The view from the top

Q: What about the tech-savvy younger market, the millennials and others coming up behind them? Are they more likely to invest in ETFs?

A: I think so. People getting close to retirement and with higher average net worth, as well as the millennials just beginning to invest, are the two groups embracing ETFs the most aggressively. I think the millennials like data; they like evidence. [Research has] found asset allocation is the most important thing in terms of determining your portfolio’s return. Get that right and you have 90% of what you’re going to get. And so the millennials look at that and say, “I’m going to invest in those asset classes in the most inexpensive way I can.”

I think millennials are changing the way we think about providing [investment] advice. Whether it’s the so-called “rise of the robo” or of blended services, technology-based solutions are very appealing to [millennials]. Advisors are going to have to embrace technology in different ways to serve that group.

Q: Can you comment on the robo-advisor trend?

A: I’m impressed by the technology of at least some of the robo firms. We’ll see many firms come and go – that’s just what happens in starting new companies. But the more interesting thing for me is what you can learn from the technology. Can you apply it to more traditional ways of providing advice? I think we’re just beginning to see that. You’re seeing the best advisors out there embrace the user interfaces that some of the robos are using and trying to figure out how they can provide clients with something like that while still giving them the personal touch.

[Technology] is going to continue to evolve in a positive way for investors. It’s a little bit of a loose analogy, but if you think about MP3 players, Apple didn’t invent them. But they took the technology and enhanced it dramatically. That’s where iTunes came from, and the iPod. And we do everything on our phones now, with music and everything else. [That] all came from an application of existing technology with some interesting evolutions. I think the same thing could happen with robo-advisors, I don’t know exactly what [the future] will look like, but it would not be uncommon for an advisor to say what Wealthfront [Inc.] is doing is pretty cool, but if we adopt some of that technology to what we’re doing, wouldn’t that be even a better solution for our clients? And I think what we’re going to see is a tremendous expansion of the use of technology to traditional practices.

Q: And Vanguard offers some kind of robo technology?

A: We have Personal Advisor Services [PAS], which goes to clients with as little as $50,000 [in investible assets]. It’s a blend of cool technology with the personal touch. So, you have a virtual relationship with your personal advisor, you can FaceTime or the equivalent with him or her. We think blending the personal touch with high tech seems to be appealing to a lot of our clients. We launched [PAS] formally in May 2015, after piloting for six to 12 months before that. So, as of May of last year, [PAS] was a US$30 billion practice for us. [PAS] has robo pricing and a really good web interface for clients, but they do interface with a person as well. And we find those conversations are really valuable to our clients.

Q: And what’s the product at this point?

A: [PAS] uses Vanguard ETFs or funds.

Q: Vanguard has done some research on the value that an advisor can bring to the client. Can you comment on this?

A: The behavioural coaching aspect is huge. Getting people to rebalance to their long-term asset-allocation targets needed to meet their goals adds a ton of value. Morningstar [Inc.] produces some really great data, [used to] look at active funds and look at what the investor actually earns vs what the fund returned. Usually, for the more specialized funds, it’s about 150 bps less for the investor – and that’s because investors are coming in late and getting out at the wrong time, trying to time it. So, with that differential, just by keeping people where they belong, you’re literally adding 150 bps.

The other element that’s huge is taxes. If you hold an active fund in an after-tax account, your after-tax returns aren’t going to be nearly what your reported returns are, due to turnover and its tax consequences. The outperformance of index funds goes up dramatically when you look at it after taxes. So if an advisor says, “Hey for this part of your portfolio, we have to be 100% indexed because it’s all after-tax money,” they’ve added to your return probably another 100 bps. That’s where the ‘advisor alpha’ concept comes from.

Q: And I guess getting people to invest in areas where they may not be comfortable.

A: Yes, it’s like keeping exposure to emerging markets right now is really difficult. But we know when emerging comes back, it will come back so fast that if you don’t already have exposure to it, you won’t benefit.

Q: There is a movement toward a greater degree of active management or “smart beta” ETFs. Where does Vanguard stand on this trend vs pure index investing?

A: Smart beta is a great marketing moniker because it gives you the idea that there’s a better way to index. We don’t view smart beta as indexing; we view it as what I’ll call a “mechanical approach to an active bet.” Different smart beta funds are based on different screening factors, and you’re essentially betting that these factors will result in outperformance.

Now, some people say that’s a better form of indexing. But what we know is that if you take the simplest factors – growth vs value – there are certain periods when growth stocks outperform value stocks, and there are periods when value stocks outperform growth. These tend to be very long cycles. And when you’re in the middle of one cycle, there’s a tendency to say, “Ah, this is a better way.” We certainly saw a lot of the early smart beta products had a value bias. While if growth outperforms for a period of time, value doesn’t look so smart at that point, and people will be referring to “dumb beta” or whatever.

These products can have a place, but you have to be very clear on the risks you are taking. You’re betting that one or more of these factors is going to outperform. What we’ve found is that when you backtest these things, they all look great; but once they launch, oftentimes their performance is very disappointing. Advisors need to make it very clear to their clients that these products do not track the entire market, but are betting that this set of factors should outperform the broad market over some period of time. You just have to understand the risks you’re taking. And that’s the part that I don’t think is clear. And you’re paying a higher fee for it.

Q: Would you say that ETFs are best suited to certain asset classes, such as large-cap stocks, for example?

A: I think they’re very well suited to broad asset classes in which there is good liquidity and transparency. ETFs are less well suited to really esoteric asset classes, in which there is less trading ability and less liquidity.

Q: What about less efficient markets, such as emerging markets?

A: The efficiency aspect is an interesting thing. When we first launched emerging markets index funds and then the ETFs afterwards, everybody said, “Well, that’s crazy because it’s such an area in which active managers can add value. They’re such inefficient markets.” We actually believe all markets are inefficient, including large-cap U.S. stocks. The inefficiencies get smaller in certain categories.

To me, the cost of investing is the single biggest reason why indexing works. So, if you think about a traditional fund in any asset class – let’s use emerging markets because it’s a good example. Most active managers in this region charge 1.5%; and then when you look at trading costs, there’s probably another 300 basis points [bps] of implicit costs vs an index fund. So, you as an active manager have to add 4.5% of outperformance just to match an index fund in emerging markets. It’s pretty rare to do it consistently. So, that’s why the index story is so powerful. Obviously, where there’s less liquidity and less efficiency, the potential for outperformance may be a little bit greater. You can see active managers try to do it, but it’s tough.

Q: Are trading costs really as high as 300 bps?

A: When you add it all up, yes (in emerging markets.) Even in the U.S., an active manager is typically creating a drag of 100 bps – 150 bps a year. Most active managers turn their portfolios over pretty frequently. The commissions [paid to] the brokers to trade the stocks [raise the costs]. Indexing doesn’t trade much except to rebalance.

Q: With more competition in the area of fees, is this going to be a race to the bottom?

A: There will be more competition – we’re seeing it, and we think it’s a good thing. Every year, we’re looking for ways to reduce expenses on the funds further. And we’re just going to keep doing that across the board.

This interview has been edited and condensed.

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