Joel Dickson, senior investment strategist at Vanguard, says that for investors, the long-term payoffs related to the index switch it did on the Vanguard FTSE Emerging Markets ETF (VWO | B-86) are inevitable.
He shared his views on the company’s $51 billion fund with IndexUniverse Staff Writer Cinthia Murphy on the sidelines of Morningstar’s annual ETF conference in Chicago almost exactly a year after his company shook up the world of investments with an announcement that VWO would drop its MSCI index in favor of one from FTSE.
Dickson also shared his opinions on a number of other subjects, including Vanguard’s idea about where indexing investing ends and where active management begins.
IndexUniverse.com:This month brought the first anniversary of the announcement of that major index switch from MSCI to FTSE and CRSP. How has this transition been, and have any cost savings materialized yet for investors?
Joel Dickson: The transition, from our standpoint, went smoothly. Tracking error in our index funds, while there was a slight increase during the transition from one benchmark to the next, has returned to normal—if not below-normal—levels. So the management process is working extremely well. The investor reaction has been good—our cash flow continues to be strong and we’ve not heard a lot of concern expressed.
I think overall it’s been pretty smooth. Now, cost savings are really long term in nature. This is about curtailing the growth of index-licensing fees that our clients were paying in the investment management process. There are certainly some cost savings today, but the real cost savings are down the road, and will continue to be enjoyed.
IU.com:You’ve filed for an active minimum-volatility global fund. Why make it active? And why start with a low-vol fund? How does that fit in with your lineup of products?
Dickson: It’s a global minimum-vol hedged product that tries to smooth out the ride of owning global stocks. That’s all I can say about that product right now. But we have had active applications before. We first filed for three Treasury funds and a TIPS fund in 2006, but we don’t have exemptive relief for active ETFs.
We believe in both active and passive. We have a robust passive and active lineup on the mutual fund side. Active ETFs in many ways represent the potential to do for our active products what has happened in passive products. Because we don’t pay commissions, Vanguard has not had distribution access in large swaths of the financial advisory community.
What index-based ETFs have done is open up a large distribution platform that Vanguard had underserved until several years ago. Active ETFs are not as much about a new philosophy or approach, but they might allow a greater access to some of our active capabilities.
We have signaled that we might file for an active ETF in the future, but we haven’t tied that to any particular product or particular strategy. What they might look like, don’t know.
IU.com:While we’re talking about product development, Vanguard has yet to jump into the factor investing or on the fundamental indexing bandwagon. Do you think you’re missing out on that trend?
Dickson: If you think about it, some of the most recognizable factors are small-cap and value, and we have small-cap and value ETFs and funds. I think it’s a question of other factor exposures that some people have put the moniker “smart beta” around—which is a moniker we despise, by the way. It’s really a marketing term. Maybe alternative beta might be more appropriate here, but I’ve never thought of beta as getting smart.
In terms of where we might think about factors and exposures, a lot of fundamental indexing has been rejiggering factor exposures. Is it a better index construction or just tilting towards, say, value? What I think ETFs have done in some ways is blurred lines. Are we talking ETFs or are we talking active and passive? Are we talking ETFs or are we talking low-cost investing?
It’s not that the ETF has suddenly allowed some sort of new way of offering these types of strategies, but the index-construction environment has glommed onto ETFs as its main delivery mechanism.
Where we’ll go with factor investing, we’ll see. What I’ll say is that what people have been calling factor investing is essentially making an active choice relative to the broad market. There are some behavioral issues that come into play here, such as, Can you stick with it? Will investors stick with a small-cap tilt when it underperforms? You’re taking a significant deviation from the broad equity market, and that’s an active choice that’s been made, even if with a passive product.
Again, ETFs have blurred lines. Now, relative to 10 years ago, your only choice when it came to a value exposure was to go with an active value manager. Now, you can do it with a passive instrument, but it’s still an active position.
IU.com:The Fed didn’t taper, and that took some pressure off emerging markets. But in the past 12 months, VWO lost $5 billion in assets, while EEM has gathered $5 billion. Are these flows related to South Korea exposure?
Dickson: Korea recently has been performing well. In fact, since our transition, Korea has done well, so emerging market indexes that include Korea have been outperforming those indexes that don’t include it. But it goes back to the question of, Should Korea be considered an emerging market or not?
We believe—and I actually think our transition in VWO demonstrated—that Korea is appropriately categorized as a developed market. We sold $10 billion of Korean stocks, and we did it in a low-cost, effective way, trading the currency, trading in the markets. From a trading perspective, Korea is a developed market. That’s to say that if one benchmark outperforms another due to a misclassification, well, it’s all about the exposure and getting the right exposure.
That said, what puzzles me about the cash flows that we’ve seen is that there seems to be no full recognition of the cost differentials to obtain similar exposure. Why people are paying 69 basis points for emerging market exposure when they can get a much lower cost with similar liquidity and characteristics beats me.
IU.com:About fixed income, what are you telling investors to do when it comes to duration exposure?
Dickson: There’s been a lot of discussion about shortening duration or substituting credit risk for interest-rate risk, whether it be floating rates or high yield in some form. We actually think that’s a pretty dangerous strategy, because you haven’t enhanced your diversification at all by doing that.
If you’re going to substitute credit risk for interest-rate risk, you most likely are creating a portfolio that’s correlated to your equity portfolio. From a total-portfolio standpoint, you may have to actually reduce the diversification of your overall portfolio to all possible situations that may occur.
The other thing that I think gets lost is that we’re still in the throes of an extremely steep yield curve, and when you short duration, you may be protecting yourself from short-term increases in yields if they were to occur, but you’re making a bet that the amount of increase in interest rates is going to make up for the income you’ve lost by going short and giving up on that income you had at longer maturities.
In addition, we also find that when people talk about their fear of rising rates, we have to ask what they mean by rising rates. What everyone seems to think when they say that is that we’re going to have a parallel shift in yield curve, but if you look at the long-run forward Treasurys curve, what’s priced in over the next five years or so is a bear flattening scenario.
That is, short-term rates rising more than long-term rates. So it’s not at all clear that the opportunity cost of shortening the duration in terms of lost income and higher rates makes sense, although it might provide some comfort. We end up counseling clients to stick with broad diversification across the fixed-income space.
IU.com:The message here is to own BND?
Dickson: Yes, and to a certain extent, what we have also been saying—which is included in BND—is that agency mortgage-backed securities are something that are appropriate in a portfolio because, in many ways, you get some of same features with them as you would get with high-grade sovereign debt—high credit quality, a spread to Treasurys that’s not the same as a credit risk spread on the corporate side.
So, there’s some diversification of the spread product in fixed income, and you get that in an aggregate index approach. There are still ways to get yield but have diversification, and this is one way of doing that.