2/24/2014 6:45 PM ET|
The growing case against ETFs
Exchange-traded funds have been touted as the 'better' investment vehicle, but your safety still depends on who's driving.
Sometimes it's the car, sometimes it's the driver.
Whether you are racing, cruising, stopping or crashing, safe driving comes down to a mix of equipment and personnel.
The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there's growing evidence that the people using them may not be so skilled behind the wheel.
That's a real issue because a number of studies seem to indicate that the "better" investment vehicle isn't delivering better results.
In an attempt to figure out why, let's look at the issue, and some of the latest research, done by MarketWatch columnist Mark Hulbert, editor of the Hulbert Financial Digest.
For starters, some of the folks who are giving up on traditional funds in favor of ETFs clearly don't seem to understand the basics, like the reader who recently told me he had "stopped wasting time on funds because ETFs are so much better."
The 'F' in ETF stands for "funds," and it's only because ETMF is longer that they are not widely recognized as "exchange-traded mutual funds." In some cases -- with Vanguard's ETFs, for example -- ETFs are simply a different share class of the same underlying pool of assets and management style.
The difference, therefore, is mostly in the "exchange-traded" part, because ETFs trade moment by moment, where traditional mutual funds only trade once per day.
Functionally, both are similar investment vehicles built on a different chassis, just like cars -- where one can be built for speed and another for safety or utility.
ETFs have other advantages besides ease of trading, like lower expense ratios and no front- or back-end sales charges and redemption fees. While there are brokerage commissions on trades, some of those can be waived.
Perhaps more importantly, ETFs can be structured in a way to take what the experts call a "granular" focus on a niche or an industry. If you believe you can goose a portfolio by adding the stocks of, say, Bulgaria, or of just companies in the semi-conductor business, there's an ETF for you.
If, however, you believe that active management works and you want to hire a manager to run your money rather than basing a portfolio entirely on an index, you lose a lot of choices and flexibility on the ETF side of things.
But the real issue here comes from how the different investment vehicles are used. Jack Bogle, founder of the Vanguard Group and the patron saint of index investing, has long been a critic of ETFs, mostly because he believes that if you give someone a trading vehicle, eventually they will trade.
That is what seems to be borne out by the numbers and why ETFs may be a superior investment option that is delivering inferior results.
Hulbert recently studied investment advisers who have model portfolios of both traditional funds and of ETFs, and found that the open-end fund portfolio has carried the day.
Over the last 12 months, the average model portfolio of traditional funds -- as tracked by Hulbert Financial Digest -- was up 20.9 percent, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.
Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.
Hulbert -- who noted that the performance differences are "persistent" -- speculated "that ETFs' advantages are encouraging counterproductive behavior." Effectively, he bought into Bogle's argument and suggested that if you give an investor a trading vehicle, they will trade it more often.
Looking at some of the newsletter editor portfolios where the editor uses both funds and ETFs, there's little doubt that the exchange-traded fund folios trade more frequently, and that less is more when it comes to average investors and their trading activity.
Label it this way: better vehicle, worse driving.
"The market has been spliced too finely, and people think all of these ideas work, but the need to trade the market on every tick is not something investors need to avail themselves of," said Brian Portnoy, author of "The Investor's Paradox," a new book that advocates for simplicity in the face of overwhelming investment choices.
"It's unbelievable what you can do in an ETF now, but if the premise is that you are buying the market for soybeans or aerospace stocks, it makes no sense for most people to try to do that. The fact that the fund companies have been able to crank up the factory to get this stuff and get people thinking that they need to be active investors in ETFs has been good for the ETF companies, but it's probably not good for the investors buying ETFs."
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“Sometimes it's the car, sometimes it's the driver…... if you give someone a trading vehicle, eventually they will trade.”
Agreed. I often think of the financial markets being analogous to a freeway too. We all use it at the same time as others. No matter how good a driver we are, some drunken fool can still run into us and do some serious damage. That’s a risk we always must take for being there.
Unfortunately, one difference in the financial markets is that the large financial firms who ultimately write and enforce the rules of the road for others (but not themselves) often seem to be among the drunken fools.
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