Gil’s Musings

Power on, ETFs!

Many articles are starting to surface acknowledging and critiquing the groundswell movement to passive investment strategies and near-wholesale movement to Exchange Traded Fund (ETF) investing. Several of these articles take the position that this portends doom of one type or another. For the reader’s edification, passive strategies are generally mutual fund or managed account investment services where the mandate of the strategy is to match the holdings of a benchmark, like the S&P 500, versus a typical active strategy of picking stocks. The ultimate active manager is typically a hedge fund, so it’s no wonder that the threat of low-cost passive investing has raised a few of their hackles, since typical hedge fund fees are many multiples higher. Passive strategies are often accessed via ETFs. Due primarily to lower costs, ETFs have an impressive track record of beating their active brethren; but there are also tax benefits to ETFs as well. Since active managers view this trend as a threat to their livelihood, understandably not everyone is a fan. Will Rogers once said, “Don’t expect a man to understand a fact, when his job is based on him not understanding it.”

Segment has been a big proponent of such passive strategies since the firm was founded in 2010. I had followed a similar playbook at UBS before, culminating in many heated arguments with the firm’s leaders, and defending my rights to build portfolios with a passive methodology. After they acquiesced, this resulted in me being selected as one of six advisors in the country allowed to “experiment” with 100% ETF portfolios starting in January 2003. The success of this program partially contributed to my leaving UBS to form Segment because this freed me from having to eat the “firm’s cooking.” That is also the likely reason that UBS had so vehemently opposed me constructing client accounts this way. They much prefer the use of active strategies, where client fees can run many times higher, and where advisors hand off part of the control of client accounts to the active managers. Maintaining advisor control of client account holdings makes the brokerages vulnerable to advisor departures since this often makes the advisor nearly irreplaceable to the client.

A client recently sent me an article written about the possible market problems conceivably created with ETFs. It was written by Dan Denning, for investment newsletter pioneer, Bill Bonner. The 20-page newsletter generally blasts passive investing and ETFs specifically. Some of the claims varied from partially accurate to outright fallacy. I read the first half with great interest, and skimmed the remainder. I tend to find more insight between the lines than the information in them. I envisioned newsletter subscriptions in steep decline and the author’s hackles up, since investors are losing interest in stock ideas and ETF companies don’t generally subscribe to newsletters. ETFs may be biting Mr. Denning (Bonner et al) in his pocketbook. As investors lose interest in stock picking advice, ETFs can make even more sense because one can express virtually any investment bias or opinion with a basket of securities down to individual industries like aerospace or internet infrastructure. This “basketization” tends to provide several positive buffers for the client: mitigation of individual security risk, and reduced hassles of voting and reporting requirements; all resulting in lowered client anxiety.

ETF quote.png

The Bonner letter went on to discuss several perceived shortcomings of indexing, like questionable liquidity, the herd mentality, and warped securities pricing, naming just a few; and all of which I believe to be mostly incorrect. Mr. Denning seems keenly aware that there has been a near-stampede into ETFs. But he seems unaware that this traffic has come at the expense of other products like traditional mutual funds, and ETFs beat those resoundingly on cost. Additionally, would not the investor buying an ETF have otherwise bought a mutual fund if the more efficient ETF was not available? Aren’t ETFs actually more tax efficient than old-style mutual funds because they generally don’t have capital gains distributions like regular mutual funds? And would not the manager in an active fund simply buy more of his favorite stocks if many investors suddenly put money in his fund, leading his fund to over-buy certain securities anyway? It’s disingenuous to list these traits as specific to ETFs, when in fact, those same attributes exist in the regular mutual fund a client would have bought, and at a much higher average cost.

While I might agree with Mr. Bonner that ETFs have had weird pricing that lasted just moments, they have structures designed specifically to right the ship if it tips, and those have worked every time. While those blips might be bothersome and rare, the flip side to the periodic illiquidity argument is that the sheer volume of underlying securities held by ETFs has contributed greatly to tightening spreads in all stocks, which increases liquidity and drives down trading costs for investors in the entire market. Remember the days of 12c spreads between bid and ask? Yeah, that spread is now a penny. The friction cost of trading 1000 shares of Exxon just dropped by more than $100 from that fact alone, and you can thank the ETF industry mostly. Eradicating middlemen never makes it on to the list of ETF attributes, but should. Displaced middlemen probably have plenty of negative things to say about the unfairness of it all.

I have never found myself trapped in an ETF, and my firm holds over $120 million in ETFs for client accounts, in 140 different ETFs. This is roughly 16% of our $740 million in assets under management and comprises nearly a third of our total equity exposure. Many client portfolios (including my personal accounts) have held them continuously since I bought shares of the first ETF in its debut IPO in 1993.

Having said all of this, no story is all roses and lollipops. Mr. Denning was right that the shift to indexed strategies will result in unusual outcomes. However, the most profound likely outcome wasn’t on his list. Should it come to pass that all investors prefer a passive strategy regardless of underlying fundamentals, this will create opportunities for stock picking that haven’t been around since insider trading was outlawed in the 1930s (although not really enforced until the 1980s). While active strategies have been losing performance and assets to passive for some time and the trend is accelerating, the day will come when opportunity will knock on the other side of that door. Imagine the hidden gems that might be identified when active managers are then so few and possibly very little attention is paid to seeking the gems out. With ETFs just now reaching one-fourth of all assets in mutual funds, I think we are early in that process. Meanwhile, the certainty of lower costs likely outweighs the uncertain gain of an active strategy. Power on ETFs!

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