Vanguard’s founder Jack Bogle is considered the father of indexing. And even though he himself has issues with the exchange traded fund wrapper, Vanguard today is one of the “big three” ETF sponsors, owning about a quarter of the market. Almost 30 percent of flows into ETFs go to Vanguard funds.
The firm’s chief investment officer, Gregory Davis, is keynoting the upcoming Inside ETFs conference in Hollywood, Fla., from Feb. 10 to 13.
Davis recently chatted with WealthManagement.com about the future of passive investing, the role of flesh-and-blood advisors among the robos and whether Vanguard would ever follow Fidelity’s lead and cut the management fee of some mutual funds or ETFs to zero.
WealthManagement: If the trend of passive index investing continues, what effect do you think that will have on the markets?
Gregory Davis: Indexing still represents a relatively small portion of the overall makeup of the market. On the equity side, somewhere in the neighborhood of 15 to 20 percent of assets are using index strategies. The rest are individual securities, actively managed strategies or the types of investment approaches other than indexing. So indexing still has a long way to go to capture more market share over time.
And when you think about the trading activity that happens day-to-day in the U.S. equity markets, [index fund activity] is only about 5 percent of the daily trading volume. The rest is still from active managers, individuals buying individual securities and all the other market participants that are driving the trading activity.
WM: Do active managers have an edge in volatile markets?
GD: That’s always been the claim, but we haven’t seen the data really bear that out. High-cost managers tend to underperform low-cost managers, regardless of what the market cycle is. And we know that index fund managers, which tend to be a low-cost approach, ultimately will be able to outperform, over a 10-year time horizon, a large number of active managers, because of some of those other pressures that active managers have, such as higher cost and greater turnover, will end up being a drag on performance.
WM: Will Vanguard ever offer free mutual funds or ETFs, à la Fidelity’s zero-fee funds?
GD: We are a mutually owned company where we have one mission and that’s really to serve the best interest of our clients. As we gain economies of scale and efficiency, we return that to our shareholders via two forms: one is by lowering the expense ratio and the other is by continuing to reinvest in the business. For example, since 2015, we’ve reduced the cost of investing on 500 of our funds and ETFs, saving our clients over $600 million in expenses over that time period.
We don’t launch products with that type of “loss-leader strategy,” where something is offered at a low cost in order to drive cash flows, and yet overcharge clients in another part of the firm. We have a low-cost approach across the board. So, when investors come to Vanguard, they know they’re getting a good deal at the complex-wide level, not on a product-by-product basis. Are there firms that can undercut us on one or two products here and there? Absolutely. But, complex-wide, because of our ownership structure, we will still be the best deal for investors across the board.
WM: Are robo advisors better portfolio managers?
GD: It really depends on what the investor needs to help meet their financial goals. What I would say is that hybrid approaches, such as Vanguard’s, as well as more typical robos are lowering the cost of advice, which ultimately should help investors achieve their financial goals.
WM: What’s the role then for human advisors, including your advisors in Vanguard Personal Advisor Services?
GD: We believe a big part of their value proposition is really around the behavioral coaching. That’s being able to understand your client’s needs and help them understand and make the right decisions from a portfolio construction standpoint and to keep them invested in ways that’s not going to be harmful if there’s a disruption in the market. Advisors can provide a steady voice and a steady hand when some clients may be interested in making some kind of shift in their asset allocation because of a market move.
WM: Vanguard launched some ESG ETFs this year. How do you respond to some of the critics that say these funds are merely exclusionary indexes based on ESG criteria?
GD: In many cases, that’s exactly how they’re constructed. So, when you think about the various ESG ratings that exist in the marketplace, you can have the same company with two different ratings, depending on what the methodology is. There’s not one clear way of thinking about ESG investing—exclusionary, using some type of positive screening, or even ratings—because there’s no one industry standard for it yet. It’s a bit subjective. But again, investors understand that if they don’t want exposure to certain industries that they view as harmful to themselves or to society, they have an option to invest in other types of product.
WM: Earlier this year, you launched a suite of factor-based ETFs. Why do this in an actively managed strategy?
GD: We feel like we can have the opportunity to get more concentrated exposure to those factors, and it allows us to achieve that exposure more effectively than if we were following a pure benchmark approach, which doesn’t necessarily rebalance as frequently.
When you think about active managers and how they’ve added value historically, some of that value has come from factor exposure and pure factor tilts. What investors should be paying active fees for is real alpha generation that comes from either security selection or managers who have the ability to rotate across different asset classes or different factors in the portfolio, not from pure static exposure to a factor that you can obtain relatively cheaply.
WM: Shifting gears a bit to talk market outlook, do you think we’re headed for a recession?
GD: We don’t think we’re heading towards a recession in 2019. We think that the U.S. economy for 2018 is probably going to print year-over-year GDP growth of about 3 percent, but we do expect to start slowing down next year for a couple reasons. One, the Fed is well on its way toward tightening interest rates; the other is that the stimulus that we received from the tax cuts is not going to boost growth next year. It was a boost for this year, but not for next year.
We do expect to see the probability of a recession increase as the Fed becomes more restrictive. So, the probability could start to rise when you start getting into 2020, but it’s still a bit too early to tell.
This has been edited for length and clarity.
