Vanguard’s chairman emeritus reflects on the short but profound history of exchange-traded funds and how it changed the advisory industry.
Jack Brennan served as chief executive officer of Vanguard Group from 1996 to 2008, and added the title of chairman in 1998 when Vanguard founder John Bogle retired. He began his Vanguard career working closely with Bogle as assistant to the chairman, and now retains an office at the company’s Valley Forge, Pa. headquarters, holding the title of chairman emeritus. During his tenure, Brennan guided Vanguard’s rise from renegade indexing pioneer to the biggest mutual fund company in the world, with more than $2 trillion in assets under management. Brennan remains an in-house resource for Vanguard’s senior management, and is a featured speaker at IndexUniverse’s Inside ETFs conference Feb. 10-12 in Hollywood, Fla.
IndexUniverse: Let’s start off with talking about the history of Vanguard with ETFs. Vanguard was initially hesitant to embrace ETFs, right? Can you tell us a little bit about how that changed?
Jack Brennan: I don’t think "hesitancy" is quite right. We didn’t feel pressed to jump into the ETF business. But it was clear to us, a decade ago, that this was something that could and should both enhance the visibility and the credibility of indexing broadly, where we’re the dominant force in the mutual fund space.
We weren’t totally sure about the relevance and pertinence to our clientele. But we said, “Let’s experiment,” which is the way Vanguard starts a lot of things. Then, at the same time, we said, “We think there's a better structure for these products.” And, as I think you're probably familiar, we have a patented structure. Vanguard’s ETFs are a share class of our existing index funds, which allowed us to launch the funds with scale and lower cost than most people could, as a matter of course. So the startup was slower. It’s always slower than you would hope. But in our case, the structure has turned out to be a great boon for us, in terms of the ability to get the business ramped up pretty quickly.
But I think it’s clear that we didn’t foresee how rapid and extensive the adoption curve would be. We thought it could be a good business. We didn’t—at least I didn’t—see just how extensive and how important it could be to Vanguard in a pretty short period of time.
A lot of it is great execution. In my view, the ETF is a great innovation. And the advisor community and the institutional community have seen that and adopted it quicker than I expected.
IU: In retrospect, what was so attractive about ETFs?
Brennan: First, parallel to the ETF explosion, if you will, was a relatively rapid change in the thoughts about the advisor-value proposition. Where is the advisor’s value? Is it in picking between Cisco and Intel today? Or is it picking between large-cap, growth-fund A or large-cap, growth-fund B? I don’t think so.
What’s happened is the value proposition of the advisor has gone up a level to strategy, such as helping people really do planning and helping people manage those plans and stay on that plan, rather than the small tactics of selection here or selection there. ETF fits beautifully into that. If your value added is that strategy, the tool is the ETF. That combination of a fabulous new tool in ETFs and the advisor’s change to an asset-based fee structure is a great explanation for the change.
Brennan (cont'd): The second is indexing, which was a pure curiosity when we got into the business in 1975. If you're the advisor, it fits beautifully with what you think you can do and provide to your clients, with the aim of being the highest-value advisor you can be. So you get a confluence of things that happen. And then you get a force like Vanguard that comes in and enters the advisor space, largely with ETFs. There are a lot of things that led to broad adoption of ETFs. None of it would be true, by the way, if it wasn’t simply a great product.
IU: Let’s talk briefly about Vanguard’s VIPERs. What exactly was the thinking when that started? Weren’t those really ETFs?
Brennan: They're actually the same product, just a different name. We initially branded them VIPER, which stood for Vanguard Index Participation Equity Receipts. And then, after a couple of years, we said, “When we talk to people, we say, ‘These are Vanguard ETFs.” So it was probably a misadventure on our part from a branding standpoint, although it has enduring value. But they're the same products.
The important part of VIPERs, when they came out, was this structure that allowed you to launch a bond ETF off the portfolio of a $50 billion existing index fund. And it’s why we, not uniquely, but aggressively, say, “These are index funds, just another form of indexing, where other people still want to create a sense of exoticness about them.” And advisors liked it better when they became the Vanguard ETFs, because it had explicit brand value.
IU: Are there too many ETFs?
Brennan: I've always believed there's a big difference between innovation and proliferation. And we have had both. Proliferation is a bad thing, in my view. And, yes, there are too many ETFs. Now it doesn’t mean there can't be new ones that will be valuable. But, when you look at the list of new products that have come out, you question the enduring value of many of them. That said, I think the fact that closures are occurring is a good thing, because the market is saying, “No. That’s not credible.”
I worry that too much proliferation can dilute the overall message of the power and the value of the ETF itself. This is a concern for all participants in the market. You end up with things that are so niche-y, they go against the principles of indexing. They're not low cost, and they're not diversified.
At the end of the day, the real ETF has to be scale-driven and cost-driven. Don’t forget that there are 35 or 40 ETF sponsors. You probably have too many sponsors producing similar products that can't reach scale and thus can't be low cost.
IU: How do ETFs get into the 401(k) space?
Brennan: I think that, in some ways, there is a less compelling need for ETFs in the 401(k) space than there is in other places, because the sponsor should have access to similarly priced index portfolios. For example, buying Vanguard Total Stock Market in the Vanguard 401(k) plan is functionally just as good as having VTI in the 401(k) plan. So, the question I would ask would be just a little different. How do we get correctly priced index options—ETF or not—to be more prevalent in 401(k) plans, large and small?
Brennan (cont'd): If it’s just a straight index mutual fund, arguably it’s probably better than the ETF because it’s administratively less complex. For example, there is no bid/ask spread. There are a whole bunch of things that make a fund easier to administer. And you know you're going to buy it every two weeks, or once a month, or whatever. So tradability doesn’t really have much value to you. But again, you're on the right issue, and I would just define it a little more broadly about well-priced index funds, as opposed to ETFs.
IU: When do you see this fee war coming to an end?
Brennan: At the end of the day, for Vanguard, it is a different question. We give scaled benefits back to the customer. We just give them back in lower fees. So the question is, “Do people want to use temporary or permanent loss leaders in certain instances?” They may. To me, it feels like we’re down near where that floor is. I think it’s safe to say prices aren’t going up. The investor is benefiting. And, at least from where I sit, you can see a sense for this “Vanguard Effect.” It sounds egotistical, but it’s not intended to. It’s someone else’s expression.
When a force like Vanguard comes along, builds scale and competes in a price-driven business, you have to match us or come close. And I think that’s probably the way this dynamic plays out for a while, because there is more, as you know well, than merely a temporary fee reduction or something else that goes into cost. You need large size and great liquidity to make the total cost of ownership the best that it can be.
The Vanguard Effect is not going to go the other way. There are certainly other issues such as index-provider fees and administrative fees. How the whole package adds up is a really interesting question. But the past four or five years have been dynamically wonderful for the consumer. And that’s a good thing, in the end.
IU: Do investors have better portfolios than they had 10 years ago?
Brennan: There's no question. Up until 1977, Vanguard’s history was as a load-fund company, which is sort of lost in history. But in the last several years, we’ve become, again, we hope, a very valued provider to the advisor community. It’s been a ball for us. We love it, because most of the world is going to have an advisor. And if we can provide our products and help them do their jobs better, all the better.
So we get a chance to see what portfolios looked like many years ago, and what they look like today, and they're just strategically better structured. There's always going to be tinkering at the edges. But you look at the diversification, you look at the embedded costs, and they're better portfolios.
Brennan (cont'd): And it’s not just ETFs. It’s indexing as well and a generalized awareness that cost matters. I love talking to advisors and asking them how they use ETFs. And they're using them right. They're using them instead of, again, deciding whether they like three tech stocks or four other tech stocks today, and so on. None of us stays in the business unless we have clients who make money and are satisfied. We’ve been active in the advisor space for seven or eight years, and clients have better portfolios today.
IU: One of the biggest innovations coming to the industry is the idea of actively managed ETFs. What’s your feeling about that?
Brennan: I have to admit, I have never totally gotten the active-ETF idea. It’s probably because I believe an ETF is an index fund. So the question is, How active? If it’s a broadly diversified “active portfolio,” it makes some sense. If it’s a high-turnover, active-equity strategy, it’s not totally clear to me what value there is in having that package as an ETF. It’s an interesting part of the business. The idea that active ETFs are going to be a big deal is 10 years old. But only a couple of active bond funds have gained traction. And it may make more sense in a bond fund. But I have to admit, I scratch my head. It almost feels like an oxymoron to me to say “an active ETF.” There ought to be a different categorization for an actively-managed product, to be blunt.
IU: What is your single biggest accomplishment during your tenure at Vanguard?
Brennan: You know what it is? It’s people. For me, because I had the privilege of being president for 20-something years and the CEO for 12 or 13, the biggest thing that I could do is try to get the people right, and [newly retired Chief Investment Officer] Gus Sauter is a classic example. The fun for me with Gus is that we just passed our 40th anniversary together in September. We met the first day of college at Dartmouth and re-engaged at our 11th reunion. Some may think this apocryphal, but I sat and talked to him and then came home and said: “This guy ought to be working at Vanguard.” The rest is history for the last 25 years. But he’s an example of—let’s see: ethical, brilliant, high values, humble, no ego. Why wouldn’t I want him on our team?
For me, the most important thing that I have done here is get the people right. It’s building that extraordinary success across the board. It all starts with the people. That’s the only thing I care about, frankly. One of the great things about people here at Vanguard, is that nobody will take credit for anything.
IU: Is there anything that sticks out that you wish you could redo or not have done?
Brennan: Speaking of Gus … Gus and I were dissed in the popular press for being bearish during the tech bubble, as if we didn’t get it. How could guys this young be that out of it? But I really wish we had been more strident in warning people. But I personally wasn’t aggressive enough. It was so obvious of what was happening. I look back and say “lesson learned.” When you're confident that something is awry, be as aggressive about it as you can. If you're wrong, nothing bad happened. But if you're right, you will have helped your clients a lot. Frankly. I wish I had been more strident.
IU: Any closing thoughts, Jack?
Brennan: Most people need an advisor. They really do, because they serve as a guide, as a strategist, as a shock absorber for them. If you don’t have an advisor, then how do you establish your plan? Investing is for pros. It’s not a game. This is not whether the Raiders won or lost on Sunday. This is a 20- or 30-year endeavor. You should kick the tires before you hire an advisor. Look them in the eye. Do I trust them? Give me some client referrals? How do you think about implementation of strategies? And so on. It’s a big deal. This is arguably bigger than picking a doctor.