The Dark Side of The Vanguard Effect

Just this month, Vanguard has directly and indirectly rocked the ETF world twice. On October 2, Vanguard, the third-largest U.S. issuer, announced it would drop MSCI (NYSE:MSCI) on 22 of its ETFs. On Monday, BlackRock's (NYSE:BLK) iShares unit, the world's largest ETF sponsor, announced significant fee reductions on some currently existing funds and new low-cost products aimed at buy-and-hold investors.

In the process, iShares is arguably admitting what many ETF industry observers believe to be fact: That Vanguard's low-cost approach, which made the firm one of the most dominant mutual fund providers, has translated well into the ETF business and Vanguard has been pilfering assets from iShares.

As of October 11, iShares had $525.5 billion in AUM while Vanguard had $231 billion, according to Index Universe data. That chasm is wide enough to ensure the crown iShares wears as the biggest ETF company is unlikely to be wrested anytime soon.

Still, market observers love a rivalry just as much as sports fans and however contrived it may be, iShares and Vanguard do have a legitimate tussle going it. That said, it must be acknowledged talk of Vanguard toppling iShares ignores State Street (NYSE: STT). That is foolhardy because the company's State Street Global Advisors has almost $325 billion in ETF assets.

Vanguard will have a hard enough time getting to second place, let alone first, but investors seem enthralled by Vanguard's low fees. The firm itself acknowledged it was the "Vanguard effect" that prompted the iShares fee reductions.

With what many have deemed an ETF price war in full effect, it is clear investors, particularly the retail crowd, are winning. However, a case can be made the Vanguard effect is not all its cracked up to be.

Performance, Performance, Performance Expense ratios are just one factor investors need to consider with ETFs. Bid/ask spreads, commission costs and availability of options on selected ETFs are other important factors. So is performance. Vanguard currently issues 49 ETFs, most with fees that are far below comparable funds and all but five have generated positive returns since inception.

Of course, fees impact performance. Assume Joe Investor puts $10,000 into an ETF with an expense ratio of 0.1 percent and $10,000 into an ETF with fees of 0.3 percent and parks the money there for 10 years while both ETFs generate the exact same market returns, the one with the lower fees leaves Joe with more money.

It is that scenario that might be covering up some harsh realities regarding the performance of Vanguard ETFs against rival funds.

Take the case of the Vanguard Dividend Appreciation ETF (NYSE:VIG). VIG, which charges just 0.13 percent per year. VIG is the largest dividend ETF by assets. VIG is also a simple ETF to understand. Constituents need to have impressive track records of boosting dividends for possible inclusion in VIG's index. The ETF also features a piddly 2.33 percent yield.

Over the past year, VIG is up a solid 14.5 percent, but that performance is nowhere close to the returns offered by the WisdomTree Total Dividend Fund (NYSE:DTD), the SPDR S&P Dividend ETF (NYSE:SDY) and the iShares Dow Jones Select Dividend Index (NYSE:DVY). All three of those ETFs have much higher expense ratios than VIG, but the performance gap is too wide to say it is worth it to "go cheap" with VIG.

In the case of DTD, that ETF charges 0.28 percent per year. That is not bad in general, it merely looks bad next to VIG. However, most investors would probably pay an extra 15 basis points in fees to garner more than 900 basis points more in returns and that is how much DTD has outpaced VIG by in the past year.

More Examples Since the mainstream press has anointed Vanguard the low-cost leader, it is often forgotten that, at least for now, the select sector SPDRs have lower fees than the equivalent Vanguard sector funds. The difference is scant (just one basis point in most cases), but it is the returns that matter. To be fair, not all the select sector SPDRs beat their Vanguard rivals over time, nor does Vanguard win every matchup.

Here are some examples where Vanguard does not emerge victorious. Over the past five years, the Vanguard Consumer Discretionary ETF (NYSE:VCR) is up 21.7 percent. Nice, but that trails the Consumer Discretionary Select Sector SPDR (NYSE:XLY) by more than 500 basis points. Over the past year, the gap is even more alarming as VCR is up 21.2 percent while XLY is up almost 34 percent. Remember, XLY is the cheaper of the two.

Similar scenarios are found in other sectors. The Vanguard Information Technology ETF (NYSE:VGT) is up just 12.7 percent over the past year despite a 20.5 percent allocation to Apple (NASDAQ:AAPL). With a comparable weight to Apple, the Technology Select Sector SPDR (NYSE:XLK) has gained almost 27.6 percent over the past year.

The iShares Dow Jones US Technology Index Fund (NYSE:IYW) has a higher expense ratio than both VGT and XLK, but the ETF does have the largest weight to Apple. IYW has also beaten VGT by a wide enough margin over the past year to justify its higher expenses.

Over in the energy patch, over the past year and five years, the Vanguard Energy ETF (NYSE:VDE) has been crushed by the Energy Select Sector SPDR (NYSE:XLE) and the Guggenheim S&P Equal Weight Energy ETF (NYSE:RYE). Over the past year, RYE and XLE are both up more than 24 percent. VDE is not even up nine percent.

Options Action Not all ETFs have options trading on them. In fact, the list of optionable ETFs from the Chicago Board of Options Exchange is small relative to the total number of exchange-traded products on the market today.

Maybe it is due to the belief that Vanguard ETFs are heavily embraced by buy-and-hold retail investors. Perhaps there is another reason, but whatever the reason is, many of Vanguard's ETFs currently do not have robust options activity compared to direct rivals.

Take the example of the Vanguard MSCI Emerging Markets ETF (NYSE:VWO) and its most direct competitor, the iShares MSCI Emerging Markets Index Fund (NYSE:EEM). Five in-the-money October call contracts on VWO, strikes $36, 38, $40, $41 and $42, currently have combine open interest of less than 800 contracts. The EEM October $41.50 calls, now barely in-the-money, have open interest of almost 26,000 contracts alone.

The example of VDE and XLE is even more stunning. At least this month, it appears hardly anyone is interested in VDE calls. The XLE October $82 calls, which are deep out-of-the-money, have more open interest alone than all the listed VDE October calls combined.

That scenario repeats when looking at the open interests for VGT and XLK. To be fair, it probably is not Vanguard's fault that options activity on some of its ETFs pales in comparison to rival funds. Many iShares ETFs and SPDRs have strong institutional followings, which can be a catalyst for increased options volume. Additionally, availability of options and the depth of an ETF's options market should not be an investor's primary concern in choosing a fund.

Still, it is worth noting that some conservative investors, many of which are Vanguard's target market, have embraced covered call writing over the years. That particular income-generating endeavor is diminished with some Vanguard ETFs.

Bottom line: Vanguard is dominant force in ETFs. Nearly everyone knows that now and the company's ability to affect ETF pricing is good for retail investors. Claiming Vanguard's presence in the ETF arena is bad for investors is flat-out inaccurate. However, no ETF sponsor is perfect. To that end, investors would do well to not immediately be seduced by low fees and exam some rivals to Vanguard ETFs so that an informed decision can be made.

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