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.

INDEX INVESTING: “YOU (DON’T) GOTTA HAVE HEART…”

8/21/14

The Wall Street Journal reports this morning (“Investors Pile Into Vanguard, Eschewing Stock Pickers”, page A1, 8/21/14) that investors are buying into index funds big time, driving Vanguard’s assets under management (“AUM”) to almost $3 trillion and making Vanguard’s Total Stock Market Index Fund the largest mutual fund in the world.  (A note is in order here; Vanguard, a firm that I advocate and highly respect is widely known as THE passive manager.  While it is the premier passive manager, and the virtual inventor of the index fund in practice, Vanguard has a big actively managed fund business, just about all of which is done through sub-advisors.  Further, you don’t have to invest with Vanguard to invest in passively managed index funds; most fund managers, even those, like Fidelity, who pride themselves in being great active managers, have substantial businesses running passive index funds.  Most of you knew that, but my readers span a wide range of financial sophistication, so I wanted to clarify that.)  Further, money flowing into index funds exceeded money flowing into actively managed funds by a factor of 6 last year and by a factor of over 2 this year.

Some of this influx has been attributed to something Warren Buffett, one of the few active (in his case, VERY active) managers who has beaten the indices over long periods of time, wrote in Berkshire Hathaway’s letter to investors in March.  He stated that he gave the following advice to the trustee of his estate:

“…put 10% of the cash in short term government bonds and 90% in a very low cost S&P 500 index fund.  (I suggest Vanguard.)”

Great minds apparently think alike (See below.); some just get to the party later than others, but getting there, not when they get there, is the key.  But I digress.

The world seems to have caught onto the argument, long advocated by yours truly (See, inter alia, EXOTIC INVESTMENT PRODUCTS FOR THE “AVERAGE GUY”:   WHAT’S THE POINT?, 8/16/13 and the posts to which it will refer you.), that index funds are the way to go.  Combine the inherent efficiency of the financial markets with the low cost and lack of manager risk of index funds and you are nearly sure to beat active managers over meaningful periods of time by investing in index funds.   Just about all my money is in index funds. 

(A point of digression here:  So why do I have any actively managed money?  That’s a long and not all that interesting story that I will save for another time.  For now, suffice to say that almost all of my non-index money is invested in funds that use screening techniques and thus eliminate, or at least minimize, manager risk, much like index funds, and keep costs reasonably low, though not as low as index funds.  I like to refer to them as “index-like” products and they play a limited role in my portfolio.  Much of my remaining non-index money is there to entertain myself, to indulge my market prognostication propensities while keeping my acting on those propensities away from amounts of money that would really matter.   So, while I don’t have ALL my money in index funds, I eat my own cooking; just about all of it is in index funds.  Of course, lately, all my money doesn’t amount to very much, but that is another issue.)

Many years ago, when I was managing portfolios at a big Chicago bank, I appeared at a forum sponsored by a major mutual fund company with whom we did business.  This particular family of funds, which will remain nameless, was and is primarily an active manager and an advocate for active management.  At this forum, I was there to represent the passive investing argument and the deck was stacked against me, but the sponsoring fund family was, and is, good people and I was confident enough in my argument that the set-up didn’t bother me.

After I made my pitch for index funds, the firm’s representative said something like (paraphrasing, not quoting; it was a long time ago):

What Mark is advocating is putting your money with a manager who has no brain.   Does that make any sense?

It looked as though he had me, until I retorted

Yes, I agree that an index fund has no brain.  But it also has no heart; it invests without emotions.  In your life, when you’ve made mistakes, was it because you weren’t smart enough to avoid those mistakes or because you let your emotions get the better of you?  

The answer, to most people was obvious.  I went on.

It’s the same with investing.   For the most part, money managers are very smart people.  (Perhaps I exaggerated a bit here, but I digress.)   It’s not a lack of intellect that gets them into trouble.  It’s their emotions.   They won’t sell a losing position that is getting worse.  They won’t add to a losing position that is only becoming an even more compelling value.  They continue to add to a winning position that has gotten way too rich.  It’s human nature that leads to investment mistakes.  Index funds eliminate the emotion from the process.  So, yes, I would rather invest with a manager with no brain…as long as it also lacked a heart.

I don’t know whether I won the day there, but I was quite happy with my defense of index funds and passive investing.  I have more or less stuck to that philosophy until this very day and probably will for the rest of my life, with at least one caveat:

Index investing does not entirely remove the emotion from investing.  Effective index investing (or even active investing) still requires nearly religious rebalancing (See, inter alia, Bill Gross Has A “Bad” Year:   Lessons For Your Portfolio, Rant Lifestyle, 1/4/14) and emotion can certainly get in the way of effective rebalancing; who wants to sell “winners” to buy “losers,” which is one of the things rebalancing forces us to do.  So to nearly eliminate all emotion from investing, even the dangerous emotions that come into play at rebalancing time, one would have to invest in a balanced index fund, or set up an arrangement in which your index funds are automatically rebalanced for you by the fund company.  Such arrangements are growing increasingly common.  Or you can do what my clients (at the time, mostly institutions) did:  hire a manager to do the emotionally wrenching things for you.

If you want to entertain yourself, do what I do:  watch “The Godfather” again, read a compendium of the musings of H.L. Mencken, watch “Shark Tank,” drive long distances in a car with a manual transmission and satellite radio, watch Big 10 football and basketball, read and write about politics…and maybe trade a few dollars like a scalded dog and hope to keep your underperformance, or outright losses, reasonable.  If you want to invest sensibly, buy index funds and religiously rebalance.

EXOTIC INVESTMENT PRODUCTS FOR THE “AVERAGE GUY”: WHAT’S THE POINT?

8/16/13

Today’s (i.e., Friday, 8/16/13’s, page C1) Wall Street Journal contained an article (“Mom-and-Pop Pitches Draw Flak,” by James Sterngold) discussing the concern of some in and around the investment industry about the increasing number of esoteric investment products being sold to small and medium sized investors.   These products, born largely of search for yield in the wake of what I like to call Ben Bernanke’s War on the Elderly and a desire to avoid the kinds of market downturns we saw in 2008, include long and short funds, private equity funds, funds that buy unregistered bond issues, and a range of investment products limited only by money managers’ imaginations and ability to sell.

Regular readers can probably guess my reaction to this proliferation of esoterica in the financial marketplace:   What’s the point? 

I have long contended that the best strategy for just about everyone to follow is to hold a balanced portfolio of stock index funds and bond index funds, with the proportions of each based on one’s long term risk tolerance rather than one’s perceptions of where the market is going, which are as likely to be wrong as they are to be right.   (See my 5/8/13 post,ANOTHER OF THOSE TRITE BUT TRUE INVESTING MAXIMS for only my latest, until now, expostulation on this point.) The only trades one should do in one’s portfolio are an annual rebalancing, which must be done with nearly religious fervor.  It would also help not to look at one’s investments with any degree of frequency; doing do can lead to panic or euphoria, both dangerous emotions in investing.    By holding index funds and religiously rebalancing, one will capture a portion of the stock market’s upside, avoid a portion of the market’s downside and, in almost all cases, beat the performance of more “sophisticated” products in any meaningful time frame.  (The size of the portion of the market’s upside and downside one will avoid depends, of course, on the proportions of one’s portfolio invested in stocks.)  If one really wants to simplify one’s investment life, one could hold a balanced index fund, which holds both a bond index and a stock index and does the rebalancing automatically, though generally in a slightly different manner than an annual rebalancing.

Why do I make this case for index funds with such fervor and certainty?

First, it is difficult for anyone to beat “the market” over any meaningful investment horizon.  The definition of “the market” varies with the asset class in which one is investing, but virtually every market is represented by an index and there is an index fund for just about every index.   These percentages vary as rolling ten year periods change, but the latest I saw is that only 13% of active large cap stock managers beat the S&P 500 index over the prior ten year period.

Second, while there are managers who outperform their indices, there are few (See the last paragraph.) who do so after the fees that actively managed funds charge.  For example, the aforementioned Journal article talks about a retired physician in Florida who bought the Mainstay Marketfield Fund, which takes long and short positions on stocks depending on who knows what criteria.   This fund charges management fees of 1.50%, or 150 basis points.  The Vanguard S&P 500 Index charges 10 basis points on its Admiral Shares.  The spread between index and active fees is not usually this large, but the spread is always considerable and acts as a kind of ankle weight on the performance of actively managed funds.

Third, while there are managers who outperform their indices even after fees, there are not many of them and the chances of your finding the manager who will do so over the next five, ten, or more years are miniscule.  Remember, past performance is not necessarily a good indicator of future performance, so simply picking the best performers for the last ten years doesn’t work.   Things change.  This is called “manager risk.”  One supposes one could find a broker and/or investment advisor who is skilled at finding really great managed funds, but one would have a hard time finding such an advisor who is clairvoyant.  And brokers who can find such great managers will doubtless charge more fees, further reducing the chances of your outperforming “the market,” as defined by an index fund.

Fifth, these exotic new products will not necessarily perform as advertised.  The same physician cited in the Journal article reports that he is not dismayed by the underperformance year to date of his Mainstay Marketfield Fund of the S&P 500 by about 900 basis points because

“I was happy to sacrifice optimal performance on the upside for the defensive characteristics.”

There may be something to this; the Mainstay Marketfield was down only 13% in 2008 while the S&P was down 37%.  But then again there may not be anything to the doctor’s argument; we simply don’t know how the Fund will do in a similar downturn in the future.  And even if Mainstay does that well on relative basis, not every such exotic fund will. 

We do know how a well run index fund will perform; it will do as its index does, less fees.  And we also know that we can adopt defensive characteristics by not putting all our money into a stock index, by balancing out the risks of stocks by holding a bond index.  We further know that we will force ourselves to buy low and sell high with a portion of our portfolios if we religiously rebalance.   And we can achieve all this while not paying an active manager 14 times more than we pay an index “manager.”

A necessary word…

Some have mistaken my enthusiasm for index funds as a rejection of the work of financial advisors.   This is certainly not my intention.   We who have invested, or do invest, for a living and know what we are doing tend to underestimate the difficulty for the average person of techniques such as rebalancing.  We also tend not to be intimidated by talk of markets and the use of jargon by the investment community.  In short, we think it is as easy for the proverbial “average guy” to invest as it is for us to invest.  While this can be the case with just a little bit of effort and a mastery of some pretty elementary arithmetic, it is usually not the case that the “average guy” finds this stuff as easy as I and my colleagues do.   And sometimes people simply need a trusted hand to hold, figuratively of course.  If you are an “average guy,” at least as far as money and investing go and/or you’d feel better working with an expert, by all means work with a financial advisor.   It would be best, though, to work with a financial advisor who is open to index and index fund like products.   More importantly, be careful; while there are some good advisors out there, there are plenty of charlatans in the money business.   And one can usually detect such a mountebank by his or her promises of to deliver “above market returns,” “more yield with the same or less risk,” or “consistent market beating performance.” 

Trust and honesty are far more important characteristics for a financial advisor than are purported investment skill and knowledge.

Even I work with a financial advisor on a portion of my portfolio and have been doing so for about the last 25 years.  It’s good to have someone with experience both similar to and different from mine with whom to discuss things.   He is smart and honest and does his best to keep the costs down.   I trust him and like him and he more than tolerates my enthusiasm for index and index like products.   

YES, I’M STILL HOLDING ONTO MY TIPS

2/2/13

Occasionally, I will write purely financial pieces on Mighty Quinn on Politics and Money; this is one of those occasions.

In this weekend’s (i.e., 2/2/-2/3/13’s) Wall Street Journal (“Looking for Inflation Protection?   Take TIPS off Your List,” page B7), Brett Arends argues against holding Treasury Inflation Protected Securities (“TIPS”), which comprise an astronomical proportion of my portfolio and large proportions of the portfolios of those I informally advise.  Naturally, Mr. Arends’ comments merit a response, if only to clarify my thinking.

Mr. Arends’ main argument is that TIPS, with their negative real yield, are “a lock to lose money in real, inflation-adjusted terms.”   But this is not news to my readers; I’ve written extensively on this point at the now defunct Rant Finance:

1/8/13              TIPS:  STILL WARY, BUT STAYING, AFTER ALL THESE YEARS

10/3/12            WARY OF TIPS AT THESE LEVELS?  A LITTLE, BUT…I’M STAYING

7/19/12            10 YEAR TIPS AUCTIONED AT A RECORD LOW YIELD—NEGATIVE 63.7 BPS—WHAT, ME WORRY?

In the interest of space, only the most recent of these has been reproduced below.

While Mr. Arends reiterates my, and most people’s, primary objection to TIPS, he fails to

Answer a question I’ve asked in all the above posts:   What’s the alternative?  Yes, it seems crazy to hold an investment with a negative real yield, but, in an environment characterized by investments with negative real yields, TIPS make sense on a relative basis.

With the conventional ten year treasury yielding 2.01% and the ten year TIP yielding a negative -0.57%, if one holds ten year treasuries, one would be betting that inflation will average less than 2.58% over the next ten years.  I, for one, would take the other side of that bet all day.  If one were to hold cash at 0%, one would be betting that inflation will average less than 0.57% for the next ten years or that short rates will turn up quickly and decisively.  While I might consider taking the latter bet, would anyone care to take the former?

Mr. Arends did suggest going from long TIPS to shorter maturity TIPS (So how much can he really hate TIPS?  But I digress.)   This might be a good idea, primarily because TIP yields get less negative as one moves in the treasury curve (shortens maturities) and because short TIPS are less exposed to increases in real rates than long TIPS.   But to take one’s capital gains (As Mr. Arends points out, the February, 2040 TIP is up 40% in price since its issuance three years ago.) and pay the attendant taxes (even at the lower capital gains rate, as Mr. Arends also points out)  for such a small change in positioning seems a little silly.   And those of us who hold our TIPS in funds (the exchange traded fund (“ETF”) TIP or a TIP fund from a major mutual fund family) don’t have that option, though Vanguard has now come out with a short maturity TIP ETF, and I’m sure Vanguard isn’t alone.   Still, moving out of TIP into the short term TIP ETF involves a lot of taxes for not much of a change in one’s portfolio.

Mr. Arends suggests that those who are buying TIPS for inflation protection go into real estate and commodities.   I, and those I advise, have plenty of gold and silver exposure, primarily through the ETFs GLD and SLV.   But one has to understand that TIPs and, say, gold, display profoundly different risk profiles and therefore are not ready or obvious substitutions for each other.

Mr. Arends did not suggest common stocks, and especially big dividend payers, as an inflation hedge.   There would have would been some merit to this suggestion, but stocks, while providing a good inflation hedge in the long run don’t do so well in the short run when inflation starts to pick up.   Further, increasing one’s equity exposure because one no longer likes his or her TIP position seems to be making an asset allocation decision with too many other variables swirling around it.

Mr. Arends makes some good points and I thank him for causing me to reexamine my assumptions, but I will continue to hold my TIPS…and will let my readers, and those I advise, however informally, know quickly should I change my minds.

PROMISED 1/8/13 POST REPRODUCTION:

TIPS:  STILL WARY, BUT STAYING, AFTER ALL THESE YEARS

1/8/13

Treasury Inflation Protected Securities, or TIPS, have taken a beating over the last month or so.   The yield on the ten year TIP has increased from a record low negative 93 basis points (“bps”) on 12/6/12 to a negative 67 basis points as I write this.  The ETF TIP has fallen from a high of 123.30 on 12/6/12 to 121.07 as I write this.  As loyal readers know, I have been long TIPS in one form or another in a big (for me) way for a long time.   This investment has worked out very well for yours truly, so, naturally, I am nervous about it, as any prudent investor should be after a prolonged pleasant experience; complacency is dangerous in investing, as it is in most aspects of life.  So I have been watching TIPS closely and have curbed, but not abandoned, my enthusiasm for them.  See my 10/3/12 post, WARY OF TIPS AT THESE LEVELS?  A LITTLE, BUT…I’M STAYING.

The recent drop in TIPS is entirely attributable to the drop in treasuries in the wake of anticipated and actual “progress” in the fiscal cliff negotiations (See, inter alia, my 1/2/13 post at Rant Political, FISCAL CLIFF REVISITED for some thoughts on the so-called fiscal cliff.); note that the implied inflation rate in the 10 year TIP has increased, albeit by only 2 bps to 2.54%, since 12/6/12, indicating a very slight outperformance of the conventional 10 year by the 10 year TIP.   Therefore, a logical conclusion would be that if one really believes that the fiscal cliff deal was sufficiently salubrious for the economy and the market to justify the post January 2 rally in stocks, one should be abandoning both conventional treasuries and TIPS and doing so with enthusiasm.  

Yours truly, for one, is not yet ready to declare that the patchwork excuse for a deal that the eminences in Washington managed to barf out after their deadline has removed the obstacles the economy and the stock markets faced in seeking their true, and much higher, levels.  Indeed, the fiscal problems of the U.S. government are merely one range of mountains the world economy must surmount, and even those problems were not solved by this poor excuse for a deal.   While the rally could be justified for a trade, largely on the greater fool theory, which tends to work well in the world of short run trading, it is utterly baffling from an investment standpoint.   And if one believes the stock market rally has no legs, as the last few days seem to be indicating, it’s hard to think that treasuries and, by extension, TIPS, are in serious peril at this juncture.

However…

We are not dealing with conventional times or conventional markets.   The reason that the conventional ten year treasury is yielding 187 basis points, a yield still laughably paltry though way up from its low of 138 bps in July, is because the Fed is buying the lion’s share (about ¾) of treasury issuance.   If the Fed were to back off, conventional rates would increase, if not soar.  And if the Fed were to back off, it would, necessarily, stop creating the money it uses to monetize the debt (Let’s call a spade a spade.).   That would presumably tamp down inflation expectations, which would cause TIPS to underperform a poorly performing conventional treasury market as real rates increase and inflation expectations decrease.   This is a bad, if not a nightmare, scenario for TIPS.

So if one believes that the economy is improving sufficiently for the Fed to back off its aggressive bond purchasing programs, or the fiscal cliff deal impresses Obsequious Ben and His Merry Men to the point at which they no longer feel that their wise beneficence, and prodigious money creation, is necessary, then, yes, one should get out of TIPS with alacrity.   But yours truly believes neither that the economic roads have been made smooth nor that the fiscal cliff deal solves much of anything.   So I will continue to hold TIPS.  

Admittedly, part of my reason for being tenacious, or stubborn, on TIPS, as it was on 10/3/12, is that I can’t think of anywhere else to go with the money.  While that is not generally a good reason to hold anything (There is always cash at a few basis points.), my October 3 theory on the dearth of alternatives seems to have held; the stock market has been essentially flat since then.  And I suspect it continues to hold.   Stocks are scary in the wake of this rally and just about any scenario that would make cash attractive would make TIPS more attractive.  I have liked, and profited from, gold for the last several years, and I like it more after its recent defenestration, but to commit TIPS money to gold would be to move into an entirely different risk universe.

So, yes, I am staying with TIPS.