ETFs: Too Much of a Good Thing

“ETFs have polluted the indexing industry,” Rick Ferri says, “They have gone from evolution to pollution.”

Strong words, yes. But Mr. Ferri, who manages nearly $1 billion in index fund-based portfolios at his firm, Portfolio Solutions, Inc., can speak with authority on the subject. He wrote a book on it: “The ETF Book: All You Need to Know About Exchange-Traded-Funds” (Wiley & Sons, $30). You should also know that we are not talking about some arcane corner in the investing world. We are talking about a product that is disrupting the financial services industry. Indeed, with an asset pool that has reached $1 trillion, ETFs may rank with the disruptive power of the iPad in media.

ETFs are a game-changer.

So what is an Exchange-Traded-Fund?

It is an investment fund, usually an index fund, which trades on an exchange, so it is priced minute by minute rather than at the end of the day. Most have lower costs than comparable mutual funds and, today, many can be purchased without even paying a $10 discount brokerage commission.  Want to buy the U.S. stock market and pay practically nothing for the privilege? You can do it with ETFs. The SPDR S&P 500 ETF (ticker: SPY) costs 0.09 percent a year. The iShares S&P 500 Index ETF (ticker: IVV) also costs 0.09 percent and the Vanguard S&P 500 Index ETF costs 0.06 percent a year.

That’s dirt cheap. The low cost means more return for you and less spending money for Wall Street.

Basically, ETFs are a new distribution channel for financial service firms. And the first firms to market not only dominate it, they are causing money to flow out of traditional mutual fund firms and into the new funds.

One recent indication is the loss of assets from the American Funds group, about $82 billion in 2011. A stalwart of the traditional mutual fund industry, the American Funds group manages mutual funds at very low cost but distributes them through the brokerage industry. American Funds was the largest of all the mutual fund firms as recently as 2007.

But last year both the American Funds group and Fidelity lost assets, about $126 billion combined. During the same period Vanguard gained $44 billion.

Significantly, American Funds has no ETFs. Fidelity has just one. Vanguard has jumped in feet first. It has 64 ETFs that clone most of their index mutual funds.

This enormous shift is not what bothers Mr. Ferri. What bothers him is the number of exchange-traded funds that were created for speculative purposes. These are funds, he says, that don’t represent an asset class. Instead, they are intended as short-term trading vehicles, which is proof positive that Wall Street can’t leave a good thing alone.

“They’re just muddying the water, making life difficult for advisors who want to do basic indexing,” he told me. As evidence, he points to the 685 ETFs (according to Morningstar) that struggle along with less than $50 million in assets. This is about 50 percent of all ETFs. Many in the trade call them “Zombie ETFs” because they are neither dead nor alive. He could also point to the odd names and purposes some ETFs have, such as:

  • Direxion Daily Energy Bear 3X Shares
  • ProShares UltraShort DJ-UBS Crude Oil
  • QuantShares US Market Neutral Anti-Momentum

“The type of indexes being created now has nothing to do with indexing. It’s a form of active management being done with ETFs. It confuses people. That makes it difficult to get the basic idea (of indexing) across,” he observed.

In fact, the problem with the proliferation of speculative ETFs doesn’t end with confusion. Since exchange-traded-fund shares are traded, they must have both size and trading volume to actually be the low-cost blessing they have the potential to be. The lower the assets in the fund and the lower the volume of shares traded, the more likely investors will lose money to a large spread between the bid and asked price. The smaller and more obscure funds can also sell at unpredictable premiums, or discounts, to the net asset value of the underlying securities, just as closed end funds do. That isn’t always a disadvantage— careful investors can work to buy at discounts and sell at premiums— but it is a major distraction from being able to commit, at very low cost, to a fund that invests in America, Europe or Emerging Markets stocks on the way to building a low-cost and tax-efficient portfolio.

Is there a cure?

Yes. Just remember this: Wall Street makes money on complexity. Everyone else makes money on simplicity. If it isn’t simple and cheap, don’t buy it.