In January 1993, a new investment vehicle was listed for trading. It was SPY, or the SPDR S&P 500. It had all the right attributes and appeared to be a very useful trading vehicle for individual investors. It was the first in a long line of ETFs, exchange traded funds.
Investing in an ETF gave the investor:
- A passive investment because the goal is to mimic, not outperform, a specific index
- The ability to buy or sell shares any time the markets are open
- Very low management fees
To me, these represented the ideal replacement for mutual funds and gave shareholders the opportunity to own a diversified portfolio that included only the type of stocks the investor wanted to own (large caps, small caps, pharmaceutical stocks etc).
These investments were passively managed. That means there were no high-salaried managers charging excessive fees for their services in attempting to beat the market averages. Why not seek outperformance? First it requires a research team and frequent trading. Those are expensive. Second, data shows that most professional money managers are unable to consistently beat their benchmark indexes. Sure some managers did very well, but the difficulty is finding those mutual funds before they outperform, not after the fact. By eliminating such managers, ETFs aim to earn 'average' returns. This significantly reduces costs and the savings are passed along to the investor.
The managers use cash to buy a portfolio that comes very close to replicating the performance of the specific index being mimicked. However, a bit of intelligence is required. These managers do not buy every stock in large indexes because some are illiquid, and trying to buy or sell them can move the market. Thus, IWM, which mimics the Russell 2000 index does not own all 2,000 stocks in the index. However, the correlation between IWM and the Russsell Index is near enough to 1.00 that it's not necessary to own each stock.
One other important advantage was that investors could buy or sell during the trading day. Mutual funds allowed trades to occur only after the market closed for the day and the net asset value had been determined. That's very inefficient for traders and investors.
In my opinion, ETFs were an excellent investment choice. And to make them even better, all actively traded ETFs eventually had options listed for trading. Traders could employ their favorite option strategies on a diversified portfolio – a less risky proposition than trading options on individual stocks.
Next came bearish, or inverse ETFs. Instead of selling an ETF short, an investor could purchase the bearish ETF to meet the same investment goals. This was a sound idea for an investment vehicle and made it easy for those investors who may prefer not to hold short positions.
Then came the leveraged ETFs which were supposed to perform as if they owned twice (or thrice) as many shares as the 'regular' ETF. In other words, the investment objective for these ETFs was to move higher or lower by two or three times as much as their 'regular' unleveraged counterparts. These instruments became very popular with the investing public. And that's the problem.
The leveraged ETFs are designed for day traders and very short-term swing traders. They are not designed for buy and hold investors. Despite the warnings, too many individuals bought these leveraged (both bullish and bearish) ETFs and suffered the consequences. As has been described elsewhere, leveraged ETFs are designed so that's it's likely they will slowly lose value – and owning them as an investment is simply tossing cash into the trash.
Don't try to save on commissions in this scenario. Instead of owning one 3X ETF, it's safer to own 3X as many shares of the original, unleveraged ETF.
Most commentary regarding commodity ETFs is that they significantly underperform their underlying commodities. [Here is one example.] Whether that's the fault of bad portfolio management or poor design of the investing algorithm, is unknown to me. Some professional traders consider commodity ETF managers to be patsies and claim it's easy to make good money by taking advantage of the ETFs monthly required trading (closing front-month positions to open next-month positions).
If owning an ETF does NOT simplify the investment process at a reduced cost and provide comparable (to owning the underlying asset) returns, then there is no reason to trade ETFs.
In today's world, there are a huge number of ETFs (~800) and collectively, investors have poured almost $800 billion into them. Many ETFs continue serve a useful purpose, as described above. However, in recent years ETFs have become complex, difficult to understand trading vehicles, and it seems to me, are designed for the sole purpose of earning profits for the ETF manager with little concern for their suitability for investors.
When choosing to trade ETFs please be certain that the specific ETF is designed to do as you anticpate. No one likes to spend the time reading a prospectus, but please do not invest blindly.
Another view: This from yesterday's Abnormal Returns (if you don't follow this blog, do so):
That is not to say there are not problems with the ETF industry. As with all financial products the ETF industry seems to be living up to the old motto of MTV: “Too much is never enough.” We have written extensively** about the proclivity of the ETF industry to create me-too and poorly designed funds. One could also argue that the rise of indexing has helped distort the pricing of individual securities. There is little doubt that the rise of certain ETFs have changed the underlying dynamics of certain markets. Further one cannot discount the possibility that additional market meltdowns could be exacerbated by ETFs.
All that being said, the rise of the ETF industry has been net-net a boon to investors. The allocation of assets in ETFs reflect the collective decision of millions of professional and amateur investors alike. If the underlying prices of those assets are ultimately proven incorrect, then those investors will pay the price. In the meantime they provide many investors with the means to invest in a wide range of asset classes in a relatively cost efficient manner. In that respect, the ETF experiment has to-date proven a success.