ETF Expert Corner
Vanguard’s Rich Powers Talks Low Cost ETFs, ETF Growth
February 7th, 2017 by ETF Store Staff
Rich Powers, Head of ETF Product Management at Vanguard, explains Vanguard’s low cost positioning in ETFs, offers his perspective on ETF growth, and spotlights two popular Vanguard ETFs.
You can listen to our interview with Rich Powers by using the above media player or enjoy a full transcription of the interview below.
Nate Geraci: We're now very excited to be joined by Rich Powers, Head of ETF Product Management at Vanguard. Vanguard is currently the second largest ETF provider in the country. They offer 70 ETFs with over 630 billion dollars invested in those ETFs and, of course, Vanguard is the largest fund company overall. Last year Vanguard took in a record 305 billion dollars and Bloomberg's Eric Balchunas reported last week that Vanguard took in 47 billion dollars this past January alone, which would put them on pace to smash the record from 2016. Rich is joining us via phone today from Pennsylvania. Rich, a pleasure to have you on the program.
Rich Powers: Nate, Conor, thanks for having me.
Nate Geraci: Rich, anytime we talk Vanguard ETFs on our program, it seems like cost is always a part of that conversation and so I thought we might start today with fund costs. Can you explain for our listeners Vanguard's overall philosophy here? Why has low cost always been such a focus?
Rich Powers: I think you are absolutely right that low cost, high quality has been largely synonymous with the Vanguard brand over the 40 plus years we've been in business. I think the key reason why cost is so important is that the less it costs for you to make your investments, the more you get in return as an investor. It's a ... the less you pay, the more you get effectively ... the higher value you get is effectively the Vanguard operating motto when it comes to investments. It's been key to how we've operated and just to give you a sense for our standing in the marketplace, as it relates to costs, I think a couple stats might help illuminate that point for investors. Just looking at our ETF lineup, 99% of our ETFs are in the lowest quartile of costs relative to their category, so basically our entire lineup is in that very cheap category of offerings. If you looked at just our 70 ETFs individually, what you'd see is the ETF with the highest cost would be our emerging markets government bond fund. That has an expensive ratio of 34 basis points. Now that's, as I said, at the higher end of what we do across our lineup. There's a couple factors why that's a little bit higher relative to our other offerings and that's the fund is only three years old, it's about 900 million dollars in size - so it's large but not extravagantly large. Then, obviously, an investment in a pretty extensive segment of the market, emerging market debt - so these are all the reasons why that fund would be at 34 basis points. At the other end of the spectrum, you would look at two of our largest ETFs and they're both at five basis points, so our Vanguard Total Stock Market ETF (VTI) and Vanguard 500 Index ETF (VOO) both at five basis points. Pretty close to the cheapest funds in the marketplace today. Then, I'll just kind of wrap it up from a stat standpoint, across that 70 fund lineup that we have, the average actuated costs for our ETFs is around 10 basis points. We are really very clearly committed to lowering the costs of investing for investors so they can have more in return for whatever long term objective they have.
Nate Geraci: Rich, for our listeners who may be unfamiliar with Vanguard's unique structure, where the company is owned by its funds, which are owned by the fund shareholders. Can you maybe explain this in a little more detail? How does this structure help keep fund expenses low?
Rich Powers: Great point there Nate. Our organizational structure is unique in the marketplace. It's very much akin to years ago how you might have thought about the insurance industry where they're mutually owned, that the policyholders owned the insurance company. Actually, that's how we organized as well. Our funds own the Vanguard Group, and our investors who own the funds, therefore own the Vanguard Group. What that does, it ensures there's no conflict in how capital is allocated or spent. Normally, what you would see in the asset manager industry is that the asset manager is either publicly owned or owned by a family or a small group of individuals. In those instances, those owners, whether they be public or private owners, expect a return on their capital and so that comes at the expense of the owners of the mutual funds or ETFs. In our case, as we get larger and gain scale and efficiencies, the savings of those efficiencies are returned to clients, the owners of Vanguard, in the form of a lower expense ratio. That has allowed us to set ourselves apart for the long term and create value for our investors.
Nate Geraci: Now, oftentimes when we talk about low cost investing, it does tend to be tied at the hip with indexing or passive investing - but as it turns out, and this may surprise some listeners, roughly a fifth of Vanguards assets are actively managed mutual funds. I know cost is an important focus here as well. At the Inside ETFs conference a couple of weeks ago, your colleague Tom Rampulla said "Active management isn't dead, high cost active management is dead" and we've made the point on this show that it is cost driving many of the trends we're seeing in investing right now. I'm just curious, what do you think changed over the past several years that made costs such a focus for investors?
Rich Powers: I think we need to go back and just reflect on the idea that indexing is still a relatively new concept. We were the first firm to bring indexing to the masses in the mid-1970s and I would say for the first 15 or so years of our existence, indexing was, maybe a novelty, a curiosity. It was gaining momentum but hadn't really gotten on the radar of many investors. The 90s is when I think indexing became a bit more of an accepted practice to invest your portfolio. Probably a function of that, is that index funds delivered very strong returns in a pretty strong equity market environment. Then, I think you look at the mid-2000s and then probably at the inflection point where indexing becomes the dominant form in which cash is allocated from an investor standpoint. More specifically, I would point to the global financial crisis as perhaps the very specific inflection point where if you are purchasing an active fund and you are hoping that asset manager can outperform the market or minimize the risk you have in a portfolio, unfortunately, many active managers just didn't stand up to the test and, as a consequence, investors decided to vote with their feet and move those assets to index funds where the purpose here is to track the performance of a particular segment of the market, minimize your costs, minimize or almost eliminate manager risk and then you also gain the benefit of some tax efficiency that comes just from index funds having low turnover. I think that's the history around indexing. As you point out, Nate, we're very committed to active investing here at Vanguard. We have 25% of our assets in active funds. In fact, our first funds were active portfolios across a range of categories whether they be equity, balanced or fixed income. There's room for both, it's not either or, it's and, but I think one of the key requirements for an active fund on the go forward basis really is, historically it's been, it needs to be low cost. You need to have a talented manager involved and I think for investors, investors need to have the right time horizon in play. Active managers can be out of favor for a prolonged period of time, but if the people, process, and the cost are all in place, perhaps there's some patience that needs to be ...patience might be warranted there.
Nate Geraci: Again, we're visiting with Rich Powers, Head of ETF Product Management at Vanguard. Rich, Nigel Brashaw from PricewaterhouseCoopers recently estimated that ETFs could see over a trillion dollars of inflows during the next year regardless of whether this DOL fiduciary rule goes into effect and his overall point was that the momentum created by the potential implementation of the DOL rule is what's pushing advisors and investors towards ETFs. Now, obviously, this is an aggressive number and we just found out this past Friday that the Trump Administration is reviewing this rule, but I'm curious, number one, what impact do you think just the talk of a fiduciary rule has had on ETFs and two, any thoughts on what might happen moving forward? Both with the rule and any additional impact on ETFs?
Rich Powers: I think you can look at the changes or the potential changes to DOL Rule being quite fluid and it's unclear as to how it will manifest itself, whether the rule goes into effect as originally contemplated, if it's delayed or if it's altered in some meaningful way. I think regardless of whether any of those develop, I think there's good reason to be optimistic about continued adoption and growth of ETFs and indexed mutual funds, for that matter. I would point to what you alluded to Nate, which is that many firms, many advisory firms had already gone down the path of rethinking their offerings as it relates to cost and to fiduciary best practices. We are aware of a handful of relatively large firms who've made some pretty substantial changes in terms of how they've directed their advisors to operate assuming that the DOL Rule would be on the horizon in the not too distant future. We don't suspect that they'll be inclined to walk that back since in many ways these are the right things to do for the investors that they serve. Regardless of how it plays out, I think the DOL Rule would've been a nice tailwind. If it's not in place, I think ETFs continue to have, and index funds continue to have a pretty good tailwind from them regardless. I think it comes back to a couple things and I've alluded to this before. One, you look that indexing has just become accepted and expense ratios are low and so investors have gotten comfortable with the idea of "you know what? If I pay less, I'm going to get more in my return". Two, you also have to think about investors being disappointed with the performance of many asset managers. We've all seen the stats from the S&P and other providers that show the weak performance of the asset active manager industry as a whole over the last decade. That becomes pretty problematic when you're paying a pretty high price point for the service. I think three, investors have gotten a little more in tune to taxes with their investments. Typically, those that are outside an IRA or another tax deferred vehicle, because the ETF structure, in particular, has a couple advantages in that regard. One being the strategy of ETFs, which are generally passive funds, which means there's less trading and therefore less potential capital gains generation. Then two, the ETF structure has the built in, in kind create redeem mechanism that allows the low cost basis shares a fund manager might have purchased 20 years ago, out of the portfolio and not create a capital gain. I think all of those reasons set up for indexing and ETFs in particular to do well. As to what the future holds in terms of actual tactical gathering for ETFs - your guess is as good as mine. Certainly, we've gotten off to a pretty phenomenal start here in 2017 and building off of momentum last year. We're not in the prognostication game, but I think there's good reason to think ETFs will win their fair share of assets.
Nate Geraci: Alright, one last question here as it pertains to fund fees and I'll preface this by saying that I'm fully expecting you to give a typical very humble Vanguard answer, but how in the world can other fund companies compete with Vanguard on costs? We know there are so called fee wars occurring in ETFs and just given Vanguard's unique fund structure and tremendous scale, you do have the ability to put a lot of downward pressure on fees. Can anyone compete with Vanguard on costs and, if so, what's the longer term strategy there?
Rich Powers: I think what you're alluding to Nate, is that there's been a lot in the press over the last couple years, but even the last couple months in particular, where you've seen pretty significant reductions in fees from some of our major competitors. We look at that and say it's gratifying, it's great to see our competitors lowering the cost of investing for many of their clients. In fact, there's some in the media, who've dubbed it the Vanguard Effect, which is when we enter a product category or geography, you'll see competitors selectively reducing costs in those areas where they compete with us. It's not only just happening here in the US, it's happening abroad. When we've gone into Europe in a big way, or kind of big way, we've seen the same effect take place there. I think, when you think about competitors' actions, they're probably looking at this in terms of different profit pools that they can tap into to offset maybe potentially products that are close to being loss leaders or minimally profitable from their perspectives. They might be able to lower costs that they have a broad US stock market fund that can compete at a level of our product, which comes because of our organizational structure, but leave prices higher in categories that are a bit more esoteric where we don't have a competitive offering or where others who are worrying that the low costs have a competitive offering. I think you've seen that very vividly across a number of major competitors. I think that's kind of the present and probably the future for many of these firms as they try to compete in a pretty intensely competitive environment where cost is becoming more and more of an issue. I think the one thing I'll just kind of wrap it up with is we're low cost across the line up and across the 40 years that we've been in business and that's not really going to change.
Nate Geraci: Our guest today is Rich Powers, Head of ETF Product Management at Vanguard. Rich, we have just a few minutes left here and to give our listeners an idea on the types of low costs ETFs Vanguard offers, I was hoping we could briefly spotlight two of the most popular Vanguard ETFs and I thought we might start with an ETF you mentioned earlier - the Vanguard Total Stock Market ETF, ticker VTI. This is actually the most popular Vanguard ETF. Can you just briefly walk us through what this ETF holds, what the fund fee is and where it might fit in an investor's portfolio?
Rich Powers: I think one thing to start with is that our ETFs are a shared class of our funds and that's a little different from the industry as well. We have conventional mutual fund shares, ETF shares, all sharing the same holdings and economies of scale. VTI or Total Stock Market, it was our first ETF that we launched a little more than 15 years ago and it's the largest mutual fund in the world with over 500 billion dollars in assets. About 70 billion of those assets are in our ETF shares so that makes the ETF on its own the 3rd largest in the marketplace. Fund benchmark is the CRSP US Total Stock Market Index and this index captures about 100% of the US equity market cap, which holds large and mid and small and micro-cap companies in the same proportion as the market. About 4,000 stocks are held in the portfolio with the biggest names being companies like Apple and Alphabet, which is the former Google, and Microsoft. Then you look at things like financial technologies and consumer services as being the largest sectors for the fund. As you alluded to, large fund, a successful fund, a fund that gained a lot of investor interest last year with around six billion dollars in cash flow in 2016.
Nate Geraci: Okay and then another very popular Vanguard ETF is the Vanguard FTSE Developed Markets ETF, ticker symbol VEA. Tell us a little bit about this ETF.
Rich Powers: FTSE Developed Markets Index or VEA, it's the 8th largest ETF in the marketplace and as I mentioned, same structure in Total Stock in that it's a pool of conventional mutual fund shares and ETF shares so the total fund is around 67 billion dollars in size. The ETF is 40 billion. The fund’s benchmark is the FTSE Developed All Cap ex-US Index and so it’s invested in large, mid and small cap companies in developed Europe and Asia holding almost 4000 stocks. The big holdings here are Royal Dutch Shell, Nestle, and Samsung Electronics and the largest country exposures are Japan, United Kingdom and Canada. Financials, consumer goods, and industrials are the largest sectors. What's interesting about this fund is that in 2016 we transitioned it to a new benchmark and that new benchmark now includes small companies and Canadian companies and so the fund has broadened its exposure without any additional costs. I'd say our transition went really smooth. It took us about six months to make those additions to the portfolio and we saw no changes really in the tracking error of the fund versus this benchmark, or in the secondary trading activity of the fund. What was pretty gratifying again, as well with all that happening, the fund was very successful with investors. It received about 11 billion dollars in cash flow for the year, which would make it among the top five winners from an ETF cash flow perspective.
Nate Geraci: Again, that ETF is the Vanguard FTSE Developed Markets ETF, ticker symbol VEA. Rich, with that, we'll have to leave it there. Thank you so much for joining us today - always enjoy talking Vanguard and Vanguard ETFs and we certainly hope to visit again soon. Thank you.
Rich Powers: Thank you, Nate. Have a great day.
Nate Geraci: That was Rich Powers, Head of ETF Product Management at Vanguard.