In my last piece – which I am happy was so widely passed around – I made the case that we are far from too much indexing, and the growth of indexing is a good thing for investors.
Recently, WealthManagement.com had an article in which they asked “Does the explosion in new ETFs benefit advisors and investors, or does it just confuse them? In this case, my answer is different. The amount in indexing and ETFs is not too high, but we have long since passed the point where there are too many ETFs. While some people like the idea of “spaghetti against the wall” as a tool of innovation, with a Darwinian selection process separating the wheat from the chaff, I am more inclined to see it is a spaghetti cannon, making a terrible mess.
Let’s go back to basics. The original, broad-market, indexed ETFs had many features. Among them are:
- Low cost
- Broad diversification, and thus lower volatility in a portfolio
- Extraordinary tax efficiency
- They don’t underperform the market by making bad choices (they track the market)
Sadly, ETFs have become something of a victim of their own success – or, I should say, their “sizzle”. Because of the great adoption of those early index funds, people tried to attach all sorts of investment ideas they could never sell as a mutual fund around an ETF wrapper to get the sizzle. In fact, we now have as many ETFs (or more) in the U.S. as we have listed equities on major exchanges. In many cases, this is turning wine into grapes.
My first issue is fees. If you believe equity markets are going to deliver 7%-10% annually, giving up 0.50% to a manager eats into nearly 10% of your returns. Many, if not most, of these new ETF ideas have a “this will beat the market” flavor. And, as a result, they often charge much more than the low, single-digit basis point prices of the large and venerable index ETFs. Strike one.
Second is diversification and volatility. Many people fail to realize that volatility is a return thief. A bond that pays 10% annually for two years turns $100 into $121.00. But a security with just a little volatility and the same average return of 10% comes up short: a year of 11% (to $111.00) plus 9% ($9.99) gives you $120.99. What if the spread is larger? Consider annual returns of 10% plus or minus 40% – i.e., a year of 50% followed by a year of -30%. Now you are down to $105: 75% of the return has vanished due to volatility. Narrower, less diversified baskets with more volatility have a much larger hurdle than most people realize to overcome fee, tax and volatility drags.
Next on my list is tax efficiency. The traditional, large ETFs have often been very tax-efficient. This is because (1) there is enough liquidity (and inventory) of shares of the ETF that creations and redemptions are fairly rare (and when they do occur, are usually highly tax efficient); (2) they have low turnover of holdings and don’t need to trade much inside the fund ; and (3) they are run by firms which have the resources to squeeze out every tax benefit possible. Many of the “new” ETFs have a more active security selection element, possibly driving up taxes. Remember, if you can invest for 30 to 40 years and not pay taxes until the end, you are much better off than paying taxes on realized gains along the way. How much so? An investor could amass $1.5 million, after tax, by paying no taxes along the way or he could end with only $1 million at the same returns with even a 20% realization rate each year. Once again, this was one of the great features of the original ETFs: you don’t lend the government money, interest-free, for 40 years based on what happened inside the fund that you had no control over.
Finally, let me address the “shinier, new and improved” argument. Yes, some of the oddball ETFs have beat the market. But that proves nothing at all. Frankly, if we just built 10,000 ETFs by having monkeys pick stocks from a bucket of bananas labelled with stock tickers, each year about half would outperform the market – some wildly – and over 10 years about 10 would have a significant, above market return every year. But that should give no one any incentive to invest in those ETFs that did well. If enough people play the lottery someone will win, but that is not a reason to play the lottery.
Am I totally opposed to some new ideas in ETFs? No. I can, in fact, think of missing products. If they have a solid investment need, then by all means bring it on.
But we should all question the wisdom of what there is today. Getting the basics right matters a whole lot. Ever more novel ETFs give the temptation to build a house of cards in an earthquake zone on sand, rather than building a strong foundation first that won’t crumble and disappoint.
Opinions expressed are current opinions as of the date appearing in this material only. While the data contained herein has been prepared from information that the author believes to be reliable, the author does not warrant the accuracy or completeness of such information. This communication is for informational purposes only. This is not intended as nor is it an offer, or solicitation of any offer to buy or sell any security, investment or product.