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I HAVE LONG ADMIRED my grandfather, John H. Watson, for chronicling the contributions to criminology made by his close friend, Sherlock Holmes, Esq. Since retiring from my psychiatry practice, I have similarly had the pleasure, if not the duty, to record the efforts of his grandson Sherwood to expose wrongdoing in the financial industry.
The more informed among you are no doubt familiar with my latest study, The Disappearance of the Load Fund. This account concerns one Mr. Jack Bogle, who revolutionized the mutual fund business in 1976 by opening the first index fund available to individual investors. Not surprisingly, he was derided and vilified by the mutual fund establishment, which had for more than half-a-century gorged itself on excessive management fees and ancillary charges that maintained massive—and massively inept—research departments.
In the face of propaganda from the mutual fund establishment, Bogle’s innovation garnered little acceptance at first. But as the fund began to deliver on its promise of low cost, tax-efficiency and improved performance, the concept of the index fund achieved a pedigree once reserved exclusively for the actively managed no-load fund. For several decades now, assets of index funds have continued to grow exponentially, even as those of traditional active funds have stagnated. For his foresight and tenacity in developing the index fund, Jack Bogle is a market legend.
But just yesterday, I received this pugnacious post from an aggrieved investor:
Last weekend, I attended a lecture given by your associate, Mr. Sherwood Holmes, esteemed advocate of the index mutual fund and exchange-traded fund (ETF). I must express my profound disappointment with his insufferable airs and ignorance about the last stage of Mr. Bogle’s career. Doesn’t your friend know that Bogle inveighed against the advent of the ETF? That he would have denied retail investors access to one of the most dynamic financial products ever launched? No, no, no, this fellow Bogle was no intrepid explorer, but rather an obstacle to progress.
Please convey my displeasure to Mr. Holmes, who I am sure will be so gracious as to reimburse my payment for his presentation to my charge card. He will no doubt be familiar with my name, as it was my grandfather James who pushed his grandfather over the Reichenbach Falls.
As ever,
Prof. Daniel Moriarty
My incredulity at this bombast was interrupted by the rapid three-knock arrival of Sherwood Holmes. “Holmes, Holmes, what a propitious moment for you to return,” I said. “I am in receipt of a post calling you out as undignified and uninformed about Mr. Jack Bogle’s opposition to the proliferation of the fabulously successful ETF. He is positively apoplectic about your unconditional praise for this pioneer of low-cost index mutual funds.”
“Have some tea, Watson, and perhaps one of those benzodiazepine pills you peddle,” Holmes responded. “The Moriartys have been a Holmes family nemesis for over 100 years. I am not in the least deterred.”
Without warning, Holmes sprang out of his chair, his angular frame facing the door. “Watson, we have a visitor. When you hear the knock, please invite our guest into the consulting room.”
“But Holmes,” I stammered, “how could you possibly—”
“Elementary, my dear Watson. I always scan my audience. I quickly identified Moriarty and anticipated this harangue. Our guest is a Morningstar employee, and I requested he bring the firm’s recent article about Bogle and the ETF to clarify my position. As to your question, Watson, our guest was the only man on the sidewalk approaching our flat carrying a briefcase. If you would imbibe less CNBC and turn off that boisterous clown Cramer, you might learn there’s more to know about human behavior than momentum.”
Naturally brusque and stone-faced, Holmes could feign propriety. He gestured our visitor toward the couch across from his chair. “Please enlighten us about our subject, Jack Bogle’s view of the ETF.”
Holmes leaned forward, his eyes glistening.
“Well, Mr. Holmes, Jack despised ETFs,” said the Morningstar employee. “He considered them more a marketing ploy than a legitimate investment vehicle. He felt people wanting to build a nest egg for education or retirement would misuse the product and miss out on the compounded 10% average annual return of the stock market. But that fear hasn’t been borne out. We’ve found that most retail investors don’t rapidly trade ETFs, but rather hold them for the long haul.”
My friend slumped back in his chair. “But I thought—”
“Yes, Mr. Holmes, Jack was spot on about something important—the greed of the purveyors,” our visitor from Morningstar went on. “The asset managers who issued ETFs were flush with their ingenuity and their profits.”
Holmes shifted impatiently in his chair.
“It was only a matter of time before fund families realized they could pump up ETFs’ attractiveness by offering higher volatility than mutual funds. They created funds built on narrow sectors, leverage and even commodities, appealing to investors’ craving for quick and big profits. They launched these funds during bull markets, only for the funds to suffer mightily when the mood turned sour. When you add to that the penchant of people to buy high and sell low, you get a sorry outcome.”
The Morningstar employee continued: “But remember, Jack was an old mutual fund guy and his index fund was already tax-advantaged. He just couldn’t appreciate the many virtues of this investment alternative. He was loyal to his invention. In other words, like most market observers, Mr. Bogle was right and he was wrong. Fortunately, his mastery of the machinations of the financial business and his development of the broad market index mutual fund qualify him as a market visionary.”
We thanked our guest for his affability and knowledge, and I accompanied him to the front parlor. When I returned, I was hardly surprised that partial redemption was not enough for my dear friend Holmes. I began to protest as he was about prick his forearm with the needle, but to no avail. He was already reclined on the couch and beginning to imagine peace from the avarice of asset management companies.
As I leaned over to say goodnight, he said, “Watson, no worries, it’s just Prozac.”
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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Nicely done! Some fun; some education.
Very well written. Thank you!
Thanks for the kind words.
In order to understand how ETFs make money, and make much more money than the nominal fees charged, you have to look at the internal structures behind the funds. Do you know what an Authorized Participant does? If the ETF is trading at above the NAV of the underlying stocks, the AP can buy the underlying stocks and trade them in to the sponsor for ETF shares. If the ETF is trading below the NAV of the underlying shares, then the AP can buy shares and trade them to with the sponsor for the underlying stocks.
So any ETF, even a vanilla S&P 500, offers the AP a chance to make money via arbitrage. The total artitrage profits may be much greater than the published fees, and depending on the terms of the contract, the AP may have to split these profits with the sponsor. This arbitrage does keep the ETF price in line with the underlying stocks, but at a cost. The only source of these profits is the investors in the ETF.
Yes, I am very familiar with the AP process, although not with an articulation as clear and thorough as yours. But be fair. The friction involved is very small in proportion to all the tax savings, liquidity and other benefits of the ETF structure.
The amount they’re making is secret – but why do you think there are thousands of ETFs with very low official fees? I have to admit, I suspect this money is not small, particularly in violently gyrating markets.
You have the reputation to pull off the creative Sherlock Holmes vehicle. My reputation would limit me to using Inspector Clouseau.
Ha ha. I am bumbling enough but I don’t have the sense of humor!
Elementary!
Ha, ha. Hey Mike, but trying to write this thing was anything but elementary!
Thank you. I have always been drawn to relentless detectives (like Holmes and Columbo) for their relentless pursuit of the truth. They remind me of my Dad’s approach to sizing up the investment merits of a building. He would dismiss the seller’s income and expense statement and ask for the tax return and access to the repair superintendent.
Yes, ETFs can invite abuse. One disadvantage is that unlike mutual funds they have bid-ask spreads, nicking periodic retirement contributions and eroding the power of compounding. This is especially the case for those low volume, high friction erotic ETFs that play on investors stock-picking impulses.
Sorry, intended for Edmund Marsh! But thank you. I am hoping readers enjoy the piece as much as I did writing it.
That was both clever and fun.
Great vehicle for your story, Steve! My daughter uncovered it first, and clued me in this morning that I shouldn’t miss it. You captured Doyle’s style and included many of the essential elements of a good Watsonian tale. And I believe you have previously presented a short monograph on the dangers of some ETFs…
Sorry, Edmund, but I inadvertently posted my response to you over Dan Smith’s comment above. Must be too early in the morning here for an old man!