Exchange Traded Funds: A once efficient investment tool Jumps the Shark (UPDATED)

More and more, Exchange Traded Funds (ETF’s) are becoming a common security in most people’s portfolio and with good reason. They provide an instant diversification at a much lower Management Expense Ratios (MER) (from 7 bps and up) compared to other products like mutual funds and they are more accessible in that they can be traded on the stock market. The other big thing is their performance is supposed to mirror the performance of an index. In other words if the S&P500 goes up/down 10%, then the value of the ETF will go up/down 10%. You can expect to earn the market rate of return. There is a mountain of research that has also shown that a simple buy-and-hold strategy of basic ETF’s that track major indexes will outperform 75-80% of money managers who are actively picking and buying/selling stocks. In other words, 75-80% of money managers (i.e. the “experts”) cannot earn even the market rate of return!

I still hold to the belief that if you have no interest in analyzing and researching companies for the purposes of buying stocks, then a portfolio of ETF’s diversified across core asset classes and business sectors that are rebalanced once or twice a year is a prudent way to grow your savings over a long period of time. Furthermore, adding to your positions in bear markets and selling positions in bull markets also will put you ahead of the game and let you sleep better.

I’ve been a fan of the ETF product. I’ve always believed that an ETF is a more efficient way of investing than mutual funds, but my belief is being tested. I worry now that the marketing machines of the major financial institutions have embraced the ETF model and are going into overdrive to crank out products that may not necessarily serve investors interests. I’m wondering if ETF’s are close to or have officially Jumped The Shark? From my observations, they seem to be packaging ETF’s as index funds but when you look at the components inside the ETF, they seem no different than a high priced mutual fund and most investors will not realize it. The beauty of being an investment coach is that I don’t sell ETF’s or stocks or mutual funds, so I have no financial interest to gain by calling these out.

Seven to ten years ago, there were only a handful of ETF’s and they mostly represented the major global stock indexes (i.e. S&P500, Dow Jones Industrials, Nasdaq100, TSX/S&P Composite etc) as well as regions (US, Canada, International, Emerging Markets) and industries (Gold, Oil, Technology, Health Care). The concept was simple. When you bought an S&P500 ETF, you are buying exposure to the S&P500 index and the value of the ETF would move in unison with the index. When you bought an ETF that invests in physical gold like the GLD, the value of the ETF moved in unison with the price of gold. It was simple. Today there are thousands of ETF’s that attempt to mirror components or slivers of the same indexes, sectors, and regions and criteria for selection of securities is not necessarily just whatever stocks are in the Dow Jones Industrials. Now these companies are using sophisticated algorithms to select companies based on various financial variables, which to me is no different than a portfolio manager selecting stocks for their portfolios. The impact of this evolution is that ETF’s are looking more and more like mutual funds with marketing machines of the ETF companies blurring the distinction. Of course the costs of these efforts is being passed on to you. Traditional ETF’s which passively invest in an index are much cheaper because there is very little management effort required. This is sadly changing as institutions are bastardizing the product.

As an investor, you may think you're buying an ETF that represents the Health Care sector, but if you drill down, you’ll see that there are only a handful of companies with one or two taking the dominant position in terms of assets invested and instead of being charged single 10-20 bps, you are being charge management fees of 60 bps and higher.

There are also ETF’s that bet on the direction of a specific index or sector. If you think the S&P500 is going to go down, you can buy an ETF that will go short the S&P500 and will pay you a return that is 2-3 times the return (almost like doubling/tripling down your bet). Conversely if you thing the index is going up, you can buy an equivalent ETF. These type of short-term trading products are being marketed to uneducated investors as components for their retirement portfolioís which is absolute blasphemy. They also carry higher Management Expense Ratios (MER’s) which will also chip away at your portfolio.

Brokerage houses like iTrade have introduced no-trading fee for selected ETF’s, which are of course carrying higher MER’s and also encourage short-term trading and not long-term investing which most people are trying to work toward.

The issues with this new generation of ETF’s comes down to performance and costs. These “managed” ETF’s have a higher tracking error which means they do not necessarily follow the performance of the selected index in question, which means you could be leaving money on the table or losing more money than necessary. These “managed” ETF’s charge higher MER’s which overtime can eat away at your portfolio.

If you put all these elements together, the financial services industry is marketing ETF’s as short-term trading stocks that carry higher expense ratios, do not necessarily track benchmark indexes efficiently and may not yield adequate returns.

 

It’s more important than ever to not invest blindly in these types of instruments, but understand what the investment strategy being adopted is, the type of securities and it’s % composition of the portfolio and the amount of MER’s it is charging. More and more financial advisors are pushing ETF’s to their clients so make sure you understand and ask questions about what you are putting your hard earned savings into.

 

If you can avoid the marketing sheen of Bay/Wall Street and stick to the basic vanilla ETF’s that track the broad stock market indexes domestically and globally, you can build a nicely diversified portfolio of investments that will grow modestly over time with little stress.

 

UPDATE; October 26, 2012

Since we posted this article, there was noticeable event that took place. Recently index fund behemoth Vangaurd announced that they were changing the indexes they use to build 22 of their index funds and ETF's, specifically switching from the MSCI indexes to the FTSE based indexes. Finance site Canadian Capitalist provides a very thoughtful analysis of the impacts (and there are some) of these changes.

Upon some reflection, I'm wondering if this type of change is any different that a mutual fund changing portfolio managers? It doesn't seem any different and if this is the case, as investors, are we now expected to track index changes as well? I would say tracking the makeup of an index that contains hundreds of companies is much harder to do than analyzing the financial statements of a single company. This index benchmark change is a "managed" change that is marketed to claim that investors will enjoy lower costs. That will remain to be seen. My first impressions are this muddies the waters for ETF's even more so.