ETF: EXCHANGE TRADED FRAUD?

9/14/15

This (i.e., Monday, 9/14/15’s, page C1) morning’s Wall Street Journal featured an article entitled “The Problem With ETFs,” which outlined a host of problems with exchange trade funds.   These problems, almost exclusively manifested on the wild trading morning of Monday, August 24, included wide bid/asked spreads, stop orders getting executed at far lower prices than the stop prices, and, most saliently, ETFs’ trading at prices far below the net asset values of the funds.  

The first of these two problems (wide spreads and blown through stop orders) were not at all unique to ETFS on that wild morning; the same problems plagued trading in stocks of individual companies.   The third was an ETF-centric problem; prices of the ETFs were falling much further than were the prices of the stocks comprising the ETF.   Thus, some traders were, to use a technical financial term, screwed if they sold their ETF positions in the panic stricken trading of the morning of 8/24.   On the other hand, some traders, to use another technical financial term, lucked out if they bought during those ulcer inducing hours, or, really, minutes.  The article tells the story of one such fortunate investor, CIC Wealth CEO Ryan Wibberley, who, to his credit, not only had the courage to buy in that panic stricken downdraft but also has the class to admit that he did indeed experience some very good luck that morning.  As Mr. Wibberley put it

“I was just waiting for them to take it away from us.  (i.e., for the exchange to cancel the trades)   There’s someone on the other end who just is not having a good day.”

Two observations come to mind to yours truly, who both invests in and trades ETFs.

First, trading is not for the faint of heart.   Most people shouldn’t engage in it.   Most days, I think yours truly shouldn’t engage in it.

Second, the problems of ETFs that manifested themselves on the morning of 8/24 were problems not for investors but only for traders and thus do not detract from the inherent beauty of the ETF product for investors. 

Initially, ETFs were promoted as types of index funds that could be traded throughout the day, which is, effectively, what they are.   The target market at that time was thus people, probably primarily traders, who liked traditional closed end mutual funds, and especially index funds, but didn’t like waiting until the end of the day to close or initiate a position.   Such traders wanted to be able to get in and/or out of a position at any point in the day, often to take advantage of short term fluctuations in the market.   Traders wanting a more exciting sport and/or a bigger adrenaline rush could trade options on ETFs, which were, for obvious reasons, almost instantly active with the introduction and expansion of the ETF market.

However, as time went by, ETFs were seen not only as trading vehicles but also as lower cost alternatives to already low cost index funds for long term investors.   Many ETFs feature expense ratios far lower than comparable closed end index funds.   For example, here are the expense ratios of comparable Vanguard ETFs and closed end index funds: 

                                                Expenses, in basis points

                                              Closed End Fund       ETF

S&P 500 Index                                 17                       5

Total Stock Mkt Index                   14                       5

Bear in mind that the expense ratios on the closed end funds are themselves, to use another technical financial term, super cheap compared to actively managed funds.   And if an investor can put more money to work in Vanguard index funds and thus go to the Admiral class of shares, the expense ratios fall to the same as those of the ETFs.   However, several brokerage firms, including Schwab, TD Ameritrade, and Vanguard’s brokerage arm, allow investors to buy certain ETFs with no commissions, usually with no, or very small, minimum purchases, thus making ETFs, at worst, even money propositions, expense wise, with the cheapest closed end funds.

So while ETFs originally were designed to appeal to traders, or to nervous investors, and still retain that appeal, more and more ETFs are being used as cheaper alternatives to closed end mutual funds by long term investors.  ETFs have served that function exceptionally well…unless, for some reason, investors felt compelled to get out of, or even into, positions precisely during those few hours (minutes, really) on the morning of 8/24 when the market was in turmoil.   Such periods of ETF market inefficiency should be rare…unless the ETF product is fundamentally flawed, which is possible but highly unlikely, given the 25 year track record of the ETF.

Long term investors, in ETFs or otherwise, were not, or should not have been, much fazed, or damaged, by the, er, eccentricities of the trading of the morning of 8/24 or by similar trading which is bound to briefly repeat itself, perhaps in the near future.  They don’t use ETFs as trading vehicles and thus weren’t hurt by wide big/asked spreads, blown through stop orders, or ETFs’ temporarily trading at big discounts to their NAVs.  Such investors were just riding the markets…and paying the lowest possible price for their tickets.   For them, ETFs remain what they have been since their inception, i.e., very low priced and efficient ways to execute long term investment strategies.