The Exchange Traded Funds (ETF) Myth

      The first Exchange Traded Funds (ETFs), began trading on Jan. 1, 1993.  Since State Street launched S&P SPDR, it has grown this fund to where it currently has over $86 billion in assets under management and trades a quarter-billion shares on an average day.  ETFs as a sector have increased to become one of the fastest growing investment vehicles for both individual and institutional investors. Today there are now 1,651 U.S. domiciled ETFs available, managing over $1.98 trillion in assets.  Why? Because ETFs market themselves as an easy, cost-efficient way for investors to incorporate various indexed asset classes, investment styles, sectors, industries or even commodities and currency trading into their portfolios. Because ETFs are “Passively Managed”, they tout themselves as having lower operating expenses and lower management fees with a perceived “set it and forget it” investment strategy. 

    Like individual stocks, ETFs give investors the flexibility to buy and sell shares throughout the day, at the ETFs market price. It’s important to keep in mind that frequent ETF trading, which typically occurs through brokers, can significantly increase brokerage commissions potentially washing away any savings from low fees or costs. But even as ETFs have grown in popularity, there is still a great deal of misunderstanding over how they are structured and regulated, how they trade and how their performance compares to other kinds of investments. Increased disclosure, greater transparency and improved investor education are vital to helping investors decide which financial products are most appropriate for their investment needs, including the explosion of ETFs on the markets.  Let’s try to clarify a couple of ETF Myths in an effort to help investors understand the risk.

Myth 1. ETFs perform exactly as the basket of securities they are indexed to. (FALSE).

     A stock or bond is a type of security that signifies equity or debt ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. These securities can be bought and sold privately, over-the-counter, or on major stock exchanges throughout the day at their market price. A security’s price will generally reflect the market’s supply and demand and tends to rise and fall based on many factors including distributions or dividend payouts, investor sentiment, and the real or perceived value of the corporation. 


     An ETF is a commingled investment vehicle comprised of a collection or ‘basket’ of securities that attempts to track, and is intended to represent, the performance of a broad or specific segment of the market, such as DJIA, S&P 500 equities, small cap stocks or emerging markets.  Like index mutual funds, ETFs are meant to allow investors to track the returns of hundreds of domestic and international indexes. Similar to individual stocks, however, ETFs give investors the flexibility to buy and sell shares at market prices on the major stock exchanges throughout the day, and then they too will reflect the market’s supply and demand for the ETF shares.   Similar to stock and bonds prices tend to rise and fall, based on many factors including investor demand, which may also be based on market sentiment of the underlying indexes and investors’ perceived value of the “basket of securities” which may actually be the market’s approximation of the direction of the underlying index.

Myth 2 – Passive Investing is Much Safer than Actively Managed Investing (FALSE)

     Any short-term or long-term analysis of the markets will demonstrate that no particular investment category or type consistently outperforms another. Performance of any security, whether it’s a stock, bond, mutual fund or ETF, is determined by any number of factors, including the economy, monetary policy, market conditions or issues affecting a particular security’s asset class or industrial sector. For individual stocks, fundamentals such as earnings, valuations and financial stability may also affect share prices. For bonds, factors such as interest rates, inflation and credit ratings may influence their yields. 

     Recently Investors are increasingly buying relatively cheap passively managed ETFs that mimic indexes, while shunning active portfolio managers.  Passive investing has continued to gain popularity in the asset management industry.  In 1980, almost all investment funds followed actively management strategies, but according to Moody‘s, passive funds currently account for 29 percent of the U.S. market.  ETFs are playing the leading role in this rapid rise of passively managed investments. 


     Some may argue that this shift to passive investing is welfare improving, due to the logic that active portfolio managers, who strive to beat market indexes, often come up short when there are broad corrections or unforeseen economic declines.  Given the lower operational costs and management fees on passive funds, investors may feel they pay less for equally poor performance….alternatively in rising markets Investors may feel high waters float all boats.  They may even argue that the rise in passive investing is symptomatic improvement in portfolio management and that ETFs provide improved market efficiency, the proof being profit opportunities for active managers are shrinking, but I would debate this is completely wrong.  
    
     The popularity of ETFs from indolent wealth managers has been a primary factor for the inflow of dollars into these investment vehicles.  The lack of real asset management has been the primary causal factor for the expansion of ETFs, and recent passive investment swing.  As wealth managers, at the largest firms, continue to be rewarded on assets under management, rather than investment performance, these mediocre “set it and forget it” passive investments have reigned supreme, but at the detriment to investors.

     Wealth managers should not be allowed to alter the reality of who is responsible for poor portfolio performance. If they can simply say, investment declines are nobody’s fault, and that it is the fault of the market, index or sector, they take themselves off the hook.  Efficient markets should flow into the highest and best performing investments, net of fees and expenses.  So logically, if huge amounts of money flow into higher performing investments, such as BDCs or other higher performing alternatives, regardless of whether they are actively managed, you would see similar expansions in those investment vehicles and declines in the lower performing investment alternatives. So why do lower performing passively managed ETFs continue to have popularity? I would argue, it’s because risk adverse wealth managers are selling ETFs as low cost and relatively safe haven investments, while never really doing the research necessary to source the higher performing alternatives for their investors. What does it matter? They get paid on how much money they manage, not on investment returns.      

     Unfortunately, because of their peculiar characteristics, ETFs do not conform to the traditional view of low risk passive investments for buy and hold investors. For example, ETFs provide intraday liquidity to their investors. As a result, they attract high-frequency demand, which translates into price pressure on the underlying securities, due to the arbitrage relation between the ETF and its basket of securities. This trading activity is potentially destabilizing for the underlying securities’ prices, because it likely reflects qualitative motives.  To compound this effect, the lower trading costs of ETFs relative to the underlying securities can increase the rate of supply and demand shocks to the market. Specifically, trading strategies that were too expensive when buying all of the securities held in the basket, without ETFs, suddenly become affordable thanks to these instruments. Noise trading can therefore leave a bigger footprint on security prices because of ETFs, suggesting that they may pose new challenges to the efficient pricing of the underlying securities ETFs are indexed to.
Passive Broad Market Diversification is better then Actively managing securities.  (FALSE)
     Broad market economic declines generally correlate and affect most pooled investments similarly.  The advantage of active management on commingled vehicles such as mutual funds, private equity, BDCs, REITs and other alternatives is that they offer, not only the potential benefits of diversification, which helps to reduce the overall risk of a portfolio, but they attempt to avoid the decline in the price of one security offsetting the rise in price of another.  The Active Manager, with proper analyst coverage, should better understand the fundamentals of all of their underlying securities, and better predict and hence avoid the securities with pressures to decline.  

     Likewise when indexing any basket of securities, you have the obvious one-third “best of breed” “Winners” in that sector, the obvious bottom one-third  “Losers” and the middle-market “Transitioning” performers, some of which may become Winners, while some may unfortunately become Losers.  Active Managers attempt to do what individual investors and ETFs are incapable of doing.  They maintain an analytical relationships with their industries and market segments and monitor all of the securities within their given basket.  They then can predict the top performers, weed out the losers and hopefully catch the rising stars and drop the falling meteors that make up the middle.  Theoretically, a Passively Managed investment, must take the entire basket of securities winners, losers and transitioning middle regardless of its directional move.  In doing so, the Losers weigh-down the performance of the Winners and the descending and ascending middle-third securities offset each other. The best you can hope for with an ETF is a total sector “top to bottom” expansion.

     ETFs, and the underlying securities held by them, may be setting atop a bubble due to the monetary expansion caused by the massive inflows of capital from inattentive wealth managers.  Savvy wealth managers should begin moving back to sector specific, actively managed investments and alternatives with keen portfolio management.  Understanding portfolio managers, who are conducting proper analysis, have the capability of outperforming, passively unmanaged ETF investments, within the same sectors, is half the battle.  Professional wealth managers need to recognize the ETF’s baskets of securities, they are placing their investors money in, includes all the segment losers, which may be holding back their investors’ returns.  Sourcing better quality investments, rather than living with lackluster investment returns from ETFs, should be the measure of wealth management success.

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