual funds. ETFs, he believed, were the mortal enemy of true investors because they would tempt investors to trade, and short-term trading almost always hurt returns. Index funds were the ally and friend of the long-term, buy-and-hold investor. Yes, they were boring, but that was their big advantage: Boring made it easier to stay invested, and staying invested was the key to long-term success.¹

To explain “what the heck was going on?” you’d need to go back almost two years, to the beginning of 1998 when Sauter was concerned that the Asian financial crisis of 1997, known as the “Asian Contagion,” could spread throughout the world. His fear was reinforced later that year by the Russian debt crisis. Sauter had joined Vanguard exactly two weeks before the Crash of 1987, when the market melted down 22.61 percent in just one day. As he said, “We’re shaped by our experiences, and that event definitely left a mark on me.”

In reality, the redemptions from Vanguard’s sole index fund during the Crash of ’87 had been much less than those experienced by most equity funds. Still, Sauter feared that a similar event would have a far greater impact on Vanguard’s funds because by 1998 the assets were so much bigger. If many investors redeemed their fund investments, the funds would have to sell stock into a weak market to cover the redemptions.

Sauter had majored in math and economics at Dartmouth and enjoyed solving quantitative puzzles.² He saw the problem as a quantitative challenge and decided to try to solve the dilemma. His first step was to recognize that conventional index funds and ETFs had one attribute in common: basic indexing. What distinguished them was the investors’ primary purpose and the related decision criteria. Those investing in index funds expected to stay there for years. They had zero interest in hour-to-hour liquidity.^†††† Those investing in ETFs might stay invested for many years, but they liked having the option to sell whenever they might decide to sell. Registered Investment Advisers, or RIAs, and their clients were an important part of this second group.

Historically, Vanguard had refused to offer sales support payments to brokers and advisers for distribution, which most fund managers gladly did, so Vanguard got little help from RIAs and others. But ETFs were different. Traded on an exchange, ETFs generated commissions. The challenge for Vanguard would be to win a share of the ETF volume going through that channel of distribution.

Sauter considered: Why not create an ETF “sleeve”—or index fund access vehicle—to the conventional index fund? That way, ETF investors could have both indexing and liquidity without causing disruption to the host index fund. Reversing the question, Sauter devoted nine long months to exploring all the possible negatives he might have somehow missed. He kept asking colleagues in quantitative investing what could go wrong. He spent hours with colleagues in the legal department “looking for trouble.” He challenged marketing people: Would this really meet the needs of RIAs and other financial intermediaries? Would they flock to Vanguard, and if so, why? Would demand be large enough to make it all worthwhile? By asking question after question, and then asking even more questions, Sauter became sufficiently confident that he had invented something of real value, and that, with some trepidation, he should finally take it up with Jack Brennan.

Brennan’s initial reaction was skepticism, but the very next day—in the way college friends relate to each other—he admitted to Sauter that this might not be Sauter’s worst idea. In truth, Brennan was enthusiastic, and said, “Gus, let’s bring it up with the board right away.”³

The board of directors approved moving ahead quickly. Then the pace returned to s-l-o-w while Vanguard sought SEC approval for this product: the first ETF based on an existing mutual fund. As a regulator of a notoriously creative industry, the SEC knows from experience to evaluate complex innovations with caution. All other ETFs were self-contained, so if investors rushed to sell, the ETF would simply wind down. If the ETF were directly linked to a large, existing mutual fund, what collateral damage might be forced onto the investors in the conventional shares of the fund that had nothing to do with the ETF shares? What unforeseen problem could the addition of ETF shares lead to for markets or for the regulators? A non-negative ruling—meaning regulators neither ban nor endorse the action—takes time; in this case, it took two full years for the SEC to agree that the amount of share selling would be the same, whether originating in the ETF shares or the index funds.⁴

One indicator of the “invention’s” significance: Sauter’s six patents related to ETFs. Vanguard launched its first ETFs in 2001 under the collective name Vipers. By structuring each ETF as a share class of one of its large, established index funds, Vanguard was able to use the scale advantage of the large fund and charge an expense ratio of only 0.15 percent—less than half the 0.35 percent expense ratio of market leader Barclays Global Investors (BGI). In 2006, it dropped the name Vipers and renamed its various ETFs simply Vanguard ETF. A full roster of Vanguard ETFs was soon produced; by March of 2007, it offered 32. ETFs were marketed as providing instant liquidity, and several sponsors disparaged traditional mutual funds for only allowing purchases and redemptions at the end of the day. What if investors wanted to get into a market that was soaring? ETFs provided the opportunity to get in at any time of the day. And if the market was collapsing, an investor could get out in the middle of the day, instead of having to wait until the end of the day. With that marketing theme, most people presumed that ETF clients were traders or speculators, not long-term investors. That was certainly Jack Bogle’s view. His view seemed to be supported by the tremendous trading volume of the SPDR 500, the first ETF designed to track the S&P 500 Index.

Bogle believed ETF trading volume meant individuals must be doing the trading. He was making a big mistake. Most of the trading volume actually came from institutions, particularly hedge funds that frequently traded ETFs as a way to offset risk in their portfolios. ETF arbitrageurs also generated a lot of activity as they traded to keep ETFs close to their underlying portfolio values.

Short-term trading is not always speculation. To be obvious, a one-second in-and-out trade is not speculation. Nobody bets or speculates on what will happen in one second—or a tenth of a second. Even habitually long-term investors can have non-investment reasons for a short-term position. For example, when a pension fund or endowment terminates a manager, where does it “park” its money for one to three months while it searches for a new long-term manager?

Furthermore, a large and growing percentage of ETF trades are made by financial advisers for their clients. There was a presumption that advisers wanted the flexibility to be able to make a shorter-term call on the market if they chose to. But most financial advisers have a long-term view, and it didn’t ring true to Sauter that they liked ETFs just for short-term investments.

Early in the millennium, many market participants, including financial advisers, began to talk about the possibility of offering actively managed ETFs. The advisers’ interest in this wasn’t clear to Sauter. In 2003, Vanguard hosted a conference for advisers in Chicago. He was a presenter and the night before the event, Vanguard held a dinner for some of its larger adviser clients and prospects. Sauter was seated with five Registered Investment Advisers, and naturally all six were talking shop. The conversation had been friendly and candid, so Sauter decided it would be okay to ask the question that had been bothering him. “I understand why you would want the flexibility of trading that indexed ETFs provide, but I don’t understand why you want active ETFs. Certainly no one believes they can time a manager’s alpha.”

The response was unanimous. It was not about timing managers. It was all about advisers’ record-keeping platforms. They use a brokerage platform to keep the records for their clients, and buying an ETF fits nicely into the platform, just like a stock. You place an order at 11:03 a.m. and by 11:04 the execution is already recorded. The adviser knows instantly how many shares were bought and at what price. Traditional mutual funds don’t fit so nicely into this system, since you place your order during the day but it’s not executed until the market close. Then the mutual fund company has to calculate the price for the fund and process the trade. It could be 5 or 5:30 p.m. before the adviser and the client could know exactly how much they bought and at what price. It was all about ease of administration.

From the start, marketers have declared that ETFs were a great new product. Sauter contended that ETFs were not a new product. They were simply a way to distribute an old product—an index fund—through a new distribution channel. The advisers’ response to his questions confirmed his belief.

Before Vanguard offered ETFs, its business volume with advisers was a fairly small portion of Vanguard’s assets. With this whole new way to distribute now open to advisers, that business has grown to more than $2.4 trillion.

^* Most was head of new product development at the American Stock Exchange.

^* Unlike mutual funds, which are valued once daily, ETFs can be traded any time the markets are open. (For a more detailed discussion, see Appendix 1: “ETFs 101.”)