Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.