Mostly: Classical

[Sexton O Blake]

BW: What's Wrong With ETFs?

(Ed: Read the bottom of this)

They encourage frequent trading, which helps Wall Street more than investors, says the father of the index fund

Since he founded Vanguard Group Inc. in 1974, John C. "Jack" Bogle has used his position as a bully pulpit for low-cost investing. But in the decade since he retired as chairman and chief executive officer, the 77-year-old Bogle has emerged as the mutual fund industry's most outspoken critic, railing hardest against funds with high fees and cruddy performance.

In his latest volume, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (John Wiley & Sons Inc., $19.95), Bogle continues to press his case for investing in index funds because of their low costs, minimal taxes, and predictable returns—that is, investors should earn whatever the market earns. In the edited chapter excerpted below, Bogle argues that many of the newly popular exchange-traded funds (ETFs), which are presented as index funds, are in fact gimmicks with dangerous implications for investors.

Traditional indexing is under challenge by a sort of wolf in sheep's clothing, the exchange-traded fund. Simply put, an ETF is a fund designed to facilitate trading in its shares, dressed in the guise of a traditional index fund. But the differences between a classic index fund and the index fund nouveau are stark. ETFs 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 ETF, created in 1992, was named "Standard & Poor's Depositary Receipts" (SPDRs) and quickly dubbed "Spider." It was a brilliant idea. Investing in the Standard & Poor's 500-stock index, operated at low cost with high tax efficiency (since it doesn't trade stocks, taxable distributions are minimal or nonexistent), and held for the long term, it appeared to be a ferocious new competitor to the traditional S&P 500 index mutual fund. (Brokerage commissions, however, made it less suitable for investors making small investments regularly.)

Most Spider investors, 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 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% share, up from just 9% as 2000 began and only 3% a decade ago. 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 willingnessonay, 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 formed during 2006, and the range of the investment choices is remarkable. (Early in 2007, 343 more ETFs were on the drawing board.) There are 12 stock market index funds (U.S. and international) with the Spider still the largest segment in terms of assets, 68 focused on investment styles, 173 based on stock market sectors, and 58 concentrating on particular foreign countries. There are also a handful of bond ETFs and a scattering that utilize high leverage (doubling the swings in the stock market), tracking commodity prices and currencies, and using other high-risk strategies.

Broad-based ETFs are the only ones that can replicate, and possibly even improve on, the classic index fund. Their annual expense ratios are usually—but not always—slightly lower than their mutual fund counterparts, though 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. 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 to the renowned Purdey shotgun, supposedly the world's best. It's great for big-game hunting. 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 because the turnover of Spider shares is running at a 3,600% annual rate. The turnover for the NASDAQ Qube (QQQQ )s (an ETF based on the NASDAQ 100 stock index) is even higher: 6,000% per year. It is only guesswork, but long-term investors hold perhaps 20% of the $100 billion assets of these Spider-like broadly diversified ETFs. The remaining assets, I presume, are held by market makers and arbitrageurs making heavy use of short-selling and hedging strategies.

A VAST DEPARTURE
Trading in the major-sector ETFs is also remarkably high. The shares typically turn over at an average annual rate of 200% per year (an average holding period of just six months), with the most popular ETFs recently running turnover rates from 578% to 735%, all the way up to 7,100% (Russell 2000 iShares (IWM ), a small-cap stock index) and 8,500% (SPDR Energy shares (XLE )). 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. Could there be speculation going on here?

Yes, these specialized ETFs are diversified, but only within 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, broad-based index funds.

The net result of these differences is that sector ETFs as a group are virtually certain to earn returns that fall well short of those delivered by the stock market. Perhaps 1% to 3% a year is a fair estimate of these all-in costs, many times the 0.1%-to-0.2% cost of the best classic index funds. It is not a trivial difference.

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 investing in them after the fact is a recipe for disappointment. One lesson I've learned over the years is that mutual fund investors almost always do significantly worse than the funds they own, and that lesson is likely to be repeated in ETFs.

Let me now address what I noted at the outset of this chapter: "What have they done to my song, ma?" As the creator of the world's first index mutual 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 exchange-traded fund is a traitor 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, our common sense should reassure you that the number of strategies that are worse is infinite.

http://www.businessweek.com/magazine/content/07_18/b4032089.htm

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If you go to the site, there are some good comments from users on this article.

Here are a couple:

Nickname: Tom
Review: I like Jack and think he has done a great service for the average investor, but this is the equivalent of Communism taking over Wall Street - everybody gets the same mediocre returns. Capitalism works because smart people figure how to make more money (or lose less) than dumber people. It is economic Darwanism, and it works!
Date reviewed: May 4, 2007 2:07 PM

Nickname: Rick
Review: I'm tired of the same old investing conventional wisdom. If few people can beat index funds then why don't all the investment houses shut down and professional money managers get new jobs? Someone out there is beating the market or they wouldn't be selling Manhattan penthouses and homes in the Hamptons. How many index funds does Buffet own? Current investing advice only serves to promote mediocrity. Blame the ignorant investor and not the ETF tool.
Date reviewed: Apr 28, 2007 2:53 PM


iSoB