[00:03:07] Rebecca Hotsko: So I think our listeners are generally quite familiar with ETFs, but I think sometimes we still don’t know how they actually work. In order to frame today’s conversation, I was hoping you could start out by explaining how the ETF structure and ecosystem works. 

[00:03:23] Andrew Kadjeski: Absolutely. Rebecca. Actually, maybe before I get into the structure and ecosystem of ETFs, I can give just a brief 1 0 1 on ETFs and then I can dive into the structure.

[00:03:33] Andrew Kadjeski: Sounds great. So as many of your listeners probably already know, right? An ETF, which stands for Exchange Traded Fund, it’s exactly what it’s name implies, right? They’re, they’re funds that trade on in exchange generally tracking and index. And, you know, while they’re sometimes portrayed as these unique investment instruments, they’re actually overwhelmingly similar to, to mutual funds.

[00:03:57] Andrew Kadjeski: I would say the biggest difference between the [00:04:00] two is how they trade mutual funds. They’re priced, they trade once per day at the end of the day, based on their net asset value or n a AV of the securities in their portfolio. ETFs, on the other hand, they trade in the secondary market just like stocks, and they’re trading throughout the day.

[00:04:16] Andrew Kadjeski: And it’s this accessibility, which is one of the biggest advantages of of ETFs, like mutual funds, ETFs are pulled investment vehicles, right? They allow investors to own part of a basket of securities, and ultimately they help investors create a low cost, broadly diversified investment portfolio, especially when implementing index-based strateg.

[00:04:38] Andrew Kadjeski: For example, you know, one share of an ETF can give you access to, in some cases, thousands of securities, right? That would otherwise be extremely expensive and timely, right? For you to purchase and manage on your own. Take V t I, for example, that’s Vanguard’s total stock market ETF one share, which is trading at about $200 a share right now.

[00:04:58] Andrew Kadjeski: But for that, investors are getting [00:05:00] access to a portfolio that holds over 4,000 stocks. You specifically asked about the E TF ecosystems. I’ll go there now, but hopefully that background was helpful. So the way I think about it, for the average investor, you know, there’s really just three parts of the ecosystem that matter to them.

[00:05:16] Andrew Kadjeski: First is the e TF issuer, meaning what investment company is running the ETF like Vanguard. Second is the index that the ETF actually tracks. You know I mentioned V T I A moment ago that E TF tracks the CRISP US Total Stock Market Index. Most investors are familiar with the S&P 500, right?

[00:05:37] Andrew Kadjeski: Another popular index. Vanguards has an ETF V O O that tracks the S&P 500. And then the third element of the ecosystem that matters kind of the most is the actual brokerage firm where the investor has an account like an ira, where they’re going to actually buy and sell and hold the ETFs. Now, beyond those three core parts of the ETF ecosystem, I mentioned a little earlier ETFs trade on the [00:06:00] secondary market.

[00:06:00] Andrew Kadjeski: So the exchanges are a important part of the ecosystem. And then maybe the final unique element of the ecosystem to mention is what’s known as authorized participants or aps. And really at the highest level, investors can think of APS as the institutions that are responsible for holding the underlying securities of the ETF.

[00:06:22] Andrew Kadjeski: And ultimately, they’re the ones providing liquidity in the ETF market by matching supply and demand with available ETF share. Hopefully that’s, that’s a helpful landscape of the, the ecosystem of ETF. 

[00:06:35] Andrew Kadjeski: That was really helpful and I want to dive into those parts in more detail. One quick question on the authorized participant, because I think it’s really interesting to hear you talk about that because there’s lots of scandals going on in different exchanges with cryptocurrencies where they didn’t actually hold the physical asset.

[00:06:55] Andrew Kadjeski: And so I think that’s a good point to make about ETFs where if you’re buying the ETF, you [00:07:00] know that the. Participant is actually holding those underlying shares so it’s not just fake 

[00:07:05] Andrew Kadjeski: there. Exactly right. So to dive a little bit deeper into that, right? Again, you and I trade ETFs in the secondary market, products in the secondary market, right?

[00:07:15] Andrew Kadjeski: They’re priced based off of, you know, what people are willing to buy and sell them for. The risk here, just like any other stock, is that this could cause some high and low demand for an ETF, right? That could drive the price of above or below the underlying basket of securities and what they’re worth, but to alleviate this risk, that’s the role that these aps, these authorized participants, They have contracts with the ETF issuers like Vanguard, right?

[00:07:38] Andrew Kadjeski: So they can create and redeem ETF shares and bring that price back in line with the underlying securities. Hopefully that’s a, a helpful example to bring that to life. 

[00:07:47] Rebecca Hotsko: For sure. And I also want to touch on the index because this was something that I found quite confusing when I started out ETF investing.

[00:07:55] Rebecca Hotsko: Because every ETF you buy, even if it says it tracks the same, say like [00:08:00] US small cap market. Well, the underlying index, it’s tracking matters so much because that can really change the number of holdings and the ultimately the performance of it. And so I guess I’m just wondering how can investors tell what makes one index better than the other?

[00:08:17] Andrew Kadjeski: First all, I’ll take a couple steps back. I think it’s important to recognize that indices, you know, they serve a variety of purposes for the market, for investors. First, you’re often hearing stock market indices quoted in the media, right? They’re constantly flashing across the screen on c n BBC throughout the day.

[00:08:36] Andrew Kadjeski: First and foremost, they, they play a really important role in just providing investors an indication of the day’s market activity and performance. Second, and this is what you, what we’re going to talk about a bit more is, you know, indices also serve as these target benchmark. Right. For index funds and ETFs, the most widely followed benchmark I mentioned earlier, the S&P 500, that’s a gauge of the large cap US equities, right?

[00:08:59] Andrew Kadjeski: That [00:09:00] covers approximately 80% of the US stock market capitalization, and they may one final point worth making, you know, indices, they also provide this comparative performance measure, right? For investment products and like for mutual funds, ETFs, hedge funds. But to answer your question around how investors can think about comparing ETFs that have the same objectives, but hey, maybe different underlying indices.

[00:09:20] Andrew Kadjeski: At the highest level, we’d encourage investors to ensure that, hey, they’re getting full exposure to the market or sector that they want to invest in. Yeah, I mentioned the S&P 500 a few times now, but if a client wants exposure to the full investible market of US equities, they really should be investing in a total stock market fund like V T I, right?

[00:09:40] Andrew Kadjeski: Because the S&P 500 is only going to give them exposure to to large cap. 

[00:09:45] Rebecca Hotsko: And then I guess, what about combining different ETFs? Because I know if you are building, say, a globally diversified portfolio using a few different ETFs, if you combine ETFs that track different [00:10:00] indices, I think it’s footsy versus the crisp versus m, Ms C I.

[00:10:04] Rebecca Hotsko: And then you can have actually 

[00:10:05] Andrew Kadjeski: overlap. You’re exactly right Rebecca. Right, and hey, for any variety of reasons, some investors may choose to gain exposure through multiple sub-asset classes that you mentioned, right? Whether it’s they want an individual large cap or individual mid or small cap ETF. Now, if that’s the case, again, it’s really important for investors to understand how the different index providers define the sub-asset class.

[00:10:26] Andrew Kadjeski: You need to get under the hood of the e t. For example, again, if an investor were to choose an S&P 500 ETF, like Vanguard’s VOO right, for large cap exposure, but then the Russell 2000 ETF, like vt w o right, for small cap exposure, that investor would actually end up with gaps in their portfolio, right?

[00:10:45] Andrew Kadjeski: They’re, they’re going to be missing exposure to certain mid-cap companies. Again, at the end of the day, the simplest way for an investor to ensure they have exposure to the kind of the full investible market is to choose a total market. Yeah, that 

[00:10:58] Rebecca Hotsko: was really helpful. And then I guess [00:11:00] just on this example still, I know that back in 2012, Vanguard dumped the M S C I index in favor for Chris for most of the US funds.

[00:11:09] Rebecca Hotsko: And so that changed the benchmark that these funds were tracking. I was wondering if you could just talk about what was the reason for this change? I guess obviously Vanguard thought that it was a better index to track than the M S C I. Could you paint some color on maybe why that was? 

[00:11:24] Andrew Kadjeski: Yeah, absolutely.

[00:11:25] Andrew Kadjeski: You know, when it comes to evaluating and selecting the benchmarks for our index funds and ETFs, as you can imagine, Vanguard has a really robust process, right? We’re looking at multiple dimensions. You know, we’re looking at every front thing from their index construction methodology to their market coverage, their classification criteria, their approach to rebalancing, and of course we’re looking at their.

[00:11:48] Andrew Kadjeski: We also place a lot of value on the objectivity, the credibility, and the independence offered by the different index provider. In the case of Crisp back in 2012, as you, as [00:12:00] you mentioned, Vanguard did end up choosing their benchmarks for 16 of our domestic equity funds, including our flagship total stock market fund.

[00:12:09] Andrew Kadjeski: A couple key points I think are worth highlighting on that decision First. Crisp, they’re considered to be the premier data provider of historical US stock market data. They have a really strong standing, whether it’s across different academic government, the institutional investor circles, and that’s really be the product of, hey, they have more than 60 years of academic and research experience at crisp.

[00:12:32] Andrew Kadjeski: You know, second, I think it’s worth hiding, is their indices. They’re owned and they’re operated by crisp. And what’s that mean? That it means that they don’t really have any real or perceived conflicts of interests. They don’t have an exclusive relationship with Vanguard. They don’t have an exclusive relationship with any other fund manager.

[00:12:47] Andrew Kadjeski: Instead, they’re actually routinely working with us and other firms to get input and insights to improve their benchmarks. And it really, that all contributes to what we believe is a best in class practice for effective index Cons. [00:13:00] Right. They start with a, an objective rules-based methodology. You look at it, there’s really no ambiguity in their process about what they’re including and what they’re excluding and why in their benchmark.

[00:13:11] Andrew Kadjeski: And maybe the final point I’d make, Rebecca, is that this move, it enabled us to lower the cost of investing for our clients. About a decade ago when we made that decision, it was at a period where index providers were converging towards a set of industry standards and things like indexing, licensing costs.

[00:13:28] Andrew Kadjeski: They became an increasingly important factor. And so this move really provided some long-term cost certainty and savings for our millions of investors. 

[00:13:37] Rebecca Hotsko: That was really helpful. And I guess one of the benefits of holding ETFs is that they generally are these very low cost investment vehicles, but they still do have costs.

[00:13:48] Rebecca Hotsko: And as the ETF products are expanding, they can vary significantly based on what strategy. But one thing that comes up when it comes to the fees is that when we buy and sell an ETF, we [00:14:00] can see the expense ratio it charges. But if I sell my ETF, I don’t see those fees deducted on my brokerage. So I’m wondering if you can explain when and how ETFs actually take their fees.

[00:14:12] Andrew Kadjeski: So there’s actually three main costs that investors need to consider when they’re buying, holding, and, and selling an ETF. The first is actually the. These days, it is actually quite rare for a brokerage firm to charge a commission for an ETF trade, particularly if the investor’s, you know, doing it themselves online.

[00:14:31] Andrew Kadjeski: But nonetheless, it’s still an important cost to be aware of as an investor. Right? So that’s one is the commission. Second is what’s known as the bid ass spread. Just like a stock, there is a price spread, which as I’m sure your listeners know, right? That’s the difference between the highest price of buyers willing to pay the purchase, the shares, right?

[00:14:48] Andrew Kadjeski: That’s the. And then the lowest price that a seller’s willing to accept for the shares. That’s the ask. Many wildly traded ETFs though, in including Vanguards, you know, they have spreads that they’re as tight as a penny, right? So there’s, [00:15:00] it’s typically not that much of an issue, but again, it’s definitely something for investors to be aware of, particularly with brokerage firms that accept payment forward or flow midpoint, a trade at the midpoint, which is right, you know, in the middle of the, of the bid in the ass.

[00:15:14] Andrew Kadjeski: That’s generally considered the best price available. And at Vanguard, right? We provide midpoint pricing on over 95% of our clients’ Vanguard ETF trade. So execution quality on the spread is, is another cost to keep in mind. And then the third cost to be aware of it is what you mentioned, right? It’s the ETF’s expense ratio, which just like a mutual fund, it represents the annual operating expenses expressed as a percentage of the ETF’s average net assets.

[00:15:42] Andrew Kadjeski: In short to keep it simple, right? You can, the expense ratio, it’s actually already factored into the ETF’s N Nav. So the easiest way to think about this is that without an expense ratio, the price per share of an ETF would be actually slightly lower in in the market. And actually, one last thing I think [00:16:00] is worth mentioning, right, from an ETF cost perspective, is for an investor to actually be mindful of the time of day that they actually.

[00:16:07] Andrew Kadjeski: Generally speaking, an investor may want to avoid trading really early in the opening of a trading session. Or if they do, they should consider using a limit order versus a market order. And the main reason for this is what we call price discovery. So the underlying securities and ETF, you know, they’re opening trading at the same time as the ETF and it sometimes it takes a moment for the ETF to reflect the prices of the underlying basket of secur.

[00:16:34] Rebecca Hotsko: I was going to actually ask you about that because that comes up when buying International ETFs. Two, if a Canadian investor is buying a Vanguard International ETF that trades on the T S X, but it’s bought and sold during the hours that the market is open in North America, but the underlying stocks, the ETF are international stocks and they trade in a different market.

[00:16:56] Rebecca Hotsko: What kind of problems come up when trading these international [00:17:00] ETFs and then how can we avoid them? 

[00:17:03] Andrew Kadjeski: In general, it’s better to trade international ETFs at a time that coincides with the trading hours of the underlying shares local markets. So intuitively, if you think about it, right, the prices of an international ETF, trade it in the US are Canada.

[00:17:19] Andrew Kadjeski: They tend to be closer to the value of the underlying shares and typically trade with a narrower bid ass spread when their respective of markets are open and overlap with the US or Canadian trading hours. For example, right? The first half of trading in the in the US and Canada is going to overlap with the latter half of the trading day in Europe.

[00:17:38] Andrew Kadjeski: Having said that, the E tf, their market price could actually better reflect the true value of its underlying shares, whose last available set of prices may maybe they haven’t had a chance to adjust yet to the latest news at events when the markets are closed, information does continue to flow. That could affect the prices of an international ETF’s underlying shares.

[00:17:59] Andrew Kadjeski: So it’s a [00:18:00] unique advantage that ETFs provide. They’re a valuable tool for the for price discovery, right? When the underlying assets aren’t readily available for direct investment, they still provide an avenue for investors to access those securities. 

[00:18:13] Rebecca Hotsko: And I guess in the grand scheme of things, this isn’t a major issue.

[00:18:17] Rebecca Hotsko: It’s not something that would release skew returns, but I guess if someone’s trading often, which I don’t think many of our listeners are trading ETFs often, but would that just come, I guess, in the form of wider bid ask spread? So you would get, I guess, worse pricing perhaps. 

[00:18:34] Andrew Kadjeski: That’s exactly right Rebecca, and it kind of, it goes right back to the point of being really thoughtful about when you’re actually going to make your investment in an ETF, particularly in international ETF, you know?

[00:18:44] Andrew Kadjeski: So in the us typically that’s going to be earlier in the day for a European based strategy. 

[00:18:50] Rebecca Hotsko: And then I guess the other thing I wanted to talk about is I think ETFs are often thought of as a long-term portfolio play for myself. They’re investments that I just [00:19:00] plan to hold for the long-term rebalance here and there.

[00:19:03] Rebecca Hotsko: But I guess unlike individual stock picking, these are investments I think of as a core part of my long-term investment plan. But what are some of the ways that ETFs can be used in an investment portfolio for short-term goals as well? 

[00:19:18] Andrew Kadjeski: First, I’ll say, it’s great to hear you use the words long term, right?

[00:19:22] Andrew Kadjeski: Because at Vanguard we stress the importance of investing for the long term, right? And creating clear and appropriate investment goals. You know, we’re always coaching our investors to remain disciplined, take a long term perspective in their investment plans. And as you mentioned, right, ETFs are often the right investment vehicle to utilize in your portfolio to achieve your long-term goals, whatever that is, whether you’re saving for retire.

[00:19:46] Andrew Kadjeski: You’re saving for your children’s education, maybe you’re saving for a down payment on a home. With that being said, right, that doesn’t mean that if you have a shorter time horizon, such as six months, maybe even to a few years, that there aren’t ETFs that [00:20:00] won’t work for you, for example, right? Depending on your time horizon and your risk tolerance.

[00:20:05] Andrew Kadjeski: Something like a ultra short term bond ETF like Vanguard’s, V u sb, that could fit the needs of someone with a shorter time horizon as. That’s 

[00:20:16] Rebecca Hotsko: really helpful. And then I think thinking about if we plan to sell an ETF, there are two types of capital gains that investors need to be aware of. Can you talk a little bit about these and what implications they have?

[00:20:31] Andrew Kadjeski: First and foremost, ETFs are well known for being highly tax efficient. I mentioned earlier that one of the biggest advantages of ETFs was their accessibility, right? Their ability to be traded throughout the day. Well, the tax efficiency of ETFs is right up there as another top advantage that they, that they have as an investment vehicle.

[00:20:53] Andrew Kadjeski: And there’s a few reasons for that. First many ETFs, they track what are known as market cap way to indices. And the [00:21:00] effective tracking of these indices can, and frankly should. There that’s achieved with minimal portfolio turnover, especially for equity indices. This low turnover that means less trading in the portfolio that contributes to ETF’s, you know, tax efficiency.

[00:21:15] Andrew Kadjeski: Second, earlier we talked through the ETF ecosystem, right? Again, because ETFs trade on exchanges, much like the way individual stocks do, the vast majority of trading ETFs that takes place between me and you, right? On the secondary market, right? So there’s no impact on the ETF’s underlying securities. We also talked about those authorized participants, the aps, right?

[00:21:37] Andrew Kadjeski: Their transactions for providing liquidity in the ETF. Those are actually done with baskets of securities not cash. These in-kind transactions, they’re not considered taxable events. So combined the market, the secondary market aspect and the AP aspect of the ETF ecosystem, they also contribute to ETF’s tax efficiency.

[00:21:58] Andrew Kadjeski: But having said all this [00:22:00] right, a, as you mentioned Rebecca, it is important to recognize that while ETFs are tax efficient, they’re not tax. And this really all comes down to the realization of capital gains within ETFs. Consider the fact that prior to the bear market this year, you know, global equities have generally enjoyed significant gains for more than a decade.

[00:22:19] Andrew Kadjeski: So as a result, many ETFs, they’re holding securities with underlie unrealized capital gains that can, they’re going to start to become realized through the normal course of portfolio operations. You know, the important thing to keep in mind with ETF capital gains, though it’s just a matter of timing.

[00:22:35] Andrew Kadjeski: Ultimately, as an investor, you’re going to pay taxes on your gains at some point. So put another way. When an ETF distributes capital gains, you’re going to see them show up in, I think, what’s called your T3 slip, which I think is the same in the US as our 10 99. But anyway, those taxes, those, they’re paid on those gains now rather than the future when perhaps when you do sell your ETFs at a gain at that point.

[00:22:56] Andrew Kadjeski: So it really is just a matter of timing, and that’s the difference in capital gains. Those [00:23:00] realized within the fund as you’re holding. And then those that you realize when you actually sell the ET t F and get the proceeds. 

[00:23:07] Rebecca Hotsko: It was really helpful because I know that some brokerages you have to request for that information, but I think it’s gotten a lot better over the years now and it’s just automatically done for most.

[00:23:20] Andrew Kadjeski: Exactly at Vanguard rate the bi at the end of each year, you can go in the tax season, we’re able to get 8 million tax forms produced and out to our clients in early January, beginning of February, right? All automate for clients to be able to their taxes, whether it’s either capital gains realized within the ETFs, or again, because of the proceeds from from sales, other et.

[00:23:42] Rebecca Hotsko: And then I guess one other thing I wanted to chat with you about is, one misconception I had when I started investing was that if I buy a Canadian listed US ETF, such as V un, for example, instead of buying the US listed ET T F, that tracks the same market v T I. [00:24:00] Then I’m not subject to foreign currency risk because I bought the Canadian listed one, but can you talk about why this is not the case?

[00:24:09] Andrew Kadjeski: Yes. At the highest level of first year, right? Right. When investing in an international ETF, your returns, they’re not only affected by the prices of the underlying securities, but you do need to consider the impacts of currency exchange rates as well. That is very much an important factor for investors to be aware of when you use your Canadian dollars.

[00:24:27] Andrew Kadjeski: Right. Or Looneys. Did I, did I get that right? You? All right, so when you’re, when you’re using your Canadian dollars to invest in a US ETF, the first thing that the fund manager needs to do is convert your money to US dollars. Right? That, that’s no different than a US investor that’s investing in a fund tracking, say the FOOTSY 100.

[00:24:48] Andrew Kadjeski: We need to convert the US dollars and the British pounds before we invest invested on your. And then later, if you called and told us, Hey, to sell your investment, we would receive the British pound proceeds [00:25:00] and then we needed to convert them back into U S D before you can deposit them back into your account.

[00:25:04] Andrew Kadjeski: Obviously, with each exchange of currency, you as the investor are facing some level of FX risk. Now, back to your specific example, whether the US ETF you’re looking to invest in is listed in the US. V T i in your example, or it’s listed on an exchange in Canada, which was v U n in your example. In either case, it will require converting your Canadian dollars into U S D for the fund manager to put your money to work.

[00:25:33] Andrew Kadjeski: So you’re right, the foreign exchange risk is the same in each case. You know, the really, the main reason why a US E TF might be cross listed in another market like Canada, it’s to help minimize taxes, right? Faced by foreign investors, right? When they want to invest in a US product. So essentially they risk being double tax, right?

[00:25:52] Andrew Kadjeski: As a Canadian investor buying V T I through a US exchange, you’re going to risk getting taxed by both the US and the Canadian government, [00:26:00] not the case. If you buy a Canadian listed version of the ETF, Having said all this, Rebecca, I might, I might be able to help you out right? With the FX risk, because there’s actually often hedged share classes of ETFs.

[00:26:12] Andrew Kadjeski: In the case of v t I, there actually is a share class available in Canada that is hedged the Canadian dollars that ET t F is V us. So you can actually get the same exposure as V T I to the US total stock market while mitigating currency risk. But it’s worth noting that typically with head share classes, you know, they, they come at a cost.

[00:26:34] Andrew Kadjeski: In this case, the expense ratios of V S and V N, they’re actually the same. But you gotta think about things like previous discussion on capital gains, right? So a head share class is more prone to capital gains, right? Because of things like the monthly role of currency forwards, for 

[00:26:50] Rebecca Hotsko: example. Such an interesting time to think about should we currency hedge our portfolio or not, especially if you are outside of the US [00:27:00] and a lot of your investments are in US dollar and whether those investments make sense, but I’m glad that you pointed out that aspect there.

[00:27:08] Rebecca Hotsko: And they typically come with higher fees and it’s up to the investor, I guess, to do their due diligence to think if that makes sense for them, if that makes sense for a portion of their portfolio. Because I guess the differences between those is with the unhedged for a foreign investor, my returns for investing in the US are made up of the currency and then the equity return.

[00:27:30] Rebecca Hotsko: But if you do the unhedged, it’s just the equity return. So it’s, you’re kind of gambling because if the US dollar goes up, well, I would’ve been better off, but if it goes down over my holding period, then I would be better off with the hedged one. So it’s kind of speculating in a sense. 

[00:27:46] Andrew Kadjeski: I think you’re asking in all the right questions and making all the right points.

[00:27:49] Andrew Kadjeski: Rebecca, the main point that I’d add to all that is something we talked about earlier is focusing on the long term. Typically, things like foreign exchange rate [00:28:00] risk is something that you have to worry about in more shorter term horizons. But if you’re, you’re focused on a long-term investment goal, particularly retirement, you’re typically going to be safe in investing in the on hedge version, the on hedge share class.

[00:28:15] Andrew Kadjeski: And then you don’t have to deal with the costs and the capital gains that are associated with, with the hedge share class. 

[00:28:21] Rebecca Hotsko: That’s a really good point and I’m pretty sure that I read some Vanguard papers on that as well, the benefits of hedging or not. So if I find that, I’m going to link that in the show notes because I do remember reading that and it was really helpful.

[00:28:34] Rebecca Hotsko: And then another thing that I wanted to ask you about was typically ETFs trade quite close to their net asset. But they can be a little bit different. So can you explain why ETF prices are different than their net asset value and what does this mean? Is this a bad thing? 

[00:28:52] Andrew Kadjeski: It’s definitely not a bad thing, but you are right.

[00:28:54] Andrew Kadjeski: ETFs typically they trade at a very modest, right, very modest premium or [00:29:00] discount to their N A V, you know, and really it all comes down to supply and demand. Earlier we talked about, again, that role of the authorized participant and what they, the role they play in the ETF ecosystem. Yeah, I used the word liquidity before, but this is really what it’s all about.

[00:29:15] Andrew Kadjeski: You know, they’re helping minimize the divergences between the an ETFs market price and its N nav. But again, these divergences, they’re more often than not quite minimal. It is worth noting though, right? It is a, and I think this is why you’re asking the question, and it’s a good one, that there are periods right of elevated market volatility and reduced liquidity in underlying securities where divergences between an et s market price and their N Nav V, they are more likely, particularly for fixed income ETF.

[00:29:43] Andrew Kadjeski: Actually there’s, there’s a really great case study for ETFs and this particular issue back in March, 2020, right when we had the pandemic related volatility. If you think back to that time period, liquidity in the bond markets, they were significantly lower than normal, right? Given the widespread uncertainty that we were [00:30:00] facing during that time period.

[00:30:02] Andrew Kadjeski: Despite that illiquidity though on ETFs, continued trading with tight bid ass spreads at that. With higher than normal discounts relative to N Nav, which is what we’re talking about. Ultimately bond ETFs, they proved to be a extremely resilient option for liquidity and price discovery for investors during that period, right?

[00:30:22] Andrew Kadjeski: There were investors who were seeking fixed income exposure during that period, could not access the underlying securities, but ETFs proved to be extremely valuable tool during that period. Very similar to the example we were talking about earlier with international ETFs. Again, it shows how ETFs are an incredibly valuable tool for investors to be able to gain access to the underlying securities, but via the pulled vehicle.

[00:30:45] Rebecca Hotsko: If an investor is comparing, say, two ETFs that are both tracking the similar market, but one is trading for a bigger discount to its net as net asset value than the other, is that a warning sign or is that just more a function [00:31:00] of liquidity like you just talked? 

[00:31:02] Andrew Kadjeski: If they’re tracking the same index, I think it is a warning sign, Rebecca.

[00:31:06] Andrew Kadjeski: Right? And that’s another key aspect when you’re looking under the hood and choosing not only the ETF that you’re looking to invest in, but the provider that you are choosing to invest with. Tracking error is a really important part of choosing ETF. And how widely traded an ETF is, is what’s really ultimately going to determine what that bid as spread is.

[00:31:30] Andrew Kadjeski: And it shows the volume in the. So I agree it, it is something that investors should be looking at that the tightness of the, the bid as. 

[00:31:37] Rebecca Hotsko: I want to talk a little bit about your expectations for ETF investing going forward. I had it on a guess not too long ago, Eric BTEs, who talked about how ETF inflows have risen considerably over recent years, and as ETF investing becomes more popular among investors, I’m wondering what are the major headwinds and maybe tailwinds that you think [00:32:00] ETF investors will face this year and going forward?

[00:32:04] Andrew Kadjeski: Well, I’m a big fan of Eric, so I’m jealous that you got to spend some time with him. Recently, I, I just read his book. I’ll give it a plug. The Bogle fact over the summer, which is a great read I’d, I’d recommend it to anybody, but you’re right, ET ETF flows, they have risen considerably over the past several years.

[00:32:21] Andrew Kadjeski: I, I’m sure you went through the stats in some detail, Eric, but you know, just in case total aum, m and ETFs at the end of 2021, there were over 7 trillion. That’s compared to just over 1 trillion in 2012. Vanguard’s ETF, AUM. It’s currently at 2 trillion. From a cash flow perspective, 930 billion flowed into ETFs in 2021, and that’s compared to just 185 billion in 2012 Vanguard’s ETF Cash flow by comparison, you know, 347 billion last year in 2021, already at 178 billion year to date.

[00:32:56] Andrew Kadjeski: But listen, I, I get where the question’s coming from despite those [00:33:00] big numbers that I just. This year has been, it’s been a tough one, right? It’s been a tough one in the markets. There’s no dancing around that, but it’s not limited to ETFs or mutual funds. In fact, it really never is. Remember in ETF, it’s anything that’s important for the listeners to recognize.

[00:33:14] Andrew Kadjeski: ETFs are an investment vehicle, not an asset class. But again, the reality is that across asset classes, it’s been a tough year. In 2022, stocks were down 19% through the end of October. At the same time, bonds were down 16%. In fact, I think we’re in the worst bond market since at least 1926 and combined, that means a 60 40 portfolio isn’t faring well, a 60 40 portfolio is down 17%, which is its worst performance since 2009.

[00:33:45] Andrew Kadjeski: But in all sincerity, right, it’s during times like this. When you as an investor are searching for what to do, what move you feel like you need. The best action is actually to stay the course and do nothing, right. Maintain your focus on your, on your long-term [00:34:00] goals. It’s very easy to say during a down market like this, that indexing won’t carry the day going forward, or ETFs won’t carry the day going forward.

[00:34:09] Andrew Kadjeski: In fact, I feel like that narrative comes out in every down market. But go back and look at the data, right? Especially over the past 30 years, seemingly every year, there is a reason that the pundits will say it’s time to pull out the markets or seek other sources of alpha outside indexing. And in the end market timers, they’re too often, they’re suffering from missing out when the markets recover.

[00:34:30] Andrew Kadjeski: We have a saying here during times like this, we call this Vanguard weather because our investment philosophy, we think it carries the. You gotta focus on things that you can control. During times like this, you focus on your goals, your asset allocation, minimizing your costs, and maintaining a long-term perspective.

[00:34:48] Andrew Kadjeski: I 

[00:34:48] Rebecca Hotsko: think that was such great advice because I think everyone’s worried at this point what’s going to happen. Narratives are so powerful. We think this time is different, but I think a lot of us would regret if in 10, 20 years [00:35:00] we just didn’t invest and we wanted to keep more cash and the market recovers and you look back on all of the gains that you could have made.

[00:35:09] Rebecca Hotsko: Sticking to your investment strategy and weathering the storm when everything seems scary, you can look back on history and the market has historically always recovered after even the worst narratives, the worst crashes. And so I think that was really helpful to hear from you. But with that said, I guess in terms of investing in ETFs, they’re considered pretty low risk investments, really diversified usually, but are there any risks in investing in ETFs that aren’t present in other classes?

[00:35:40] Andrew Kadjeski: ETFs, they, they aren’t inherently more or less risky than say, mutual funds, but when it does come to risk, it is important to note that ETFs and mutual funds, they’re designed with built-in diversification, given they traditionally include tens, hundreds, thousands of individual stocks or bonds, they are far less risky than [00:36:00] investing in, say, individual stocks or bonds.

[00:36:03] Andrew Kadjeski: As with any investment though, right, you need to ask yourself, what are your. And once you’ve determined those and you assess your risk tolerance, you can be better positioned to create a balance and diversified portfolio using vehicles such as ETFs or mutual funds, right, to best align with those long-term objectives.

[00:36:20] Andrew Kadjeski: I will point out kind of two risk themes though when it, when it comes to the ETFs first is, you know, there’s certainly been an influx of what I’ll call trendy ETFs over the past few years, right? These are really narrowly focused ETF. You need to make sure you look under the hood and really understand what these ETFs hold.

[00:36:39] Andrew Kadjeski: Many ETFs are highly concentrated, right? They have portfolios that are focused narrowly on say, an individual country or a sub-sector. Some recently launched ETFs. They only hold a single security. And there’s others that are, they’re kind of masquerading as index funds, but they’re really offering active strategies.

[00:36:57] Andrew Kadjeski: And so often these types of ETFs, they’re [00:37:00] coming with a higher than average expense ratio, and they’re trading with that wider spread that we talked about earlier as well. And by the way, you, you’re never going to find these types of ETFs offered At Vanguard, we only launch and offer products that we believe have an enduring investment merit and add enduring value for our clients.

[00:37:18] Andrew Kadjeski: And the markets they, they’ve spoken here with these types of ETFs. If you look back to the beginning of 2020, more than 450 ETFs have actually been liquidated or merged across the industry. Often there is just as many ETFs that close in a given year, if not more than tho the number that’s actually been launched in a given year.

[00:37:37] Andrew Kadjeski: And it comes down in large part because these strategies, they don’t have an enduring investment case. Right? Instead, again, they’re chasing these recent fads. So that’s kind of one big risk theme. The, the second that I’d point out is when you’re considering investing in ETFs, it’s just as important sometimes to choose not just what ETF you’re going to invest in, but actually where you’re going to [00:38:00] make that investment.

[00:38:01] Andrew Kadjeski: These days. You can, you can open up a brokerage account at any number of firms. You want to make sure though that the experience that the firm you chooses matches your goals. For example, at Vanguard, you know, we have a purposely designed digital experience that encourage clients to save more, trade less, and again, focus on the long term versus frequent trading and investing in products that are overly risky and don’t match your long term 

[00:38:26] Rebecca Hotsko: goals.

[00:38:27] Rebecca Hotsko: That was really interesting you pointed out. I want to touch on a few things there because we actually talked about, I talked with Eric about single stock ETF’s. Leveraged ETF products, and I didn’t realize that those weren’t offered by Vanguard, but that kind of makes sense. It speaks to the philosophy of the company.

[00:38:46] Rebecca Hotsko: And it’s just interesting to see how they can differ and when investors should compare which fund or provider to go to. There’s lots to consider beyond perhaps even the lowest expense ratio. It’s how they’re [00:39:00] managing those funds as well. And I do want to touch on, I found that so interesting how you mentioned so many ETFs clothes.

[00:39:08] Rebecca Hotsko: Do you have any other color you can paint on? What types of ETFs are those? Are they more of the stylized, thematic 

[00:39:15] Andrew Kadjeski: ones? I’ll hold on a couple points. May 1st on your, your last question there. Yeah. What you’re definitely going to see is the, the ETFs that are closing and, and, and don’t have a lot of, of very long shelf life, I guess, as I call it, it is going to be these more thematic, trendy ETFs, just like mutual funds, ETFs.

[00:39:33] Andrew Kadjeski: They need a u m, they need to have mark, they need to build up their capital and make sure that they’re an enduring product that investors can use. A lot of these trendy ETFs, they’ll, they’ll catch a lot of traction for a couple months and then they’re not going to get the, the cash flow and the training that’s needed via an enduring investment product for clients.

[00:39:52] Andrew Kadjeski: And to your point, again, yes, you will not see these type of products offered at Vanguard, and you kind of think about them. Think about [00:40:00] that in two different ways. One is, is Vanguard actually going to launch a product like that? We’re an investment manager, we’re a product provider, and there’s kind of three critical questions that we ask ourselves when we’re deciding whether we’re going to launch our product or not.

[00:40:12] Andrew Kadjeski: You know, again, will the fund have an enduring investment merit, right? That can improve investor outcomes. Again, we don’t face chase fad. The second is, will the fund satisfy a clear or unmet client need? And the third is, can Vanguard be best in class? Can we stand out in the marketplace and ultimately give the investors the best chance for investment success?

[00:40:34] Andrew Kadjeski: We want to make sure, again, it’s all about enduring investment, merit, and meeting a client need. That’s in the products that we launch. We’re also a brokerage firm, right? You can invest in non Vanguard products through our brokerage. And actually back in 2019, we made the decision to block the availability of leverage and inverse products on our platform.

[00:40:54] Andrew Kadjeski: And that goes again to making sure that we have products on our platform that match our investment [00:41:00] philosophy. And again, it’s all about, again, client outcomes and making sure that clients can reach their long-term goals. And those products are often misunderstood by investors and are not suitable for the average retail investor.

[00:41:12] Rebecca Hotsko: I think that’s really great from a brand and company perspective. I just had a guest on who were, we were talking about how investors can find their own investment philosophy and why it’s so important to have one and stick to it. And it goes back to a company level too, where you’re Vanguard’s is really sticking to their philosophy.

[00:41:29] Rebecca Hotsko: Even if it could make money by offering these products, it’s they’re sticking to the brand and what they believe in, in terms of investments. I guess lastly, I am wondering, most of our listeners are very familiar with how Vanguard just really pioneered the low-cost investing space, but now there are a ton of ET t F and index providers as we are just talking about what differentiates Vanguard from the rest.

[00:41:55] Rebecca Hotsko: Anything else beyond what you already kind of outlined 

[00:41:58] Andrew Kadjeski: for us? Yeah. You mentioned many folks know Vanguard for being the low cost provider. And you’re right, they’re right. We, we take a lot of pride in that. We take a lot of pride in the impact that we’ve had on investors by consistently driving down their costs of investing, right?

[00:42:16] Andrew Kadjeski: Over the past four decades. We do that through low cost index products, right? A, as you mentioned. But by the way, our low cost approach debt extends to active funds as well. So out of our 7 trillion under management, 1.5 trillion of that is actually in active funds. Most people don’t recognize that we are more than an index shop as well, and it’s, we bring that same low cost approach to those products as well.

[00:42:43] Andrew Kadjeski: And it’s actually, it’s not just about low cost, right? It’s about performance. So across both our index and our active lineups, we consistently perform at the top of our peer sets, right? Whether it’s over a 1, 3, 5, 10 year horizon. So I think you’re getting the highest quality [00:43:00] products at the lowest cost, right?

[00:43:01] Andrew Kadjeski: When you come to Vanguard, but in all honesty, right beyond the products that we offer, the thing we take the most pride in at Vanguard is our client alignment. We’ve talked a little bit about that throughout our discussion. Vanguard’s actually the only client owned investment company in the industry, so at the end of the day, we exist for one reason and one reason only, and that’s to give investors the best chance for investment success .

[00:43:25] Rebecca Hotsko: Yeah. And I know our old host Clay had Eric on talking about that. Well that was all his book was about how the Bogle effect and how it’s just so client focused. And so I just think it’s such an incredible story and I want to thank you so much for taking the time to come on today. That was so great. I learned so much from you.

[00:43:45] Rebecca Hotsko: Before I let you go, where can the listeners go to learn more about you and your work at Vanguard? 

[00:43:52] Andrew Kadjeski: First, thanks for having me, Rebecca. I, I enjoyed the discussion as well. I’d encourage listeners to visit our website, vanguard.com or [00:44:00] download our mobile app, right, to open up an account. Maybe more importantly, we have a section on our website, Investor Resources and Education.

[00:44:06] Andrew Kadjeski: It’s dedicated to providing investors with investment news, market outlooks, product insights, whether an investor is curious in learning more about ETFs, which we talked about today, or other investment products, right? We’re committed to empowering investors with the knowledge that can ultimately give them again, the best chance for investment success.

[00:44:24] Rebecca Hotsko: Thank you so much, Andrew. 

[00:44:26] Andrew Kadjeski: Thanks, Rebecca. 

[00:44:28] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show.

[00:44:48] Rebecca Hotsko: And if you haven’t already, make sure to sign up for our free newsletter. We study markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So with that all said, I will see you again next time. 

[00:45:04] Rebecca Hotsko: Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin. And every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consultant professional, this show is copyrighted by The Investor’s Podcast Network.

[00:45:34] Rebecca Hotsko: Written permission must be granted before syndication or rebroadcasting.