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John Bogle Is Wrong About ETFs

The Vanguard legend is mistaken: ETFs are a good tool.

John Bogle is wrong.

The founder of the index fund giant Vanguard took to the editorial pages of the

Wall Street Journal

just before the weekend to denounce exchange-traded funds for "their overlay of costs, limited diversification and short-term trading strategies."

These ETFs, which are booming in popularity among investors, trade all day on the market like regular shares, and they invest their money in a passive basket of stocks. Bogle said ETFs were inferior to regular index funds -- first pioneered by Vanguard -- where you invest directly with the company and which are traded just once a day. These, he argued, offer inexpensive diversification and a long-term "buy and hold" strategy.

(Jim Cramer, of course, also criticized ETFs last week. His case seems to be that you're better off buying individual stocks. That raises a different set of issues than Bogle did. You're either comfortable buying individual stocks, or you're not.)

I don't mean to beat up on Bogle. He is, or should be, a hero to every average investor. His low-cost index funds helped drive down expenses across the industry, raising investment returns for many. But his column, which has sent ripples across the financial media, misses the point. Exchange-traded index funds are only inferior to regular index funds if you use them incorrectly.

Why? There are many kinds of investors. Let's say you want to follow Bogle's strategy, which is to spread your money across the market in an index fund and forget about it. In that case, an ordinary index fund may well be your best bet. Your costs are low. You can get widely diversified: In fact, if you use the

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Vanguard Total Stock Market Index fund (VTSMX), you're spread across the entire market. You pay no broker's fees, provided you buy the fund direct from Vanguard. It's a good strategy.

And it's certainly better than the one too many people use, which is to jump into a mediocre, actively managed fund with high fees after it's had a good year, and then panic and sell if it falls.

But there are four problems with this argument. The first is that you can also pursue this strategy using an exchange-traded fund. The biggest difference is just that it will be easier to trade. If you fear that trading is going to end up destroying value, then don't do it. Leave your fund alone.

The second problem is that even if you want to follow Bogle's index strategy, you may well be using an online broker to manage your money, and that broker may charge you a trading fee to invest in a Vanguard fund anyway. Many people manage their finances through an online broker for the simple reason that it is very convenient. You can make an investment when you actually have the time, such as when you're in the office and stuck on hold.

And when you invest through an online broker, you have all your money in one place. You get to make investments easily when money comes in, and that isn't always easily predictable from month to month. For those people, an index ETF may work as well as an index mutual fund. Contrary to what Bogle suggested, buying and holding an index ETF is little different from buying and holding an index mutual fund.

The third problem is that it is harder to move money in mutual funds, even if a rival company offers a better deal. If you have your money at Vanguard, and Fidelity cuts its prices, switching is time-consuming and involves paperwork. But if you have an account with an independent broker and buy ETFs instead, you can shop around at the click of a mouse.

But the biggest problem with Bogle's argument is none of the above. It's that not everyone wants to follow his index strategy anyway.

I have said before, and I will say again: The Bogle approach is better than most investment strategies, but that does not mean it is better than any investment strategy. Some people want to manage their own investments, and some of those people will do better than the market.

I have seen the stock market do too many stupid things during the decade I have been following it closely to believe that it is always right. I have seen bargains go a-begging, and I have seen bubble stocks float up to ridiculous prices. The market and individual shares do not move in smooth, gradual progressions.

Other investors will do almost as well as the market with a lot less risk. Talking about infinite investment horizons, as Bogle does, is fantasy. Most people have bills they need to pay even when the market is down.

For people who want to manage their own money, ETFs can be simply superb. Among many benefits, they offer a low-cost way of betting on an entire sector or an asset class. They can be much better than the most common alternative, which is buying individual stocks. And you get to choose among a wide variety of ETFs, because there are multiple companies offering them.

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For example, Vanguard offers an index mutual fund that tracks "mid-cap growth" stocks. That's the kind of asset class I consider to be a joke. On the other hand, you can find ETFs that will track things such as inflation-protected bonds, the Singapore stock market or gold. These can be really useful.

(Vanguard, which is no longer run by Bogle, also offers a family of ETFs, although regular index funds still account for the bulk of its business.)

An example: Let's say that at some juncture oil stocks collapse simply because a hedge fund blew up and had to sell its position. You figure oil stocks are really cheap, and you want to invest. Twenty years ago, before the arrival of exchange-traded funds, you would have had two choices: buy a mutual fund that invests only in oil companies, or buy individual oil stocks.

Both would be very expensive for the ordinary investor. The oil mutual fund would charge you a high upfront sales fee, plus heavy management expenses every month. A rip-off.

Meanwhile, buying individual stocks would be even worse. You would have to pay a trading fee on each one, so if you tried to buy a diversified basket, you would pay through the nose. And even with the best intentions in the world, you probably wouldn't end up fully diversified. No private investor could afford the fees needed to invest in every single stock in the sector.

The result: You would start adding stock risk to your sector risk, because you would have to pick some stocks and not others.

Now consider the same situation today. If you figure the oil sector looks cheap, you can just go out and buy a sector index fund -- such as State Street's Energy Select SPDR

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-- that invests across the sector.

Costs? A one-time trading fee, which can be as low as $10, and ongoing management fees as low as 0.24% of your assets. And because it trades throughout the day like a stock, you can get in or out whenever the market is open.

I use this particular example because it is exactly one that arose in May of 2005, when I wrote a column for the

Boston Herald

. Oil futures, and oil stocks, had slumped because of some hedge-fund blowups. I recommended exchange-traded funds, or a do-it-yourself basket of oil shares.

Both have vastly outperformed the stock market since. The Energy Select SPDR is up about 45% since then, compared with just 20% or so for the

S&P 500

index. (I should add that the Energy Select SPDR and other oil ETFs did even better than my do-it-yourself fund. So much for stock selection. My takeaway was, if you just want to bet on a sector, bet on the sector.)

There is absolutely nothing wrong with Bogle's approach. It's better than most. If you don't really understand investing, or you don't have time to do all the homework, putting some money away in an index fund can be a great idea.

But if you are the kind of person who wants to manage your own investments, ETFs can be terrific. They often make better bets than buying individual stocks, with all the extra risk that entails.

What Bogle really seems to object to is people managing their own investments. He points out that many -- most, really -- do it poorly. That's true. But he then concludes no one should do it all. That doesn't follow.

In keeping with TSC's editorial policy, Brett Arends doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Arends takes a critical look inside mutual funds and the personal finance industry in a twice-weekly column that ranges from investment advice for the general reader to the industry's latest scoop. Prior to joining in 2006, he worked for more than two years at the Boston Herald, where he revived the paper's well-known 'On State Street' finance column and was part of a team that won two SABEW awards in 2005. He had previously written for the Daily Telegraph and Daily Mail newspapers in London, the magazine Private Eye, and for Global Agenda, the official magazine of the World Economic Summit in Davos, Switzerland. Arends has also written a book on sports 'futures' betting.