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Transcript

Maria: Hi. I’m Maria Bruno, head of U.S. Wealth Planning Research here at Vanguard.

Joel: And I’m Joel Dickson, global head of Advice Methodology at Vanguard. Welcome to our podcast series, The Planner and the Geek, in which we’ll discuss topics that are important to individual investors.

Maria:  And have some fun along the way.

Joel Dickson: So I spent the weekend car shopping.

Maria Bruno: You did?

Joel Dickson: I did.

Maria Bruno: You already have a car. Actually, you have two cars, Joel.

Joel Dickson: Ooohh, yeah, let’s not get into car #2. But I have one car that’s on lease, which the whole issue from a financial planning standpoint why I leased rather than bought is a subject for a different podcast. But, yeah, so the lease is running up soon; so I’ve got to find a replacement.

Maria Bruno: Well, you could also keep the car you have. That’s one option. You could buy it.

Joel Dickson: Nah…I could.  But that’s not why I made the lease choice, if you will. It’s because I actually like the new technology every couple of years. That’s what I kind of look for in a car.

Maria Bruno: Hmm.

Joel Dickson: What’s important to me is, you know, kind of having that up-to-date—

Maria Bruno: So did you actually start looking or are you starting to think through it?

Joel Dickson: Actually, kind of both.

Maria Bruno: Um-hmm.

Joel Dickson: It takes me a while to process these things, so.

Maria Bruno: So you’re going to buy the same car you have now but in a newer model? Is that what you’re going to do? Maybe in a different color?

Joel Dickson: No, it’ll be the same color.

Maria Bruno: Instead of silver, you’ll buy dark gray?

Joel Dickson: Yeah, that’s right. Yeah, you’re probably not that far off, quite honestly. But I have to see what the features are in the new model, so.

Maria Bruno: Not me. I’m fine with my old car.

Joel Dickson: Yeah?

Maria Bruno: Um-hmm.

Joel Dickson: Does your technology sync up with it?

Maria Bruno: It syncs well enough.

Joel Dickson: It syncs well enough. What does that mean?

Maria Bruno: It syncs well enough. It’s fine. It gets me where I need to go. It’s a good ride, solid car, knock wood.

Joel Dickson: Yeah? Actually, it’s funny, my—

Maria Bruno: Actually—Oh, no, I was just going to say a friend of mine used this analogy that there’s four phases of car ownership. One is like, “Oh, I have this new car. It smells great, looks great.” “Oh, no, I got my first ding or my first accident.” Then to, “Oh, I have this car. It’s great. It’s trustworthy, and don’t really care too much about it.” And then the fourth phase is, “Oh, I need a new car.” I’m kind of in that third phase right now.

Joel Dickson: That sounds like those four phases could apply to many different things in life.

Maria Bruno: What? Yeah, we were talking about it in the conversation in the car.

Joel Dickson: Relationships, you know. You know, life generally.

Maria Bruno: Different podcast, Joel. Different podcast.

Joel Dickson: Oh, yeah, this is true. We did just do one on retirement happiness.

So, it’s interesting. Years ago I had a rental car when my car had gotten a ding, got its first ding. And it was getting fixed, and I had a rental car. And I was just like, “Oh, just give me the cheapest thing possible.” And like at the time my kids were really quite young, probably about 7 and 5 or something like that. And I ended up getting this really kind of subcompact, no kind of additional accessories on the car which was great. They thought it was the greatest car I ever had because it had the roll-down windows, manual windows in the back seat, so dad couldn’t control whether or not they were playing with the windows. It was like THE best thing. And my kids are both going, “Dad, can we get a car like this? We really want a car like this.” Meanwhile, you know, at random times they’re just rolling stuff down, rolling it up. Anyway, it’s the simple things in life that are the most pleasurable, right?

Maria Bruno: Yeah, after a few trips in that car, they probably wouldn’t be happy with it.

Joel Dickson: Oh, I don’t know. They, they loved that car.

Maria Bruno: Their arms would be tired from opening and closing those windows.

Joel Dickson: That’s right, exactly. So, you know, the discussion we wanted to have today I think is a lot like the car discussion that you and I just had, which is: How much is kind of the new technology or the new approach versus the, “Hey, what I have is good enough. It works plenty well?” You know, in the investment space these days, that discussion comes up all the time and in this thing, you know, called ETFs or exchange-traded funds. And are they better than, different from, not as good as traditional mutual funds that so many people invest in?

Maria Bruno: Or really all of the above, right?

Joel Dickson: Right, exactly. And, oftentimes, it does get down to a lot—as we’ll talk about, I’m sure—individual preference.

Maria Bruno: Preferences, yeah.

Joel Dickson: You know, what’s good enough? What feature do I need? What feature don’t I need? Right?

Maria Bruno: Well we were talking earlier about phones. You asked me what version of phone I have. It’s the same thing. I think we pick our phones based upon what features we like. For iPhone users, for instance, of which I am one, it’s the convenience. It’s very easy to use.

Joel Dickson: Oh, yeah, and all the stuff that’s integrated and— Actually, I was having that discussion with my daughter over the weekend. And I said I’d been looking at our phone bill, and it was interesting to see how there are three of us on the phone plan that I have. And the three of us each use our phones very differently. But, so my daughter probably uses about 75% of the total data that we use among the three of us, whereas I do about 75% or 80% of the text messages among the three of us. And then my daughter, who used to be heavy in text messages, now never uses it. And I’m just like, and it’s because she’s gone to things like Snapchat, that uses data.

Maria Bruno: Nobody talks? What about voice?

Joel Dickson: Nobody talks. Voice, almost no one talks. Very, very little, you know, in terms of that. Yeah, I mean we maybe use, oh, I don’t know, under an hour a month of minutes.

Maria Bruno: That’s telling. Interesting.

Joel Dickson: Isn’t it? Between texts and data, that’s how all of the conversations occur now. It is interesting just to see the same use, the same, the same vehicle, if you will, but for different uses. You know, and how, you know, those approaches can meet different needs.

Maria Bruno: But we talk about this in the context, like today we’re talking about ETFs, for instance. But you could use this same argument. We’ve made this argument as well. When you think about account types, there are some accounts that are multitasking type accounts, that are retirement vehicles, but there may be some liquidity features. So, yes, I think you can port this conversation to investing as well.

Joel Dickson: Right, like not using a health savings account just for medical purposes or delaying it for many years…

Maria Bruno: That’s another podcast, Joel.

Joel Dickson: Roth IRA as an emergency spending account?

Maria Bruno: I think we did that one.

Joel Dickson: Oh, dang it. So many other podcasts that we’re covering today.

Maria Bruno: All right, let’s talk about ETFs. So exchange-traded funds.

Joel Dickson: Yes. The F in ETF does stand for fund.

Maria Bruno: First time you used that in a webcast, I thought they were going to bleep you.

Joel Dickson: I know. That would be, that would be awful.

Maria Bruno: So let’s talk about that. What exactly are they?

Joel Dickson: Yeah, when you break it down, but I want to start in reverse order because I think the key of this is the F in ETF stands for fund. That is you’re talking about, in essence, it’s not exactly this, but in essence, it’s a mutual fund concept but in a different wrapper that’s accessible to investors. So you have an investment vehicle that offers commingled investment opportunities for clients. It has an investment strategy. It has a prospectus just like a mutual fund does that explains its objectives and costs and investment approach and so forth. And there are different ETFs for all sorts of different investment strategies, just like there are all sorts of different mutual funds, each with its own kind of investment strategies. But then there’s other elements of it too, which is it’s, so it’s this mutual fund concept; but now it trades on an exchange. And so it kind of trades like a security, like an individual stock that you go out and buy on a brokerage platform. But it’s an underlying portfolio of securities like a mutual fund that gives you that diversified exposure.

Maria Bruno: Joel, this may be a topic that you’re closer to than I am, but when was the first ETF created?

Joel Dickson: So the first ETF in the U.S. was an S&P 500 product put out by State Street in 1993. But there was actually a precursor to that in Canada a couple of years earlier while the one here in the U.S. was sort of going through the regulatory process. But they’ve been around for about 25 years now overall. Over the last decade, the ETF structure in the U.S. has garnered quite a lot more cash flow than say traditional mutual funds, a couple of trillion dollars of net cash flow, whereas traditional mutual funds have had negative cash flow over the last decade or so, in aggregate. But that’s in some ways, a question of whether that’s the investment vehicle or just kind of a preference of how people access different investment strategies like indexing or active management. But they certainly have made significant inroads in many, many places in the last years, and we get the question all the time about are those appropriate for me and how.

Maria Bruno: Do you think it’s more a factor of advisors using ETFs with their clients, as opposed to direct retail investors actually selecting ETFs on their own? Or is it a good mix of both at this point of the maturity of the industry?

Joel Dickson: Well, I think it’s a lot like, you know, the discussion we were just having a moment ago on the phone—some different uses by different people. But, yet, using the same technology, if you will, in that institutional investors—professional traders, hedge funds and so forth—may use them because they like the fact that ETFs can trade basically any time the market is open, you can trade an ETF very easily.

Maria Bruno: Yeah, and that’s because they trade on a brokerage platform, right? So you need an exchange, and that’s probably one of the features that we’re most familiar with, with ETFs, is the ability to trade on the open market.

Joel Dickson: Right, exactly. Advisors have been using them more and more because they can provide nice building blocks for portfolios and portfolio construction. As a matter of fact, some of the largest ETFs are those that provide general market exposure, whether it be to the stock market, bond market, international equities and so forth. And so they’ve, in many ways, become the core of some basic portfolio construction approaches. You know, if you have an asset allocation that’s 60% stocks and 40% bonds, you can get very low-cost, broad-based exposure to match that asset allocation in many ETFs. Now, I would argue you can also get it in traditional mutual funds, but there’s definitely been a move in the advisor community to use ETFs in the portfolio construction realm. The retail investors have kind of been the third to start adopting ETFs. And, you know, again, from a portfolio construction/investment strategy standpoint, it’s generally low cost in many ways. You’ve seen a lot of increase, especially in the context of the brokerage platform and the trading that you mentioned. In the brokerage standpoint, it just sometimes can be a little bit more fungible. You know, it’s easier to move ETF or security holdings from one brokerage to another. It’s a little bit more portable.

Maria Bruno: All right, so, Joel, we’re starting to talk a little bit around maybe some of the similarities or differences with mutual funds. So one is the trading flexibility.

Joel Dickson: Yeah, I would say this is the big question that we get from clients is how do I make the choice between ETFs and mutual funds and what’s appropriate for me?

Maria Bruno: Or, do I hold both and why?

Joel Dickson: Right, exactly.

Maria Bruno: So as you start to break that down, right, so clients ask us this question. First is, well—it doesn’t necessarily have to be first—but one factor is how they trade. They trade differently. So simply put, if you want to purchase an ETF, you need to have a brokerage account.

Joel Dickson: Oh, absolutely. Yeah, you can’t just call up the mutual fund company and say, “I want to have a $1000 taken from my bank account and put directly into the mutual fund shares.” You know, with an ETF, as you said, Maria, you have to have the brokerage account, and the money has to be in the brokerage account to be able to purchase the shares on the open market.

Maria Bruno: Okay.

Joel Dickson: So, you know, oftentimes there’ll be these sweep accounts or the money is there in a cash-like vehicle, and then you can have the transaction occur.

Maria Bruno: Right, so you have the trading flexibility with an ETF, so you can trade throughout the day on the exchange. Mutual funds, on the other hand, you put in your purchase or your redemption. You don’t know the price that you’re going to get until after the market closes, right? After the mutual fund is priced, the net asset value is then the share price for the transaction.

Joel Dickson: Right. That’s certainly one of the tradeoffs. The way that we’ll often talk about it is with the mutual fund you get what I would call is value certainty. That is, the value of the securities as reflected in the value of the portfolio because it’s priced once a day, at 4:00 typically. Whenever you put in the trade, you will get the next value price. So you have that kind of value certainty. With the ETF, you get what I would refer to as price certainty. That is, you know at the time of the trade what price you’re paying for the basket of securities. It’s the way the ETFs are structured, which we don’t need to go into gory detail, but there’s a mechanism to try to keep the price of the ETF in line with the underlying basket of securities. So, for example, if it’s an S&P 500, U.S. equity ETF, its price movements are going to be pretty close to in line with the price movements of the underlying S&P 500 stocks, but not absolutely perfectly in line.

And so you might be paying just a little bit more, just a little bit less than the value of the underlying securities. That’s why it’s kind of that price certainty. But you have that certainty that when that trade happens, you know what the price is and what you’ve transacted at, rather than having to wait for whenever that next time is that it’s priced.

Maria Bruno: Right. But with that then, let’s talk a little bit around the trade execution. So with mutual funds, you have an expense ratio.

Joel Dickson: Yeah, in terms of the cost of managing the portfolio.

Maria Bruno: Right. You may or may not have commissions, depending upon whether it’s load or no load.

Joel Dickson: Yes.

Maria Bruno: With ETFs though, by and large, you’re dealing with brokerage transactions which, for many investors, may be subject to commissions.

Joel Dickson: There’s certainly some additional things to sort of figure out, if you will, with the ETF trading. There’s still an expense ratio on the underlying portfolio. We can talk about the costs of that in a moment. There might be a brokerage commission. There’s also something called market impact or bid-ask spreads that come into play with the ETFs a bit more because, you know, you’re kind of buying on an exchange, and there’s a middle man involved. So there’s a little bit of a profit from that middle man as to whether it’s, you know, so there’s a little bit often difference between the buying price and the selling price if you go at a point in time.

Maria Bruno: Is that transparent to the investor though?

Joel Dickson: It can be. You know the bid-ask spread, is available on a lot of the brokerage platforms, and you can see what it would be if you bought or you sold. There are other more sophisticated ways of trading ETFs, which probably are good to know if you start trading them a lot. Different types of orders and so forth in the brokerage space. But, regardless, there’s some amount of market impact that occurs over and above the expense ratio. But the market impact is kind of at the time you trade the security. The expense ratio is an ongoing annual charge.

The other thing though that I think sometimes is important to understand is ETFs are traded in shares, typically. You buy a certain number of shares of the ETF and a price per share gives you the next-

Maria Bruno: As you would with an individual stock, for instance.

Joel Dickson: Exactly.

Maria Bruno: Right.

Joel Dickson: But mutual funds are typically denominated in terms of the transaction amount being in dollars. I’ll buy $5,000 of this mutual fund whereas you buy 100 shares, for example, of an ETF. That has some pros and cons. I mean you may end up with a not-perfectly-invested portfolio because there’s some residual amount when you’re buying in shares. If you wanted to invest $5,000, you might not be able to invest exactly $5,000 in an ETF. It probably would be very close to it. But I think the other piece of it is that because of the shares designation, there’s really not a minimum investment.  I know that’s often a good thing for people starting out in investing, and how you think about “What vehicle do I choose?” and sometimes that might be done by how much of a minimum is there.

Maria Bruno: Yes, I do think, in particular, young investors with limited means for investing will think about account minimums. I mean one could say that ETFs could be a foray into investing since you can buy per shares, as opposed to having to do an account minimum amount.

Joel Dickson: Yeah, one share may only cost you 20 bucks or 50 bucks or something like that. Yeah, you have this entire basket of broadly diversified securities of stocks or bonds or whatever. Very low cost, you know, cheap way to get into diversified investing.

Maria Bruno: So let’s talk about young investors for a bit, right? So when I think about ETFs and I think about the mechanics of this, one of the things I think about is someone who has a systematic investment plan or reinvestment of dividends, for instance, right? So ETFs are traded on the brokerage platform. They trade like individual securities. If I’m in a situation where I’m doing a systematic investing program, right, maybe direct investments with my paycheck every two weeks or so, if I’m purchasing in ETFs, every time I do that, I could potentially incur fees, it’s a new trade. I could potentially be subjected to new commissions and things like that which take a bite out of my investing.

Joel Dickson: Yeah, if you’re paying $8 per trade, you know, it doesn’t matter whether the trade is $100 or $10,000, if you will. That could certainly eat into the sort of total investment value if you’re doing a lot of smaller systematic trades on which you’re subject to a commission.

Maria Bruno: So I think it’s one of those where, to do your homework in terms of understanding how they trade, the features that they offer and then what the tradeoff is in cost.

Joel Dickson: Well let’s talk about the features a little bit. I mean, how do we think about, are there big differences between the fund and ETF?

You mentioned there might be fee differences, minimums. I’m just thinking, you know, the underlying investments themselves, I mean often there may not be a lot of differences relative to other vehicles that you might be in.

Maria Bruno: Well, you’re using the term vehicles. It’s like cars.

Joel Dickson: Yes.

Maria Bruno: Let’s go back to our car analogy.

Joel Dickson: Yeah, the engine may be the same, right? So the ETF engine or the mutual fund engine at the end of it is a diversified portfolio of securities.

Maria Bruno: Um-hmm. It’s what features do you want in that car that will literally get you to where you want to go. Well, they’ll both get you to where you want to go. It’s just what the ride is like or what, how—

Joel Dickson: We’re going to get this transportation analogy to work.

Maria Bruno: Just buy your new car, Joel.

Joel Dickson: Just honk the horn. Rrrrr!

Maria Bruno: No, just lease your new car. That’s it.

Joel Dickson: That’s right. No, but I think that’s right. And that’s why I said, jokingly as the beginning, you know, the F in ETF stands for fund. At the end of the day, the underlying investment pool is very similar to an investment pool you would get from a mutual fund. There may be differences in the features, the cost, the accessibility, the portability, the reinvestment of dividends, as you mentioned which in a mutual fund can often be done automatically and in an ETF, it may take a few extra days before they get invested. But, you know, kind of on the margins, there, there’s some differences in how you want to access them. But, but the underlying engine is very, very similar.

Maria Bruno: Yeah, the one thing I wanted to talk to you about is around the tax efficiency, right? It wouldn’t be a Planner and the Geek podcast without discussion around tax efficiency.

Joel Dickson: We love taxes, don’t we?

Maria Bruno: So there’s a strong notion, I think, out there that ETFs, by and large, are more tax-efficient, and that may or may not be the case. Right, when you’re looking at index-based mutual funds versus ETFs, it may not be that big of a difference.

Joel Dickson: Yeah, that’s the key what you said right there, is it’s always interesting to debate the tax efficiency of ETFs, which it is definitely thrown out there as a potential benefit of ETFs versus traditional mutual funds. And there is a certain feature of ETFs which is more, if you will, institutionalized, which is that when trading occurs in the portfolio, now when, when you, Maria, or I are trading an ETF among us, let’s say I sell an ETF share, and you want to buy one, those are crossed on the exchange. There’s no portfolio management activity that occurs. So you’ve bought, I’ve sold, but there’s no security transactions in the portfolio. When securities transactions occur in the portfolio—either because a manager has to rebalance the portfolio, new security enters, or there’s an imbalance of buys and sells at the end of the day—these institutional investors interact with the portfolio. Typically these, the transactions are done what’s called “in kind” or that securities are transferred rather than cash. And in that instance, the fund, the ETF, does not have to realize a capital gain for the purposes of distributing it to shareholders. Whereas typically any capital gains that are realized from the sales of securities are distributed to all shareholders; and that’s why we talk about good tax efficiency or bad tax efficiency at times is how much additional tax do I have to pay even though I haven’t maybe sold my mutual fund or ETF. However, as you mentioned, the index ETF mutual fund debate, the key word there is index. A lot of times indexing strategies: lower cost, lower turnover, more buy and hold, just trying to replicate a market or sector of a market, tend to not have as much turnover. And all else equal—and it’s very hard to have all else equal—but all else equal tend to be a little bit more tax efficient than say more actively managed strategies where you are buying and selling securities in order to try to outperform. So from that standpoint, a lot of the benefit can come from just being an index approach—so not as much realization of capital gains. But there are some ways in which the ETF structure, although not limited to the ETF, has institutionalized a little bit more tax efficiency with transacting in securities rather than cash.

Maria Bruno: Okay.

Joel Dickson: But it is an important distinction. And, you know, when we talk about tax efficiency because then, well, should I think about these for my retirement account, for example.

Maria Bruno: That’s where I was headed, yes.

Joel Dickson: Yeah, and what do you think from that standpoint?

Maria Bruno: Well, no, I mean if it’s in a retirement account, the point is moot really, right, because all the earnings, everything is deferred or potentially tax-free if you’re in a Roth.

Joel Dickson: Right, exactly. Yeah, and just not taxed year-to-year, right? So, yeah, you think about what is often purported as of one of the benefits of ETFs, such as the tax efficiency piece, and you’re right. It just doesn’t sit in a retirement account that’s tax-sheltered, where, let’s face it, I mean the majority of people’s assets are these days, in tax-sheltered accounts, I mean especially outside of the real high-net-worth piece of it, it’s in 401(k)s and IRAs.

Maria Bruno: Right.

Joel Dickson: Now it may still be the case that an ETF might make sense because of cost. For example, take Vanguard’s products. I mean pretty much for all of our index funds, we have an ETF version and a traditional mutual fund version that all share the same portfolio. So they’re exactly the same except either in terms of their trading piece with the ETF or in terms of the costs of different, what we call, share classes. Well, if you have less than $10,000 to invest in Vanguard index fund, the ETF is actually going to be cheaper than the sort of traditional shares. On the other hand, if you have access to the really large institutional share classes, oftentimes they’re lower cost than the ETF would be. So, you know, depending on what you have access to, a large employer with a 401(k) plan may offer an institutional share class that’s lower cost than what an ETF would be. And so maybe that is the right option in that case. So it’s all this, it often will come down again back to those set of features that may be different, depending on the circumstance.

Maria Bruno: Yeah, I would agree. And as I’m listening to you, Joel, I’m thinking through, okay, well, when we think about our clients and the questions that we get from them in terms of, “How do I choose?” I often think first and foremost is cost, right. When we talk about Vanguard’s investing principles, for instance, control the things you can control, right? Focus on those things, cost is one of them. So focus on the cost differentials. Make sure you understand what you’re paying and how. And then also I think the other piece might be—if I’ve already made the decision where I want to go into an index product, do I need the trading flexibility that an ETF affords? Right, assuming I can meet the account minimums and I have the means to do that—

Joel Dickson: Right.

Maria Bruno: It really comes down then to, I’m looking for this trading flexibility potentially as the two big things. Would you agree with that?

Joel Dickson: Yeah, I generally do agree with that. And the only thing I would add on top of that is that where you are purchasing the vehicle may matter or may be different. So, for example, let’s say—heaven forbid because I’m not suggesting this—but that you’re buying a Vanguard product but at a different brokerage platform. It may be that there are different fees on ETFs or funds, and that can turn it as well. So it’s the fees of the underlying portfolio. And as we’ve talked about the other types of commissions that show up, because sometimes you can buy a Vanguard mutual fund from a non-Vanguard sort of provider, but there may be a, a transaction fee associated with that, just as there might be a commission or transaction fee with the ETF. Sometimes those are different. I should also point out that, starting this month, in August, you’ll be able to purchase not only Vanguard ETFs, but also ETFs from more than one hundred other companies commission-free when you invest online at vanguard.com.

Maria Bruno: Okay, so it does come down to cost, but what you’re saying though is to be careful in terms of any additional or incremental costs because of how you trade.

Joel Dickson: Yes.

Maria Bruno: Okay.

Joel Dickson: Exactly. And they can be different on the different structures, whether it be a mutual fund or an ETF. But, ultimately, whether it’s an ETF or an indexed traditional mutual fund, again I often reiterate this, probably beating dead horses too much, about the underlying portfolios, and especially in Vanguard’s case where they share the same portfolio. You know, if it’s an S&P 500 ETF or an S&P 500 traditional fund, they’re sharing the same actual portfolio in terms of investment results. That’s not the differentiator, if you will. You’re still getting broadly diversified, low-cost investment exposure.

Maria Bruno: Let’s go back into the Joel Dickson archives. Didn’t you call them “kissing cousins” at one point?

Joel Dickson: Yeah, and I was told never to use that analogy again.

Maria Bruno: I used it, not you.

Joel Dickson: Yeah, exactly.

Maria Bruno: I’m just as horrified now as I was back then when I heard it.

Joel Dickson: Yeah, exactly, because they are very similar in terms of the investment exposures that they give. It’s just a little bit different in how you access them.

Maria Bruno: Okay. Now you can’t use that. I can’t use it anymore, nor can you.

Joel Dickson: Wow, I thought you were going to pull out a different one, but that, yeah, I’d actually burnished that one from my memory, so. Well, you know, Maria, we had talked a little bit earlier about how these get used by different types of investors. And we, obviously, have a very kind of Vanguard take on what we’ve discussed and what we know. We did want to bring in an expert to talk a little bit more about the ETF industry generally—kind of the growth and the development—and he has a little bit of a different view on it. And his name is Eric Balchunas. Eric is a senior ETF analyst at Bloomberg. Actually, I’ve known him for years when I used to work on ETF issues more directly.

Maria Bruno: And he was still willing to come in and talk to us?

Joel Dickson: He is. I think part of it is, he’s a South Philly guy, and so he likes to help out other Philly areas when he can. Maybe we’ll talk cheesesteaks or something with him. But Eric is going to join us. As I mentioned, senior ETF analyst at Bloomberg, long time experience working with ETFs, over a decade in terms of data and designing new functions for a lot of the work that Bloomberg does in terms of its tools that are often used more by professional investors. But he’s been really on the frontlines of a lot of what’s been happening in the ETF industry, and he also writes a bunch of articles, research notes, features, blog posts. He even has a weekly TV show on Bloomberg on ETFs. So, he can provide a little bit more of this perspective of how retail investors have been using ETFs, how the ETF industry has grown, and how it may continue to develop. And so, really excited to have him join us and provide some of his experience and wisdom.

Joel Dickson: I’m joined today by Eric Balchunas, who’s a senior ETF analyst with Bloomberg Intelligence. And, Eric, thank you so much for joining us today.

Eric Balchunas: Thank you very much for having me.

Joel Dickson: It’s great to have you, Eric. I mean, one, you’re a Philly guy, right? So we could sit here and actually talk, you know, about the Eagles for the next 15 or 20 minutes.

Eric Balchunas: You guys are like local to me. And there’s not a lot going on ETF-wise in Philly besides, well, RevenueShares was there, there’s a couple analysts, and then, obviously, Vanguard, which is a little outside of the city.

Joel Dickson:  You’ve been involved in the ETF industry marketplace for really years in many ways, as ETFs really started to grow and explode on the scene, you know, both in terms of writing about them, and now much more from an analyst standpoint. In fact, for our listeners, Eric does host a podcast that is largely devoted to ETFs and the ETF industry called Trillions and so, folks can certainly find that on iTunes if they’re interested from that standpoint, as well as now even a, a weekly TV show called ETF IQ on Bloomberg TV. It’s great, Eric, to be able to get your perspective here. I’d really love to just get a sense of, you know, what intrigues you about ETFs? You know, how did you get so interested and involved in sort of the ETF industry, for your career?

Eric Balchunas: Yeah, I mean, my first job was writing for Fund Action, which is an institutional investor newsletter. And honestly, I took that job because I was a journalist and I liked the economy, so it was a pretty good job, but I just got assigned to that one. And it was a good fit. I like funds in general, because they cover everything. And so, for somebody who’s intellectually curious, and, you know, gets bored quickly, ETFs or funds, in general, take you everywhere. And so, you sort of have to be not just a mile deep and an inch wide, but a mile deep and a mile wide. And so, this endless sort of intellectual stimulation. And ETFs, in particular, which I was sort of assigned in 2008, around there, when I was in data for Bloomberg—I was in data for 15 years at Bloomberg making sure all the data was right on the terminal—and when I got ETFs, as somebody who had tracked mutual funds, I fairly quickly saw this as a huge deal because if you know the mutual fund and then you start looking around the ETF, you realize that it’s got, many, many advantages. So (A) the advantage of the ETF—I saw it as a breakthrough technology and was proven correct. And then (B) the idea that ETFs democratize everything. And I, I find that really appealing, and they basically break through all the share classes that mutual funds had. It’s basically giving you the Sam’s Wholesale Club pricing so, and everybody gets the same product. And I like that democratization angle and sort of the way they track all different areas. And, like, for Vanguard, you guys stick more to the sort of core, but there’s even some fascination of stuff you guys don’t track like the VIX market, the VIX futures, or robotics. I mean there’s a lot of stuff you sort of have to learn about when you cover ETFs, and I love that endless learning process.

Joel Dickson: And just for the listeners, VIX would be volatility approaches and so forth. Kind of the, some might call more esoteric, some more complicated, but definitely, as you said, there is a whole landscape, of ETF products and approaches. In effect, in fact, I’d like to highlight a little bit more that democratization angle that you just brought up. You know, can you talk a little bit more about—in the context of the trends that you have seen in this industry in terms of cost, in terms of investment strategy, in terms of accessibility of investment approaches to many different types of clients, is that what you mean by that democratization piece?

Eric Balchunas: It’s twofold. One is that ETFs go up and go out and wrap up everything that you can think of. So not just asset classes or sectors or countries, but also, strategies or trades, right? Currency hedged ETFs, which go along a local set of stocks but neutralize the currency effects. That’s sort of a popular trade that institutions have been doing for ages, but now it’s packaged into an ETF. Or there’s ETFs that will invest in stocks and then write call options on those stocks to give you income. That’s a trade people have been doing forever. They package that up. And so, there’s that democratization, that things that only institutions used to be able to do now retail can do. However, when you do that, you definitely wrap up some stuff that retail probably shouldn’t touch. But I think it’s worth it in the net that they do go out and do that. That’s the one way they’ve democratized investing. The second way, again, is that they just eliminated the share class system that I believe with mutual funds is like a regressive tax. The less money that you have the more they charge you, right, the A class and then the B and the C. And then the institutional class—if you can pony up a lot of money—you get charged a lot less. And so, ETFs sort of come out at the institutional class level and there is no share classes. It’s basically like everybody gets the same price. And a great example I use, which it does include this Vanguard example in my presentation, is that, it’s fascinating that VWO can count as clients my, my mom and the world’s largest hedge fund. And there’s never been any other scenario, ever, where those two people would be in the same product paying the same fee. So that’s the second way they’ve democratized investing. And both those are very exciting.

Joel Dickson: Yeah, Eric. I would just highlight, we regularly talk here about Joel’s mom and what she does from a standpoint. So, the fact that we got Eric’s mom in this too is terrific.

I did just want to clarify two quick things. One, VWO is the ticker symbol for the Vanguard FTSE Emerging Markets ETF for those listening. And then the second thing is that when we talk about share classes and this evolution of share classes, in many ways historically the mutual fund share classes were built around different commission payment structures in many ways. Now Vanguard also has share classes, continues to this day, though those tend to be structured more around pricing at different levels of minimum investment. But, as you said, the ETF share class—which is one share class of many in Vanguard’s funds— it is available to anyone regardless of their investment amount and so forth.

Eric Balchunas: Yeah, and the lack of distribution fees, or commissions, is another thing that excites me about the ETF industry because I always say that ETFs got there—I think they’re up to $3.5 trillion in assets—the hard way. They don’t pay anybody. They’re not in any 401(k) plans, where a lot of that money is sort of like fish jumping in the boat. They had to win their money by convincing picky, after-tax, early adopter do-it-yourself types. So, if you can get $3.5 trillion that way, I just think the sky’s the limit because that’s the hardest way to get those assets.

Joel Dickson: When you think about that $3.5 trillion, as you said, really growing from nothing to $3.5 trillion over the course of the last roughly 20 to 25 years, what do you attribute to in terms of the success or features of the ETF that, that have done that?

Eric Balchunas: Well, you know, I’ve frequently compared the ETF to the MP3 in that it’s not the artists or the music that you’re interested, it’s the format to get there. And I just think that the MP3 completely revolutionized the way music is listened to, I think the ETFs have done that. These are things that have many, many advantages or attributes. Now you may not care that it has intraday liquidity, but an institution sure does. Or you may not care that it’s low cost. You just want the intraday liquidity or vice versa. Other people like the fact that they don’t really distribute capital gains—they almost have a perfect record. So, there’s tax efficiency. The fact that you can see what’s in them every day, they’re transparent. So, they’ve got this laundry list of attributes. That’s one thing. If you have a lot of things going for you, you’re eventually going to attract fans, right? Just like the MP3 is just an easier, cheaper, more efficient, flexible format in which to consume music. That’s sort of what the ETF was. The other thing is, I think that people are wary of new things that come out of Wall Street, especially if it’s got an acronym. And 2008 to me was the real turning point where, up until that point, I think they even had less than $1 trillion in assets. But 2008 when, really, the market saw some wild trading days and some steep drawdowns, and people saw the ETFs could take a beating and still do their job, and the structure could hold up under that kind of a stress, I think that, really, is what convinced even skeptics that this thing is worth it because they might have liked the fact it was low cost or straight trading. Maybe they were worried that, you know it might be a structure that hasn’t really been tested. I think that was huge. And then since then, the market has had this nice bull market run which has helped. Although I don’t think that’s the only reason. A lot of active managers will tell you that the ETF in passive rises only because the market’s been so—it’s been easy to make money. I disagree completely. I think that on the flip, if there’s a bear market, that’s when you’re really going see ETFs in passive take even more market share. Or if the market stops returning so much because people will then be more focused on cost than in this type of market. So, I think all of that combined is why you saw that. And then, of course, I call it the media chain. You know, back in the day, you only heard bloggers or conferences would mention ETFs. It was sort of on the street level only. Then you had—luckily because the Internet is around—you have media reading the bloggers and then you have Barron’s reporting on it, and it sort of filtrates down. And two years ago, I saw USA Today do a huge story on low costs and ETFs and it was on the front page in that chart. And when it gets into USA Today, it’s sort of reached the end of the media line. And so, that kind of coverage, all the way from the bloggers to the mainstream media over the last ten years, I also think has helped because once it’s in USA Today, I think it, it’s been vetted and, certainly, retail people would have more trust in some of those mainstream publications and more awareness.

Joel Dickson: Eric, we just now need to get it on Saturday Night Live and in People magazine and in Cosmo, right?

Eric Balchunas: Well, the, one thing about ETFs is that if I go to Thanksgiving dinner, half of my relatives—and, you know, I do this for a living—couldn’t tell you what it stands for. So, and I think and that’s why we spoke with a different issuer on our podcast—we asked them what the white space in ETFs was. And instead of picking a product, like an asset class that they could serve, they went in the other way and said, “The retail investor is the white space.” So, I do think that there is so much room for growth for people like that. And, again, so even though it’s known and anybody listening to this is probably more on the do-it-yourself front, there’s still, I think, a lot of room for people to become aware of it.

Joel Dickson: I kind of wanted to get there a little bit in terms of this. Who is buying the ETFs? As you said, it’s a democratization that’s occurred so it’s the institutional investor, it’s your mom it’s financial advisors throughout the landscape. Who historically has been buying ETFs? And then you mentioned the, the sort of do-it-yourself retail investor. Are you seeing more and more take up by that segment?

Eric Balchunas: Yeah. So early on it was only institutions that used them. Again, because they trade, they were basically able to use them like a futures contract except, better than the futures contract, they actually held the stocks or bonds, so they were physically backed. So, it was like the best of both worlds and institutions really used them at first. And Vanguard launching, certainly, sealed the deal for retail. And then advisors, to me, are the perfect client. In fact, I think last I checked, I usually quote numbers around this, like, I think about half to two-thirds of the money is, is probably vis-à-vis advisors. And the reason they like ETFs so much is because they’ve moved from commission-based to fee-based. So, when you’re getting a percentage of your clients’ assets, all of a sudden, you’re now shoulder to shoulder with that client. And so now, your focus is going to be on fees. And advisors are well aware that cost is so huge, and they’re well aware of the lack of ability to outperform over long stretches by active. So, unless they were going to get paid by the funds, now they’re going to get a percent of the portfolio. That shift from the commission model to the fee-based model was major. And so, when you’re now sort of fiduciary and getting paid that way, that to me opened the floodgates. And so, advisors are the biggest client. And then I think you probably have—and you guys probably have your own numbers—but 15%, 20% institutions, depending on how you define institution, and then a sliver would be sort of do-it-yourself retail. That sliver, I think, is what a lot of people think will be a bigger growth area.

Joel Dickson: Yeah. I, would also like to touch on two other sort of items of the ETF space. with new technology, if you will, the next generation of the mutual fund in some ways, as some have called it, there come then these whole host of “yes, but”. And, you know, the criticisms that occur around ETFs—they’re blamed, I think, for all sorts of things like hurricanes and earthquakes. But, you know, in particular, you know, there is this question about, hey, if they are so easy to trade, you can trade them on pretty much any platform. They’re portable, intraday, so forth. Does that actually induce kind of bad behavior on the part of clients and investors?

Eric Balchunas: Sure. So, I have this PowerPoint that I’m currently doing. It’s one of my two.  I’m like a musician with set lists. And one of my PowerPoint presentations is called “ETFs Godsend or WMDs?” And there’s been a lot of attacks, especially last year. A lot of those attacks come from active managers who are nervous and scared about their own livelihood, so they lash out at ETFs and say all kinds of things. Most of them can be easily refuted with some contextual data. But what you’re bringing up to me is what I call a legit concern. So even though I shoot down some of these histrionics that you hear from active, I do pivot because I’m not a cheerleader here, I’m trying to call it like I see it. And I do think that the number one legit concern is what you just said—which is they’re so good and so easy that you could definitely lose yourself. And if you start trading too much, bad behavior would completely destroy all of the cost savings and tax benefits that the ETF offers. So that’s why I compare the ETF to the movie Gremlins, right.

Joel Dickson: Oh, an ‘80s reference. Oh, we love our ‘80s references.

Eric Balchunas: Me too. I’m big on them. Up until year 2000, I’m an ‘80s and ‘90s I’m reference king, but, anyway, in Gremlins just for people who haven’t seen it, the, the mogwai is this cute, little furry animal and it comes with three rules. You know, no sunlight, don’t feed it after midnight, etc. And of course, the boy does. And so the mogwai turns into this evil sort of gremlin with sharp teeth and they procreate and sort of tear up the town. To me, that’s an ETF in a nutshell. It is a wonderful vehicle, but you kind of have to follow a couple rules for yourself so you don’t destroy all those benefits. And I think, you know, one of those is don’t overtrade. Don’t lose your mind trading. Just because you can trade the Russia small-cap ETF at noon and sell it at two, doesn’t mean you should.

Joel Dickson:  I’m thinking, what other ways could I think about ETFs in the ‘80s? And I’m thinking, oh, in many ways, they’re like the mullet, you know, professional in the front and a party in the back. Let me just kind of ask one last sort of piece of this, which is, we’ve talked $3.5 trillion or so in ETF assets. There are thousands of different ETFs. How do you wade through —and for maybe an individual investor, somebody who’s not as familiar with the whole ETF landscape and ecosystem—how do you find what’s right for that person? And, in particular, I’m going to lead you a little bit here. I’d love for you to sort of talk about your spotlight system as a way to help cut through some of the complexity here.

Eric Balchunas: Sure. So, in terms of ETF due diligence, in my book, I outline the same way that professional ETF strategists do it. You look for the exposure. You’re going to start with what you want. I mean what’s your goal here? You want emerging markets? Okay, fine. Let’s go look at the different ETFs. What’s the exposure? What do they track? Look at the holdings. Look at how the index is weighted and what exactly is it holding? Then you’ve got to look at the cost, and that’s in terms of expense ratio, and also the spread, you know, how much is the trade, how much is the bid-ask spread, in percentage terms is useful. Then you want to look at the liquidity—how much does it trade every day, and also how liquid is the basket? You know, I have this sort of rule of thumb: think about the exoticness of what you’re trying to get. If you’re going and you want Vietnam stocks, you know, you’re going to probably expect maybe a wider spread or maybe the price moving away from the NAV a little more. You have to accept a little bit. An ETF isn’t magic. Okay, it’s not going to turn everything into trading like SPY. But you should demand a lot if it’s a plain vanilla area like the S&P 500. With that said, liquidity is important. And then also risk. I keep risk simple. I just look at standard deviation. It’s a foolproof way. I mean I know it’s simple, but the standard deviation, to me, is sort of like the sign on a ski slope. It’s how steep is the ride going to be? And you want to look at the standard deviation of say SPY or the S&P 500, and then look at your ETF versus that because you kind of get an idea of how much the S&P 500 moves. Is this ETF lower or higher than that? And then, therefore, you can get in a gauge on how much risk you’re taking on. And then, finally, the structure. There’s some weird structures out there. Like GLD is a grantor trust. It gets taxed differently.

Joel Dickson: That’s a physical gold ETF, right?

Eric Balchunas: Yeah, like all Vanguards are ’40 Act, plain vanilla, straight up funds. But there are some different structures out there. And there are some benefits to using some of the other ones, but long story short, that’s probably the fifth one. My traffic light system is not designed to do due diligence for you exactly. It’s more designed to solve this problem of what I talked about earlier, which is that when ETFs have gone out and tracked everything—you know, they wrapped up everything—some of the stuff they’re bringing back to you is pretty wild. And I find that leveraged ETFs, ETFs to track VIX futures, as we spoke about earlier, or oil futures, you don’t want to see an investor get hurt. And I think that when you have all these ETFs seemingly trading like shares of Microsoft, you can tend to think that they’re all sort of as safe as VWO or a regular ETF. This traffic light system simply looks at 10 areas where there are, we call them nasty surprises. And if there’s anything that gets triggered, like alternative tax treatment or leverage or a credit risk because of an ETN, there’s just a whole laundry list of ways it could get dinged. And if it basically comes across and has 0–1, it’s a green light; 1–2, it’s a yellow light; and 3+ it’s red. This is very akin to the movie rating system, right? If a movie has just a lot of violence, like a Quentin Tarantino movie, it’s rated R just on the amount of violence. That would be like the amount of leverage, right? Or those other movies that might have a little bit of a couple things that the movie rating agency doesn’t like to see, and you might get an R on that movie. Long story short, this is to protect the innocent while allowing innovation in products for professionals. Because the ETF structure is so good, that there are products out there tracking complicated things that people would just rather have in an ETF format. I think you don’t want to throw out the baby with the bath water but having a traffic light system makes it easy, so you could just focus on green and yellow light stuff. And I do think that lumping ETFs into say, safe or dangerous—it’s more nuanced than that. Like what would a high-yield ETF be? We call that a yellow light. It’s sort of in the middle. Yes, it’s wrapping up junk bonds, but it’s long only and it holds them like any other ETF. So, again, this is a way to sort of make it a little more nuanced and protect investors because, let’s face it, people are just probably never going to read the prospectus even though they should, and this sort of helps make their job easier and keep them away from products that could lose them a lot of money quickly.

Joel Dickson: Right. No, that makes a lot of sense. Now the traffic light system that you’ve developed is available really, through just the Bloomberg terminal, is that correct, or are there other ways that people might be able to access that?

Eric Balchunas: Most of my stuff is, besides the show and the podcast, most of my stuff is premium content on the terminal, including the traffic light. However, the traffic light has such a retail purpose, and my superiors understand that, that I’m happy to email the PDF white paper on it, as well as my spreadsheet with the ETFs and the score they get. If somebody sends me an email to ebalchunas@bloomberg.net, I’m happy to send you the system just as a friendly gesture.

Joel Dickson: Well that’s terrific, Eric. Thank you very much for joining us. Once again, I’d just like to say, Eric is a real expert and has been with the ETF industry, if you will, in many ways since its spectacular growth over the course of the last decade, as we already mentioned, he has his own ETF podcast called Trillions that you can find on the iTunes store, for example, where you can also find The Planner and the Geek here from Vanguard.

So, Eric, thanks again for joining us. Really appreciate your insight and expertise.

Eric Balchunas: Thanks, Joel. Great being with you. 

Maria Bruno: I thought Eric’s ETF spotlight—this notion of red-yellow-green in terms of complexity—is brilliant.

Joel Dickson: Yeah, I mean a way to just summarize in a very easy way because—

Maria Bruno: Um-hmm, it’s very intuitive.

Joel Dickson: Yeah, I think sometimes ETFs get used as an all-encompassing term, that they’re all the same, that they’re all part of the same asset class. But just like with any investment strategy, there are more complex ones, more volatile ones. You know, some take more risk. Some take less, and this concept of being able to highlight the ones that provide the most basic exposure versus those that are more involved if you will, is an important way to think about it.

Maria Bruno: And I think it’s good too when you think about it in the context of portfolio construction. So think about top-down approach, figure out what your asset allocation is, your sub-asset allocation within that. For instance, how much U.S. versus non-U.S. you might want, and then how do you actually implement to that in terms of vehicles, whether they’re mutual funds or ETFs? And when you’re in ETF space, something like this can help as another qualifier in terms of how are you investing to achieve that asset class or sub-asset class?

Joel Dickson: Absolutely, and as you mentioned, that portfolio construction piece, how do you fill that up, not doing a collection of funds, but focusing on that asset allocation component, and then what are the available opportunities for me at the lowest cost in order to achieve the exposure that I want, that I can use in that portfolio? And it gives that context to it, and people may find it’s a mix of things. ETF, fund that can gain that exposure that they’re seeking.

Maria Bruno: It doesn’t have to be all or nothing, as we talk about it a lot during our podcast.

Joel Dickson: Diversification, right? Many different forms.

Maria Bruno: So we covered a lot. The one thing I will suggest is for our listeners who want to learn more, as usual, I’ll make our plug for vanguard.com. We have a page on ETFs. For listeners that want to learn more, they can go there and learn more about ETFs but also help navigate whether or not they’re right for their particular situation.

Joel Dickson: Yeah, I think that’s a great idea. And, you know, as we also say, we also encourage the listeners to write reviews on the podcasts themselves. We actually read them! I know you and I end up texting if there’s a new review or something. It’s like, “Hey, did you see the new review?”

Maria Bruno: We do read the reviews. We like the ratings. The reviews are quite insightful in how we pick topics.

Joel Dickson: Yeah, I think there should be some sort of like, secret word that people who have listened to this podcast can put into the review, so that we know that they listened to this particular podcast.

Maria Bruno: Oh, you want to add another element of challenge to our podcasts?

Joel Dickson: Exactly. You know, like I think if our listeners use the term “Sangria Maria,” we’ll know that they listened to this podcast. Figure out how to put that into a review.

Maria Bruno: Um-hmm, good one, Joel.

Joel Dickson: It would be great. But, seriously, I mean we do read the reviews. We like seeing them and any topic ideas of interest that people might have for future podcasts are greatly appreciated.

Maria Bruno: All right, Joel, well thank you. I want to thank Eric as well for joining us today and to our listeners, thanks. We enjoyed this episode. We hope you enjoyed it as much as we did. We hope you enjoyed this episode of The Planner and the Geek. Just a reminder that you can find more episodes of The Planner and the Geek on iTunes and on vanguard.com.

Joel Dickson: Or simply subscribe to our series and you won’t miss an episode. And please don’t forget to rate us on iTunes. Your ratings will make it easier for others to find us when they’re looking for investing podcasts. Please join us next time for another episode of The Planner and the Geek.

Notes:

For more information about Vanguard fund or Vanguard ETFs, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

We recommend that you consult a tax or financial advisor about your individual situation.

Except where noted, opinions presented are those of the author or speaker, and do not necessarily reflect the views of Vanguard or its management. None of the information outlined here should be construed as financial advice from Vanguard. The information provided here is for educational purposes only and is not intended to be construed as legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.

© 2018 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.