John Bogle is the father of index funds -- those mutual funds that simply track various indexes of stocks, investments that we've championed for more than a decade here in Fooldom. So when he speaks, we ought to listen.
In The Wall Street Journal last month, Bogle offered some interesting thoughts (the article is accessible to WSJ.com subscribers) when he criticized the recent surge in popularity of exchange-traded funds, or ETFs.
In tracing index funds' awesome rise to prominence, Bogle mentioned how index-fund assets grew from 1% to 17% of the total assets of stock mutual funds between 1988 and 2007. But he noted with concern that today's 17% can be divided into 10% for index mutual funds and 7% for ETFs, which are growing at a far faster rate.
ETF warning
On the surface, there doesn't seem to be much wrong with that. After all, ETFs are stock-like devices based on indexes, and they work very much like traditional index funds -- they often offer low fees, for example. But since they can be traded like stocks, people can, in Bogle's view, abuse them.
He's got a point. Whereas classic index investing would have you plunk your savings into a broad-market index fund or two for decades, so as to reap market-matching returns, ETFs permit you to invest in gobs of smaller sectors of the market for as short a time as you want, and you pay just your broker's commission for as little as one share at a time. As Bogle noted, "If long-term investing was the paradigm for the classic index fund, trading ETFs can only be described as short-term speculation."
He also points out that out of nearly 700 ETFs, only 12 represent broad market segments, such as the Standard & Poor's 500, the Dow Jones Wilshire Total (U.S.) Stock Market Index, and the Morgan Stanley EAFE (Europe, Australia, and Far East) Index of non-U.S. stocks. At the other end of the spectrum are ETFs such as HealthShares Emerging Cancer (NYSE:HHJ), which invests in 22 small companies that are trying to find a cure for cancer.
What to do
Bogle makes a good case. He points out that when people are chasing hot sectors with ETFs and are investing emotionally, they've left the classic utility of indexing far behind. I agree. So perhaps what we now have to do is resign ourselves to a more complex world of indexing, with classic buy-and-hold, broad-market investing in one corner, and the active trading in big and smaller niches made possible by ETFs in another.
Fortunately, we can cherry-pick from among the possibilities facing us, too. For example, you might keep the lion's share of your nest egg in an S&P 500 index fund (or one based on the even broader Wilshire 5000), while investing some smaller sums in areas you've researched and have high expectations for, such as, perhaps, energy stocks, or Latin American companies, or what have you. Do keep in mind some cautions, though: Excessive trading -- in stocks or ETFs -- can be hazardous to your wealth, partly because of commission costs and taxes, and also of because the less reliable environment of short-term trading.
I encourage you to learn much more about ETFs by checking out our ETF Center. It features info on how ETFs stack up against mutual funds, how to develop an investment strategy with ETFs, how to steer clear of pitfalls, and how to avoid ETF impostors.
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Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
