ETFs as a tool

26Mar06

We have been commenting here about the growing complexity of the ETF marketplace. What was once a cheap and simple way to get access to indexed asset class returns has become infinitely more complex. This apparently is rubbing off on the writers of investment newsletters as well.

Mark Hulbert in the New York Times has analyzed the returns of all-ETF portfolios generated by these investment advisors and has found them lacking (and laggin).

Over the last several years, the nearly 200 investment newsletters monitored by The Hulbert Financial Digest have created no fewer than 25 model portfolios that invest exclusively in exchange-traded funds. On average, they have significantly lagged the non-E.T.F. portfolios that the newsletter industry recommends.

This comes as a bit of a surprise, given the many strengths of E.T.F.’s. Unlike mutual funds, which are priced only once a day, after stock trading has ended, an exchange-traded fund can be bought or sold — and even sold short — at any time during the trading day. And unlike closed-end funds, E.T.F.’s rarely trade at notable discounts or premiums to their per-share asset values.

These results are indeed puzzling. Given all the advantages of ETFs it would logically follow that advisors should be able to generate portfolios that outperform those that hold open-end mutual funds. However Hulbert does give us an explanation.

The newsletters’ E.T.F. portfolios have actually been slightly riskier, on average, than the non-E.T.F. portfolios, as measured by the standard deviation of their monthly returns. So on a risk-adjusted basis, the average E.T.F. portfolio lags even further behind.

There’s another possible reason, and it makes the most sense. The very advantages of exchange-traded funds — their low cost, coupled with the ability to trade them throughout the day and to sell them short — may be encouraging newsletter editors to make riskier bet.

That jibes quite well with a comment by Andrew Feinberg at Kiplinger’s is nervous about how some investors use ETFs in their portfolios versus the way he uses ETFs.

My anxiety about ETFs is that individual investors will use them just as they’ve used sector funds over the years. And that would be a disaster.

Statistics show that individuals invariably buy sector funds after the sectors have already made big moves — and then those investors lose money as the inevitable correction or bear market occurs. They do worse with sector funds than they do with plain-vanilla mutual funds. And that’s a terrifying thought, considering how the average fund investor dramatically underperforms the S&P 500.

Feinberg is indeed correct in calling ETFs a “wonderful tool.” However the well-publicized advantages of ETFs can become a disadvantage in the wrong hands if used incorrectly. Unfortunately the ETF industry is continuing to populate the universe of ETFs with ever more complex and narrowly-based funds. Choice is indeed great, but as costs and complexity rise, the chance (and costs) of making a wrong decision also rise.