Tag Archives: cullen-roche

ETFs Don’t Kill Investors, Investors Kill Investors

There was a good piece in the WSJ today discussing potential “flaws” in Exchange Traded Funds (ETFs). ETFs are a relatively new product that have amassed huge quantities of assets in the last few decades, but are still dwarfed by the mutual fund space (roughly 2.1 trillion in assets, versus 12.6 trillion in mutual funds). The SEC recently said “It may be time to re-examine the entire ETF ecosystem.” That sounds a bit hyperbolic to me. ETFs aren’t necessarily dangerous unless you misunderstand them or misuse them. Unfortunately, a lot of behavioral bias appears to be driving the misguided fears about ETFs. 1. ETFs can be dangerous when misused. The first exchange-traded fund founded in 1993 was the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) which was designed to track the S&P 500. It’s a remarkably tax- and fee-efficient product that has served its investors very well since its founding. This was a very simple product designed for passive indexing, but the ETF space has morphed substantially since 1993. Much like the mutual fund space, it has morphed from a simple indexing product into a series of products that feed investor impatience and desire for rapid profits. And so we’ve seen a substantial surge in “active” ETFs, leveraged ETFs, “hedged” ETFs and other similar products. Many of these products abuse the efficiencies of ETFs by being tax-inefficient and fee-inefficient. They sell the diversification of indexing, but saddle investors with all the negatives that result in higher fees, tax inefficiencies and poor performance. I’ve written substantially on the dangers of leveraged ETFs and how fund companies sell high-fee closet indexing ETFs in exchange for empty promises about hedging and “market beating” returns. These products, in my opinion, are often dangerous and sold on false premises. But that does not mean we should make sweeping generalizations about the entire ETF space. The fact that some ETFs are bad does not mean they are all bad. ETFs are dangerous when misunderstood and misused. As Warren Buffett says, never invest in something you don’t understand. 2. ETFs traded precisely as they should have during the August Flash Crash. One of the primary drivers of the fears around ETFs was the morning of the Flash Crash in August, when many ETFs declined by 30-40% for no reason. We should be really clear about what happened earlier this year during the Flash Crash. ETFs traded precisely how they should have during this event. ETFs are liquid trading instruments designed to reflect the aggregate performance of their underlying holdings. On the morning of the Flash Crash, there were a huge number of stocks that were halted or illiquid. An ETF trades with a market price (the price you see) and an intra-day indicative value (the price the market maker sees). The market maker will try to keep the IIV as close to the market price as they can by making a market in the ETF. But when most of the underlying holdings are halted, there is no reliable IIV, and so, the price of the ETF is basically unknown until the underlying holdings open again. This problem was exacerbated during the Flash Crash because there are fewer human traders there to identify the sorts of issues that I identified in real time: Unfortunately, a lot of people didn’t understand this or implemented stop loss orders that resulted in sales well below where the ETF should have actually been trading. I watched this happen in real time, and was even able to execute buy orders at a 25%+ discount, due entirely to these behaviorally biased investors. Make no mistake, this was not a flaw in the way ETFs work. It was purely user error. ETFs are not inherently dangerous, but like many investment products, they can be abused by people who don’t understand them or misuse them. This isn’t a product flaw. It is a human flaw as old as the financial markets themselves. If you want to better understand ETFs I recommend reading the following primer from ICI or this one from BlackRock . Well informed is well armed.

Investment Activity And The Illusion Of Control In Exchange For Low Real Returns

Study after study shows that more investment activity is correlated only with higher fees and lower real, real returns. Activity is the illusion of control in exchange for lower real, real returns. You don’t want to be irrationally long term, which usually results in huge amounts of short-term permanent loss risk. But you also don’t want to be so short term that you take no risk. The best way to reduce taxes and fees in your portfolio is to take a long-term perspective. Again, a multi-year or cyclical time frame blends perfectly with maximizing your real, real returns. I take a cyclical view on things. This means I can sometimes go years without making big changes in my views or portfolio. This is a very intentional construct, and I think it’s one that most people should adhere to. After all, you don’t want to be irrationally long term , which usually results in huge amounts of short-term permanent loss risk. But you also don’t want to be so short term that you take no risk. As we find with so many things in life, moderation is the key. Hence, my cyclical or multi-year perspective on things. Resolving this temporal problem isn’t the only reason for this, though. We know that taxes and fees are two of the most important frictions in a portfolio. And the best way to reduce taxes and fees is to take a long-term perspective. Again, a multi-year or cyclical time frame blends perfectly with maximizing your real, real returns . Of course, this is easier said than done. We live in a world dominated by “What have you done for me lately” narratives. And worse, we are confronted with our own biases that make us feel comfortable when we’re doing something. After all, letting your portfolio float in the wind feels very uncontrolled, and oftentimes, uncomfortable. Activity is the way in which we try to “control” the markets. Of course, you can’t control the decisions of other market participants. And study after study shows that more activity is correlated only with higher fees and lower real, real returns. Yet, the allure of greater control pulls us in. Activity is the illusion of control in exchange for lower real, real returns. Luckily, there is a happy medium here. There is no need to be irrationally long term or short term. But it takes a great amount of discipline to reject the illusion that activity creates control. For most, that illusion (and the sales pitch of “market-beating returns” that often goes with it) is too enticing to reject.

How Long Can You Stick With Failing Factor Investing?

Someone asked me the other day why I reject factor investing. My answer was simple. I said that factor investing is usually just a good marketing pitch to charge higher fees for something that will give you most of the correlation of a market cap weighted portfolio. For the uninitiated, factor investing is one of the hot buzz words in portfolio construction these days. Researchers found that “risk” doesn’t properly describe what drives returns over the long-term and several other factors were discovered that explain some of these outperforming anomalies. For instance, value stocks tend to outperform and momentum stocks often outperform. But this isn’t always the case. This is simply the case inside of the rather small data set that researchers have mined so far. And that brings us to a rather gigantic problem with factor investing: these factors can go through extremely long periods of underperformance. Eddy Elfenbein does the legwork over at Crossing Wall Street where he shows that value has underperformed the S&P 500 for 8 years. That’s an entire market cycle! I’m not sure there’s a single investor who would put up with that type of underperformance. And yet factor investing is more popular than ever. In fact, we keep coming up with new factors by the day. And when one fails we move on to some other fancier and more intricate sounding sales pitch. But here’s the really big problem for me. When you buy stocks you shouldn’t look for the absolute best portfolio. There are no holy grails. You are just looking for an adequate portfolio that reflects a very broadly diversified set of equity instruments. You don’t need the best return. You want most of the return. But most factor portfolios just increase tax and fee frictions while giving you a substantial amount of the equity correlation that you’re looking for in a portfolio. But what we find with all of these factor funds is that they’re still very highly correlated with their benchmark. If you can decide when that correlation shifts a tiny bit to give you some slice of outperformance then you’re much smarter than me and everyone else in this business. Here’s a simple example of what I mean here. If we look at growth relative to the market cap weighted portfolio we find that the two portfolios have a 96% correlation over the last 15 years: In the early 2000’s growth looked terrible relative to market cap weighting. And then it has dramatically outperformed since the financial crisis. But over the course of the entire cycle there’s no telling where you would have gotten on and off that roller coaster ride. All we know is that you got 96% of the equity market correlation. And if you jumped on the growth roller coaster you paid a higher fee and you MAYBE outperformed. So, when you start looking for that holy grail in the factor pool you really start doing two things that are cardinal sins in the world of indexing: You’re relying on being able to time when a factor will or won’t outperform. You’re increasing your fees in the pursuit of beating the market. Breaking those rules just don’t make a lot of sense to me. I prefer to keep things simple. So, maybe I am too hard on the factor investing crowd, but I just don’t see why we should pay extra for something that might give you better performance, will definitely give you most of the correlation and will definitely increase your fees. Share this article with a colleague