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Conrad de Aenlle's Funds For Thought: Vanguard may solve an indexing problem it helped create

July 12, 2017
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The ease and frugality of investing in the stock market through index funds has made indexing so popular that no less an authority than John Bogle, the chairman of Vanguard and the instigator of the trend more than 40 years ago, felt compelled to issue a warning: Indexing conceivably could become so ubiquitous, albeit well into the future, that the stock market essentially ceases to function.

Because no good deed goes unpunished and the law of unintended consequences tends to be strictly enforced, Bogle and Vanguard likely would receive much of the blame if that ever happened. They would be convenient scapegoats, even if some scorn might be owed to all those high-priced professionals who run actively managed portfolios and can’t squeeze out a percentage point of extra returns every year to compensate for the difference in expenses.

Vanguard, through its expertise in ultra-low-cost investing, may help bring “chaos” and “catastrophe,” to use Bogle’s words, to the market one day. But information gleaned from regulatory filings suggests that same expertise may push such a day further into the future.

The filings are somewhat vague, but it appears that Vanguard is planning to sell actively managed exchange-traded funds. Todd Rosenbluth, director of ETF and mutual fund research at CFRA, a service that rates funds, said in a recent note about the filings that the new funds could be ETF clones of existing mutual funds, such as Vanguard Strategic Equity Income












VSEQX, +0.77%










  or Vanguard Global Minimum Volatility Fund












VMVFX, +0.54%










 

Strategic Equity Income owns a mix of small- and medium-sized companies. Global Minimum Volatility holds stocks that feature characteristics likely to limit swings in prices. Both are managed through so-called quant, or black box, techniques. The managers fill the portfolio strictly through a rules-based, computer-driven process, exercising little or no discretion apart from crafting the stock-picking model.

The mutual funds are dirt cheap to run, with total annual expenses of 0.25% of assets or less, according to investment researcher Morningstar. The electricity that keeps the black box humming doesn’t put much of a dent in shareholders’ wallets, apparently, and whatever costs the funds incur are spread over multibillion-dollar asset bases.

The quant model, with its simplicity and rigor, makes the two Vanguard portfolios ideal for cloning into ETFs, and ETF versions should be even less expensive to run than the mutual funds.

The trading, administrative, marketing and overhead costs of each would be virtually the same for the mutual fund and ETF combined as for the mutual fund alone, and they would be apportioned, most likely, among a larger asset base. More important, ETFs are cheaper to operate because buying and selling of shares are done on a stock exchange, between market participants; not having to take either side of the transaction, as when shareholders acquire or redeem mutual fund shares, saves money for fund providers and ultimately the shareholders.

It’s still too early to tell what Vanguard will do. But if the regulatory filings mark the start of a trend toward active management that’s cheaper because it uses an ETF format and follows simpler stock-picking rules, whether using a black box or conventional gray matter, it could prevent the catastrophe for the stock market that Bogle warned about. It also might avert the catastrophe that purveyors of actively managed funds could encounter from a marketplace where they can’t beat index funds and face fewer investors willing to let them try.

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