Friday, 14 December 2007

Seven reasons why I am not buying ETFs and index funds

I have been observing a very common and powerful trend lately – everybody seems to be into ETFs and indexes. It is not just a trend. It is the latest fad among investors and traders, which is strongly promoted in the media. These funds have been hugely popular among different breeds of investors and traders. Experienced investors use them to diversify their portfolios and increase their exposure to different markets and sectors. Beginner investors buy them because it is an easy and affordable way to invest into the whole market or just one of its segments. Traders use them to relatively safely ride on strong market trends. Non-investors who just want to save a bit for their retirement buy them because they are told to buy them. Here is the media pressure at work here.

I have to admit that there are quite a few positive things about ETFs and index funds. They can and probably should be used in certain situations. However, overall I remain pretty skeptical about them and personally prefer individual stocks. Why am I so cautious about ETFs and indexes (let’s also throw in mutual funds into the list)? Well, there at least several reasons for that, and I will try to summarize them below:

1. Careful selection beats bundling: For experienced investors and traders with a well-defined strategy, a group of carefully selected individual stocks will deliver better performance (in terms of return on investment and/or dividend yield) that an index. In many cases, the underlying portfolio of a sectoral and topical index is dominated by large holdings of a very few companies. Why buy a bunch of companies with different concurrent performance levels if you can pick just one or two leaders from the list and these leading stocks will easily beat the index, which can be dragging behind thanks to its underperforming members?

2. A proxy will always be a proxy: An ETF or index is just a very crude proxy of an imitated broad index – it cannot reproduce a market index well enough and quickly enough because the portfolio manager can’t continuously and promptly rebalance the fund’s portfolio. If this is the case, then why the fund price should mimic the momentum movements in the market? It is just another asset with a limited level of capitalization and liquidity, which abides the law of supply and demand. If there is not enough liquidity in trading the fund, then even prompt rebalancing of the fund portfolio cannot make it reproduce all moves of the underlying market index/portfolio. What if an ETF represents a declining sector and suddenly a large investor decides to buy a large lot of the fund’s stock? Would not the fund’s price go up as a result of that? But then what about closely tracking the market’s moves?

3. A fund manager’s black box at work: Unless you work for the fund, you do not know how the fund’s management handles its portfolio, i.e., how often the fund assets are rebalanced, what stocks or other assets are picked up and in what quantities, where the assets are stored, and whether they are used for some equity lending/borrowing activities that the fund’s shareholders are not aware of. That reminds me of the fairly recent scandal with Morgan Stanley, which collected money from investors to purchase and store physical silver bullions on behalf of its clients. As it turns out this silver was phantom and investors’ money was spent on something else. Those folks surely thought they were proud owners of silver safely kept from them by the reputable Wall Street brokerage.

When I read about such cases, should I trust brokerages and funds, even if the top ones occasionally try to screw their clients? I am not so sure because the same things likely happen elsewhere too. People buy shares of numerous gold, silver and platinum funds thinking that they buy precious metals. I strongly doubt that there are physical metal holdings somewhere in these funds and even if there are some, then fund investors/ shareholders will never be able to see and touch these so attractive and expensive pieces of metal. In reality, it is most likely just paper, paper derivatives, and people are therefore trading paper, which surely is a bit too pricey for its real intrinsic value.

Of course, my stock shares are also paper, but at least they are legally linked to individual real-life companies and are collateralized by physical assets of these companies, which have decades of market reputation and which have performed real-life delivery of goods and services for years. What real things have those fund guys delivered to you and the rest of the world so far other than a receipt for your money? Have you seen the assets they claim they hold and/or store on your behalf? Are you sure that these funds will stay in place when the things get tough?

4. Always read a small-font disclaimer in the fund’s description: The previous paragraph raises another important issue with buying ETFs and index funds – the issue of reputation and investor protection. Before you invest in those funds, do you read tiny-font disclaimers under descriptions of many of them? For example, read this tiny disclaimer on CIBC investment funds:

“CIBC Mutual Funds and CIBC Family of Managed Portfolios are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer, nor are they guaranteed by CIBC. There can be no assurance that money market funds will be able to maintain their net asset value per unit at a constant amount or that the full amount of your investment in a fund will be returned to you.”

Sounds good: they collect your money, but do not promise your anything in return. In some other cases, the legal entity behind a family of funds is a limited-liability company registered in some distant offshore. If the things go sour, good luck claiming your money – some fund manager guy laying on a sunny beach of an offshore tropical paradise and sipping a Breezer will just chuckle envisioning you and other investors trying in vain to claim your money back.

5. Danger - derivatives: Many funds actively use derivatives to boost their performance or save cash intended to purchase portfolio assets. Indeed, why bother buying an asset if you can open a leveraged position at a fraction of the asset cost? For example, read this pretty note to Vanguard funds on their website:

“The fund may invest, to a limited extent, in stock futures and options contracts, warrants, convertible securities, and swap agreements, which are types of derivatives. Reasons for using these investments include: keeping cash on hand to meet redemptions or other needs while simulating full investment in stocks and reducing transaction costs or adding value when these instruments are favorably priced. Losses (or gains) involving futures and options contracts can be substantial—in part because a relatively small price movement in a contract may result in an immediate and substantial loss (or gain) for a fund. Similar risks exist for warrants, convertible securities, and swap agreements.”

I do not want to invest my money in derivatives and, even less so, I want somebody else doing it for me, without asking my permission.

6. Fees, fees, fees: Last but not least, one of the most important downturns of actively or passively managed funds is fees. Even you do not trade the fund shares, you still pay an annual management fee. MERs (management expense ratios) range from a fraction of a percent for most liquid actively traded funds to a whopping 2-3+% for the other less liquid or more "upscale" funds. Think about it: even if you annual fund management fee is pretty low at 0.5%, it means that on your $10,000 position you pay $50 a year on top of the trading fee to open the position. For $50, I can do up to 10 trades at Questrade, buying excellent individual stocks. When you invest into a fund, you regularly pay your fees to some guy you are not familiar with, no matter how well or badly the fund perfoms – it is definitely not the best way to spend your hard-earned money.

7. Exchange rate swings can boost or kill the performance of your ETFs: Unfortunately, many investors forget that buying shares of an ETF or a mutual fund may involve significant foreign-exchange risks if the fund's portfolio includes foreign assets or if fund shares are denominated in a foreign currency. For example, most Canadian investors buy USD-denominated funds because the most liquid, popular ETFs are listed in the United States and are denominated in U.S. dollars. Unfortunately, even those USD-denominated funds, which generated a positive return over the last year or less, deliver either weak or ugly performance to a Canadian investor once the latest USD-CAD exchange rate trend is taken into account. The choice of CAD-denominated and FX-hedged ETFs currently available to Canadian investors is fairly limited and includes no more than 20+ index, sectoral, and topical ETFs provided largely by iShares and Vanguard (correct me if I am wrong). Since I live, save, and spend in Canada and am planning to retire in Canada, I prefer my portfolio holdings to be hedged against the FX risk exposure. Currently, most ETFs and mutual funds come without this feature.

At the end of the day, each investor or trader decides for her/himself whether to invest in ETFs and index funds. I prefer staying away from them for the seven main reasons I stated above.


Anonymous said...

I think you need to do a little more work researching, especially ETFs - most of your points don't apply to them!

1)Careful selection does, but usually you have to be a full-time expert. And even so, 75% of mutual funds (roughly) don't even beat the S&P500. You'd be better off just investing in an index fund, or index ETF.

2)Buying a share of the index ETF is not like buying a stock - it's buying partial interest in all the stocks in the ETF. So you buy, the ETF buys the stocks. The ETF won't spike above the value of the stocks because it's also passing along that $ to the stocks - and so they'll go up accordingly.

3)Funds are black boxes, but ETFs are not. There are currently no actively managed ETFs. They passively track indexes, and so are transparent.

4)When you buy a stock, they collect your money and promise you a return - but that doesn't mean it will happen. If things go sour, good luck claiming your money.

5)Funds, not ETFs.

6)Many, many ETFs have much lower expenses (because they passively track indexes) - some as low as 0.15%. That's a pretty fair trade if you can't do research on individual stocks yourself.

Look a little more closely at ETFs, they can't be lumped into your misgivings about mutual funds - they're different animals.

BEIT said...

Thanks. Good points. I agree that they may be a great diversification tool and are probably a good starting point for newbie investors. And I certainly agree that ETFs are much better than mutual funds if you compare them. Mutual funds are a no-no in my opinion. My main point was comparing top-quality individual stocks versus funds as a family.

I still disagree on your comments about ETF transparency and objectivity in management. They do use derivatives and their index-tracking asset portfolios are selected and adjusted at a fair share of fund management's discretion. And, well, they still charge you a fee - the less liquid and the more specialized the fund is, the greater is its MER.