Chapter Fifteen
The Exchange Traded Fund
EVEN BEFORE THE RISE of the so-called new paradigm of fundamental indexing described in Chapter 14, traditional indexing was being challenged by a sort of wolf-in-sheep’s clothing, the exchange traded fund (ETF). Simply put, the ETF is a fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund.
If long-term investing was the original paradigm for the classic index fund designed 31 years ago, surely using index funds as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, surely holding discrete—even widely-diversified—sectors of the market offers less diversification and commensurately more risk. If the original paradigm was minimal cost, then holding market sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them nor the tax burdens incurred if one has the good fortune to do so successfully.
Typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market.
As to the quintessential aspect of the original paradigm—assuring, indeed guaranteeing, that investors will earn their fair share of the stock market’s return—the fact is that investors who trade ETFs have nothing even resembling such a guarantee. In fact, after all the selection challenges, the timing risks, the extra costs, and the added taxes—typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market.
These differences between the classic index fund and the index fund nouveau represented by the ETF are stark (
Exhibit 15.1). Exchange traded funds march to a different tune than the original, and I’m left to wonder, in the words of the old song, “What have they done to my song, ma?”
The first exchange traded fund, created in 1992 by Nathan Most, was named “Standard & Poor’s Depositary Receipts” (SPDRs), and quickly dubbed “Spider.” It was a brilliant idea. Investing in the S&P 500 Index, operated at low cost with high tax efficiency, and held for the long term, it held the prospect of providing ferocious competition to the traditional S&P 500 Index Fund. (Brokerage commissions, however, made it less suitable for investors making small investments regularly.) Most of the investors in the Spiders, however, were not long-term investors. They were active money managers, hedgers, and professional traders. Currently, some 65 million (!) shares of Spiders ($8.8 billion worth) are now traded every day.
From that single fund, ETFs have grown to be a huge part—$410 billion—of the $1 trillion index fund asset base, a 41 percent share, up from just 9 percent as 2000 began and only 3 percent a decade ago. Led by index portfolios whose shares are rapidly traded in narrow market segments (despite their stark contradiction of each of the five concepts underlying the original index fund), ETFs have become a force to be reckoned with in the financial markets. Their amazing growth certainly says something about the energy of Wall Street’s financial entrepreneurs, the focus of money managers on gathering assets, the marketing power of brokerage firms, and the willingness—nay, eagerness—of investors to favor complexity over simplicity, continuing to believe, against all odds, that they can beat the market.
The growth of ETFs has approached a stampede, not only in number but in diversity. There are now nearly 340 ETFs available, including 122 already formed during 2006, and the range of the investment choices available is remarkable.
22 There are 12 total stock market index funds (U.S. and international) such as the Spider, still the largest segment in terms of assets; 68 focused on investment styles; 173 based on stock market sectors; and 58 concentrating their assets in particular foreign countries. There are also a handful of bond ETFs and a scattering of ETFs utilizing high leverage (doubling the swings in the stock market), tracking commodity prices and currencies, and using other high-risk strategies.
The march of assets into ETFs has also been impressive. Since 1999, ETFs have drawn $280 billion of net new money, even larger than the $190 billion flowing into their classic cousins. What’s more, the flow into style, sector, and foreign funds has overwhelmed the flow into the broad stock market index component. While these broad funds accounted for 100 percent of the total ETF inflow in the early years, they accounted for less than 20 percent from 2000 through 2006.
The renowned Purdey shotgun is great for big-game hunting in Africa. But it’s also excellent for suicide.
All-stock-market ETFs are the only instance in which an ETF can replicate, and possibly even improve on, the five paradigms of the original index fund listed earlier. But only when they are bought and held for the long-term. Their annual expense ratios are usually—but not always—slightly lower than their mutual fund counterparts, although commissions on purchases erode any advantage, and may even overwhelm it. While their tax efficiency should be higher, actual practice so far has failed to confirm theory, and investors who trade them are subject to their own taxes. Their use by long-term investors is minimal. The Spiders are, in fact, marketed to day traders. As the advertisements say, “Now you can trade the S&P 500 all day long, in real time.” I can’t help likening the ETF—a cleverly designed financial instrument—to the renowned Purdey shotgun, supposedly the world’s best. It’s great for big-game hunting in Africa. But it’s also excellent for suicide.
I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting. We know that ETFs are largely used by traders, for the turnover of Spider shares is running at 3600 percent annual rate. The turnover for the NASDAQ Qubes is even higher, at 6,000 percent per year. It is only guesswork, but long-term investors hold perhaps 20 percent of the $100 billion assets of these Spider-like broadly diversified ETFs, or about $20 billion. The remaining assets, I presume, are held by market makers and arbitrageurs, making heavy use of short-selling and hedging strategies.
Assets of the other types of ETFs now total $310 billion. Trading these funds is also remarkably high. The shares of the major sector ETFs are typically turned over at an average annual rate of some 200 percent per year (an average holding period of just six months), with the most popular ETFs recently running turnover rates from 578 percent to 735 percent, all the way up to 7,100 percent (Russell 2000 iShares) and 8,500 percent (SPDR Energy shares). Could there be speculation going on here? In all, some $390 billion of the current $410 billion ETF base represents a vast departure from the beneficial attributes of the original index fund.
Yes, these specialized ETFs are diversified, but only in their narrow arenas. Owning the semiconductor industry is not diversification in any usual sense, nor is owning the South Korean stock market. And while sector ETFs frequently have the lowest expense ratios in their fields, they can run three to six times the level of the lowest-cost all-market index funds. What is more, sector ETFs not only carry brokerage and trading costs, but often are sold as parts of actively managed fund portfolios with adviser fees of 1 percent or more, or in wrap accounts with annual fees of 1.5 percent to 2.0 percent or more.
The net result of these differences is that sector ETFs as a group are virtually certain to earn returns that fall well short of the returns delivered by the stock market. Perhaps 1 percent to 3 percent a year is a fair estimate of these all-in costs, many times the 10 to 20 basis-point cost of the best classic index funds. It is not a trivial difference. For no matter how often derided or ignored, the tautology remains that sector funds, soundly administered, will earn a net return equal to the gross return of that sector, less intermediation costs.
But whatever returns each sector ETF may earn, the investors in those very ETFs will likely, if not certainly, earn returns that fall well behind them. There is abundant evidence that the most popular sector funds of the day are those that have recently enjoyed the most spectacular recent performance, and that such “after-the-fact” popularity is a recipe for unsuccessful investing. The lesson in Chapter 5—that mutual fund investors almost always do significantly worse than the funds they own, and still worse when they choose funds that are less diversified—is likely to be repeated in ETFs.
To illustrate this point, consider the record of the 20 best performing ETFs during 2003-2006. Only one earned a better return for its shareholders than the return it reported. The average shortfall in shareholder return was equal to 5 percentage points per year. The largest gap was 14 percentage points; iShares Austria reported a 42 percent return, but its investors earned just 28 percent. “Handle with Care” should be the first warning on the ETF label (though I have yet to see it used). Or perhaps: “CAU-TION: PERFORMANCE CHASING AT WORK.”
A “double whammy”: betting on hot sectors (emotions) and paying heavy costs (expenses) are sure to be hazardous to your wealth.
And so we have a “double whammy”: the near-inevitability of counterproductive market timing (emotions), as investors bet on sectors as they grow hot—and bet against them when they grow cold—combined with those heavy commissions and fees (expenses). Together, these two enemies of the equity investor are sure to be hazardous to your wealth, to say nothing of consuming giant globs of your time that could easily be used in more productive and enjoyable ways.
In 2006, ETFs were also at the cutting edge of the “market-beating” (at least in retrospect) strategies described earlier. These promoters and entrepreneurs seem to acknowledge that their “fundamental indexing” approach is a long-term strategy. Yet by choosing the ETF format, they strongly imply that bringing stockbrokers into the distribution mix and actively buying and selling the funds will lead to even larger short-term profits. I doubt it.
ETFs are an entrepreneur’s dream come true. But are they an investor’s dream come true?
ETFs are clearly a dream come true for entrepreneurs, stock brokers, and fund managers. But is it too much to ask whether these index funds nouveau are an investor’s dream come true? Do investors really benefit from being able to trade ETFs “all day long, in real time”? Is less diversification better than more diversification? Is trend-following a winner’s game, or a loser’s game? Are ETFs truly low-cost when we add brokerage commissions to their expense ratios? Is buy-and-sell (often with great frequency) really a better strategy than buy-and-hold? If the classic index fund was designed to capitalize on the wisdom of long-term investing, aren’t investors in these index funds nouveau too often engaging in the folly of short-term speculation? Doesn’t your own common sense give you the obvious answers to these questions?
On the broad spectrum that lies between advancing the interests of the business and the interests of the clients, where do ETFs fit? If you are making a single large initial purchase of either of those two versions of classic indexing—the Spider or the Vanguard Total Stock Market ETF—at a low commission rate and holding them for the long term, you’ll profit from their low expense ratios and may even enjoy a bit of extra tax efficiency. But if you trade them, you’re defying the relentless rules of humble arithmetic that are the key to successful investing. If you like the idea of sector ETFs, use the appropriate ones, don’t trade them, and use them in the right way—sparingly, and only to diversify your portfolio.
Let me now answer the question I asked at the outset of this chapter, “What have they done to my song, ma?” As the creator of the world’s first index fund all those years ago, I can only answer: “They’ve tied it up in a plastic bag and turned it upside down, ma, that’s what they’ve done to my song.” In short, the ETF is a trader to the cause of classic indexing. I urge intelligent investors to stay the course with the proven strategy. While I can’t say that classic indexing is the best strategy ever devised, your common sense should reassure you that the number of strategies that are worse is infinite.
Don’t Take My Word for It
In an essay entitled “Indexing Goes Hollywood,” here’s what Don Phillips, managing director of Morningstar, has said: “[T]here is a dark side to indexing that investors should not ignore. The potential for harm to investors increases as index offerings become more specialized, which is exactly what has happened in the world of ETFs. . . . In the right hands, precision tools can create great things; in the wrong ones, however, they can do considerable damage. In creating more complex offerings, the index community has found new revenue sources from . . . very specialized tools, but it has done so at the risk of doing considerable harm to less sophisticated investors. The test of character facing the index community is whether it ignores that risk or steps up and tries to mitigate it. The continued good name of indexing lies in the balance.”
From Jim Wiandt, editor of the Journal of Indexes: “I have always found it ironic that indexing—like most everything else in the world of finance—comes in waves. Hedge fund indexes, microcap indexes, dividend indexes, commodities indexes, China indexes and ‘enhanced’ indexes are all flavors of the month. And I’ll give you three guesses as to what all these indexes have in common: (1) chasing returns, (2) chasing returns, or (3) chasing returns.
“If you believe in indexing, then you know that there is no free money. Ultimately, the push toward enhanced indexing is about enhancing the bottom line for managers. . . . But it’s important for us to keep our eyes on the ball and remember what makes indexing, well, indexing. Low fees, broad diversification, hold hold hold. Don’t believe the hype. Try to beat the market—in any manner—and you’re likely to get beat . . . by about the cost of doing it.”
And now listen carefully to the warnings from two senior officers of a major ETF sponsor. Chief executive: “For most people, sector funds don’t make a lot of sense . . . [don’t] stray too far from the market’s course.” Chief investment officer: “It would be unfortunate if people focused pin-point bets on very narrowly defined ETFs. These still involve nearly as much risk as concentrating on individual stock picks. . . . You’re taking extraordinary risk. It’s possible to take a good thing too far. . . . How many people really need them?”
