Interview with Noel Archard, Principal: The Vanguard Group
ETF Investor is delighted to publish an exclusive interview with Vanguard Group “ETF Boss” Noel Archard (pictured left). Noel Archard heads Vanguard’s VIPERs® Institutional Sales Team. He was previously responsible for the product management of the VIPERs® lineup across multiple business lines within Vanguard. Mr. Archard has been involved with Vanguard’s ETF program since 2003. Seeking Alpha contributor Russell Bailyn (pictured right) spoke with Mr Archard on April 20, 2006, in an interview arranged by Seeking Alpha for publication on ETF Investor. This article is a paraphrase of Mr. Archard’s responses, should not be viewed as verbatim quotes from Mr Bailyn or Mr. Archard, and is best used as one among many information sources. You can visit the article below, or read it here.
Why did Vanguard choose to make their exchange-traded funds a share class of the open-end index funds rather than a new fund offering?
We structured it this way because we thought it was the best way to put together the ETF. There may have been easier ways, but when you think about the synergies you get out of running a portfolio, the more tools you have at your disposal the better, including both tracking and tax efficiency. When you look at the Vipers as an extension of the larger portfolios, we get a couple of really nice benefits out of it. First, Vanguard is launching the Viper class out of a broad and already established group of portfolios, so you get instant track from an established set of holdings. Second, you get the benefits of economies of scale. The REIT Viper was released at 18 basis points and six months later we were able to drop it to 12 basis points. Third is the overall tax efficiency of the whole portfolio. When you think about it, the goals of an index fund are primarily to track well and have the funds be as tax-efficient as possible. We’ve got an investor share class which is the traditional fund. If someone does a redemption, we’re out there every day with loads and loads of lot structure across that portfolio - we’re going to sell the high-cost shares for a loss to carry forward. If a big institution does a redemption in an institutional share class, just like with the ETF, we can redeem shares in kind and get the low cost at that. If there’s a Viper redemption, we get the low-cost basis stuff out. So, we feel that we have a variety of tools at our disposal to manage the portfolios as tax efficiently as possible. When we first launched, people thought the Viper was like the boogie man. They were concerned that if there were massive redemptions in the investor share class, that would ultimately transfer tax consequences to the Viper owners.
Smith Barney and Morningstar have run studies on what would happen if one investor type was selling this thing like crazy. Generally if you see big redemptions in a fund, it’s because that overall asset class has dropped down. When that’s dropping down, your cost basis is dropping down. We stress test the portfolio and we find a 10-12% redemption would be necessary before this type of cap gain scenario would even come about. We looked at all of this and decided that the benefits of the share-class structure were so overwhelming that, where we can, we want to use this format. Down the road there might be products that don’t fit that structure, but for now that structure works for us.
The other thing that is different about the Vanguard ETFs is Qualified Dividend Income. We always talk about tax-efficiency from a capital gains distribution standpoint (or lack thereof) but if you’re in a taxable account what you’re interested in is your after-tax performance. That’s made up of capital gains distributions and, in today’s environment, what portion of your income distribution you are going to have taxed at 15% vs. your marginal tax rate. With the ETFs, because of the creation and redemption cycle within them, if we have a redeem coming and need to deliver stock out of the account, if that was a lot class that had just paid a distribution, it’s possible the shares that we deliver out would mean that we don’t qualify for 100% QDI on that distribution.
Because the Vipers are built on long, established portfolios, our QDI the last two years has been above our competitors. This isn’t a make or break situation because at the end of the day this should be factored into the individual shareholder, but it can be of impact and should be factored into the after-tax return. As the ETF industry gets older and everyone’s lot structure gets increasingly deeper and broader, that QDI difference will probably fade over time. But right now that’s something that is interesting about Vipers in the short term.
New indexes which aren’t based on market-cap are popping up more and more. They also have been getting better at outperforming the S & P. One example of that is the RAFI (Research Affiliates Fundamental Index). This index, some believe, offers a better picture of the market because it underweights overvalued stocks and overweights undervalued stocks. Do you think the days of market-cap weighted indexes may be numbered?
I think ultimately indexes should represent the market that they are trying to cover. If you’re going to invest in an index, you want to get the free float adjusted market representation of that space. When you look at equal-weighting, RAFI, or however you want to approach it, it’s not a better or worse proposition. Their (RAFI) story has changed over time, but when you look back around, it’s a methodology decision; over or underweighting a security based on fundamental criteria, be it revenue or whatever factors they build into the model, is ultimately discretionary. This is similar to what an active manager would do in the value space. I think it’s currently in evolution, and you wouldn’t say that market-cap will go away since ultimately market-cap is the market. For broad free float access to market space, that’s where you want to be. Anything you look at is going to be time and series dependent. Depending on the investor at a period in time when they need to meet a liquidation need, these different strategies can work for or against you. It’s just a different approach. The only question I would pose is if it’s that easy to beat the market over time, lots of folks would invest in the same way, and then perhaps the effect would go away.
What about Powershares and the Intellidex system they are employing?
That’s a structured equity approach. Again, not better or worse, just a different way of getting to a point. There are different risk attributes and turnover profiles. The biggest thing we have to deal with in our industry in the coming years will be investor education from the big institutions because you finally have such a wide variety. You’ve got market-cap vs. equal weight vs. fundamental structure. You’ve got traditional index vs. structured-equity. You can try to build the market through sectors and sub-sectors, it’s hard to tell what will work. There’s a lot of choice, and choice is good, but choice can be confusing too.
What about the fact that none of these ETF sponsors popping up anticipate having an expense ratio as low as the Viper shares?
The expenses are in some ways a litmus test of what the methodology is. It’s cheaper to manage a portfolio which is free float adjusted, that changes on a systematic basis, that tries to minimize turnover and has ways of graduating stocks in and out of the target benchmark. You’ve got some single point commodities now that are more expensive than average ETF expense ratios because they have a trading team to focus on rollover risk and buying and managing futures within a portfolio. It’s just a different dynamic.
There’s recently been buzz in the ETF community about narrowly focused fund families such as Ferghana-Wellspring. What’s your feeling about these companies as either competition, or an important addition to the ETF market. What do you think the response will be from the investing community?
I think ETFs are like any other financial product out there. There is a lot of demand for very targeted portfolios because there are tens of millions of investors out there and everyone wants something specific for their portfolio. You’ve got two dynamics in play here: the first is exchange-traded funds because the nature of the portfolio is low cost for the fund sponsor to operate. There’s one omnibus account that you have to manage and then it’s up to the broker dealer community to provide the record keeping and distribution services for that. There might be some temptation among fund sponsors since it doesn’t cost much to run the portfolio to put out something which there’s demand for right now. Can you find enough investors to make it financially worthwhile to put these products out there? It’s like anything else - we saw in the traditional funds universe lots and lots of internet funds come back in the technology boom because that became an area of great interest which people wanted exposure to. Some of them are still around today and some are not. Ferghana-Wellspring may believe that for a variety of factors including people living longer, the boomer generation, etc., there is a need for their product. ETFs are certainly not immune to the laws of supply and demand. Although, even if the demand dies down, the fund sponsor can probably hang around a bit longer than a traditional mutual fund because the cost of running the portfolio is fairly low.
Another fund company, Wisdom Tree Investments, has recently come out with an ETF line. The firm is managed by industry powerhouses such as former hedge-fund manager Michael Steinhardt, Wharton-school professor Jeremy Siegel, and Jon Steinberg, son of corporate raider Saul Steinberg. The current rumor is that they’re releasing an all-dividend line, mostly in the small-mid cap and international sectors. Currently, Powershares is the only ETF family with an International Dividend Income Fund (PID). Have you heard about Wisdom Tree Investments, and do you think they are responding to a need, or capitalizing on a trend?
Generally, I don’t have an opinion on a competing management firm. I think this is following a trend out there recognizing that investors continue to focus on dividends going back a couple of years when changes in our tax code made it interesting to look for yield. That, combined with the demographic shift of people retiring, living longer, and wanting equity exposure with a little bit more yield to it. It’s certainly something that will remain of interest. The question will be how fine do you slice it, are there clear definitions of how you will approach yield for an emerging market, what will those benchmarks be composed of, and how do they fit into an overall portfolio. At the end of the day, we can continue to see a shift amongst investors not so much to find a product and say ‘wow let’s focus in,’ but more of a ‘let’s figure out what the overall goal is going to be, and the ultimate asset allocation which will get me there.’ Then you can consider active vs. passive management, and go from there. Like anything else, if there’s a long-term need for these products, they will continue to flourish.
Vanguard is respected for having extremely low fees on all their funds, including international funds which, historically, have higher expenses. Why haven’t the International Vipers - specifically VWO, VPL, and VGK - gained more popularity on EEM and EFA.
It comes down to the fact that they are fairly new (one year) and have grown nicely. From a point of view of coming to the market later than others, we’ve gotten the word out nicely. In a year VWO has cracked a billion dollars and VPL and VGK half a billion. Also, there may be tax implications for an investor switching their portfolios around into different fund families. In a way a lot of that growth has to do with financial advisors and institutions and we’ve seen a big pickup even in the last six months into these products. Like anything else, it’s a process to get the word out and have people aware that you have the product. We’re seeing VPL and VGK used by a lot of institutions because at 18 basis points each they can synthetically create EAFE and still get it at a lower cost even after transaction costs because they’re trading at institutional prices. It gives them a bit of opportunity to play with allocation.
Why hasn’t Vanguard rolled out more Vipers lately? Any plans for the future?
We’ve put a lot of efforts into our exchange-traded fund business and it’s grown enormously. We’ve got more Viper launches planned for this year. We’ve got a dividend growth product called Dividend Appreciation scheduled for release next week. The reason you don’t see hundreds of Vipers is to really narrow down our funds to benchmarks which are representative of certain market spaces. I can’t really speculate about the future. It’s unlikely you’ll see over a hundred Vipers, but certainly we’re not done at 23.
What about Vanguard putting out a fixed-income ETF?
We’ve got a dividend growth fund coming out in a week which will have a focus on income. As for fixed-income products, we are definitely looking into that. We have a large offering of fixed income in the traditional funds base, and we recognize growth opportunities for fixed income within the ETF space. That is an evolutionary issue as well because you need the transparency and liquidity within the fixed-income markets themselves to get better before the release of fixed-income ETF’s. When you think about that basket process itself, when we give up five million dollars of an ETF to a specialist and they give us five million dollars of bonds back, you need to know that those bonds are five million dollars worth of bonds. If they don’t trade very often and people aren’t making a market in them it can get tough - this is why you don’t see so many fixed-income ETF’s yet. As the fixed-income markets go through their own evolutions and the trading systems continue to improve, you’ll see more interested sponsors, and more capability in delivering products that better track the benchmarks we want to go after.
Do you think the strong flow of funds into ETFs in 2004 and 2005 was in any way a reaction to the mutual fund scandals? Or, do you think portfolio managers just caught on late to the positive aspects of ETF investing?
Yes, when you look at 2004, the scandals were very real and were a factor. As we moved away from it, flows into other fund families continued. The unsung hero for ETFs is really the ease of operations it offers ordinary investors. It not only trades like an individual security, but its record keeping is easier as well. Institutions love it because they can price trading firms, it makes moving books of business much easier, and lightens tax situations for an aging investment population.
Are people starting to realize that active portfolio management isn’t always the way to go? What general direction are we headed for in terms of portfolio management?
We came out of 1999-2000 where a lot of people got burned pretty badly. It’s hard to keep perspective with the rapid evolution of investment products and styles. Just thinking about the flow of money into mutual funds in the last 20 years is quite different from the fixed-income approach many of our parents used. 1999-2000 drove home the point about the risks associated with individual stocks and reinforced the point of having a plan. Having an asset allocation strategy and sticking with it is a way to go. This lends credibility to the attractive aspects of using an indexing strategy: using indexes reduces your costs and costs are both the most controllable aspect of your portfolio and ultimately a large driver of your performance. It’s no longer one way or the other, (active vs. passive); there are now places for both styles in portfolios.
Russell Bailyn
rbailyn@gmail.com
