Tag Archives: etfs

ETFs Don’t Kill Investors, Investors Kill Investors

There was a good piece in the WSJ today discussing potential “flaws” in Exchange Traded Funds (ETFs). ETFs are a relatively new product that have amassed huge quantities of assets in the last few decades, but are still dwarfed by the mutual fund space (roughly 2.1 trillion in assets, versus 12.6 trillion in mutual funds). The SEC recently said “It may be time to re-examine the entire ETF ecosystem.” That sounds a bit hyperbolic to me. ETFs aren’t necessarily dangerous unless you misunderstand them or misuse them. Unfortunately, a lot of behavioral bias appears to be driving the misguided fears about ETFs. 1. ETFs can be dangerous when misused. The first exchange-traded fund founded in 1993 was the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) which was designed to track the S&P 500. It’s a remarkably tax- and fee-efficient product that has served its investors very well since its founding. This was a very simple product designed for passive indexing, but the ETF space has morphed substantially since 1993. Much like the mutual fund space, it has morphed from a simple indexing product into a series of products that feed investor impatience and desire for rapid profits. And so we’ve seen a substantial surge in “active” ETFs, leveraged ETFs, “hedged” ETFs and other similar products. Many of these products abuse the efficiencies of ETFs by being tax-inefficient and fee-inefficient. They sell the diversification of indexing, but saddle investors with all the negatives that result in higher fees, tax inefficiencies and poor performance. I’ve written substantially on the dangers of leveraged ETFs and how fund companies sell high-fee closet indexing ETFs in exchange for empty promises about hedging and “market beating” returns. These products, in my opinion, are often dangerous and sold on false premises. But that does not mean we should make sweeping generalizations about the entire ETF space. The fact that some ETFs are bad does not mean they are all bad. ETFs are dangerous when misunderstood and misused. As Warren Buffett says, never invest in something you don’t understand. 2. ETFs traded precisely as they should have during the August Flash Crash. One of the primary drivers of the fears around ETFs was the morning of the Flash Crash in August, when many ETFs declined by 30-40% for no reason. We should be really clear about what happened earlier this year during the Flash Crash. ETFs traded precisely how they should have during this event. ETFs are liquid trading instruments designed to reflect the aggregate performance of their underlying holdings. On the morning of the Flash Crash, there were a huge number of stocks that were halted or illiquid. An ETF trades with a market price (the price you see) and an intra-day indicative value (the price the market maker sees). The market maker will try to keep the IIV as close to the market price as they can by making a market in the ETF. But when most of the underlying holdings are halted, there is no reliable IIV, and so, the price of the ETF is basically unknown until the underlying holdings open again. This problem was exacerbated during the Flash Crash because there are fewer human traders there to identify the sorts of issues that I identified in real time: Unfortunately, a lot of people didn’t understand this or implemented stop loss orders that resulted in sales well below where the ETF should have actually been trading. I watched this happen in real time, and was even able to execute buy orders at a 25%+ discount, due entirely to these behaviorally biased investors. Make no mistake, this was not a flaw in the way ETFs work. It was purely user error. ETFs are not inherently dangerous, but like many investment products, they can be abused by people who don’t understand them or misuse them. This isn’t a product flaw. It is a human flaw as old as the financial markets themselves. If you want to better understand ETFs I recommend reading the following primer from ICI or this one from BlackRock . Well informed is well armed.

For Practitioners Of Risk Parity: Don’t Panic

I’ve written about Risk Parity here before. Cliff Asness has kindly given me a chance to do so again, with a new paper about the proper perspective in which to view recent performance figures. Start with the basics, the RP portfolio is defined by its contrast with the Capital Asset Pricing Model. RP entails two changes vis-à-vis the traditional CAPM portfolio. First, a reduction of equity, down from the traditional 60%: A manager switching to RP will sell stocks and use them to buy more conservative assets until the overall risk posed by his holdings via the latter catches up with the risk posed by his holdings of the remaining stock. Second, the RPP manager will increase leverage, generally through the use of derivatives. This allows him to goose his returns, which will otherwise suffer from the sale of all those stocks. There were claims, oddly, that the spread of such portfolios made a significant contribution to the market turmoil of this August. A team of analysts at Bank of America in particular contended that the leveraging of portfolios this entails creates a dangerous feedback loop. Increased volatility causes the managers using such a system to deleverage, which in turn can increase volatility. That argument didn’t make, and didn’t deserve, converts. It is much more plausible, after all, to attribute that month’s fluctuations in the U.S. to the contagious consequences of China’s summer turmoil, and nobody has blamed RP portfolio strategists for that. If domestic causation is required for some reason, there’s a case to be made that the proliferation of new financial products that allow for speculation on VIX has helped create new volatility for the object of that speculation, volatility for volatility, and that this chicken came home to roost in August. Those two points are more than sufficient to account for the phenomena and Ockham’s razor should shave away the B of A team’s guesswork. A Real but Modest Edge Still more fundamentally, the flutterings of August don’t look all that impressive in the rear view mirror, so the argument based on those flutterings won’t make any more converts now. What might be more important in turning heads one way or the other might be … oh, I don’t know … a comparison of actual performance? Asness of AQR is an advocate of the risk parity model. He believes that it offers a “real but modest long-term edge over traditional approaches.” In the recent publication, though, he acknowledges that recent months have been a “tough relative performance period” for RP, and that if critics of the policy hadn’t gone “all tin-foil-hat” over the August sell-off they would have focused on this recent weakness. Asness puts this weakness it into a broader context. The cumulative excess return from what Asness calls ” simple risk parity,” (a calculation based on a hypothetical portfolio) continues to rise steadily though undramatically. As the graph below indicates, this strategy had a falling off during the bursting of the dotcom bubble at the start of the new millennium. A few years later it had another falling off during the global financial crisis. But there’s been nothing “weird or unpleasant” lately. Now for Relative Performance Still, when one looks at relative performance, the performance of risk parity against those traditional 60/40 portfolios, one does see a recent weakness. The downward movement on the right-hand edge of this graph is what is at issue. Asness explains that it follows from one of the basic features of RP, that of “diversification away from equity dominance.” Equities hit their historic low in 2009 and have been making a warrior’s contribution to lots of portfolios in the years since. Obviously, this warrior has been fighting more vigorously for the traditional portfolios than for the RP variants. This is, Asness concludes, no cause for alarm. It is a “painful but relatively normal occasional outcome if we’re implementing the process we think we are.” Of course, particular traders might claim that they would have made adjustments to their RP portfolio, making it somewhat less RP-ish, that would have avoided this relative downturn. Asness acknowledges this. Indeed, AQR itself offers portfolios that tilt away from RP as signals dictate. But, he writes, this is a tactical decision, one that doesn’t affect the case for RP on the level of strategy. It is well to remember that the terms “tactics” and “strategy” come from the military, and that the distinction is a matter of horizon. A general is thinking strategically when he picks the time and ground for his battles (or, a less adept general is failing to think strategically when he lets the adversary pick them). A general is thinking tactically as he is fighting one of those battles.

10 Ways To Destroy Your Portfolio

With the increased frequency of heightened volatility, investing has never been as challenging as it is today. However, the importance of investing has never been more crucial either, due to rising life expectancies, corrosive effects of inflation, and the uncertainty surrounding the sustainability of government programs like Social Security, Medicare, and pensions. If you are not wasting enough money from our structurally flawed and loosely regulated investment industry that is inundated with conflicts of interest, here are 10 additional ways to destroy your investment portfolio: #1. Watch and React to Sensationalist News Stories: Typically, strategists and pundits do a wonderful job of parroting the consensus du jour. With the advent of the internet, and 24/7 news cycles, it is difficult to not get caught up in the daily vicissitudes. However, the accuracy of the so-called media experts is no better than weather forecasters’ accuracy in predicting the weather three Saturdays from now at 10:23 a.m. Investors would be better served by listening to and learning from successful, seasoned veterans. #2. Invest for the Short Term and Attempt Market Timing: Investing is a marathon, and not a sprint, yet countless investors have the arrogance to believe they can time the market. A few get lucky and time the proper entry point, but the same investors often fail to time the appropriate exit point. The process works similarly in reverse, which hammers home the idea that you can be 200% wrong when you are constantly switching your portfolio positions. #3. Blindly Invest Without Knowing Fees: Like a dripping faucet, fees, transaction costs, taxes, and other charges may not be noticeable in the short-run, but combined, these portfolio expenses can be devastating in the long run. Whether you or your broker/advisor knowingly or unknowingly is churning your account, the practice should be immediately halted. Passive investment products and strategies like ETFs (Exchange Traded Funds), index funds, and low turnover (long time horizon / tax-efficient) investing strategies are the way to go for investors. #4. Use Technical Analysis as a Primary Strategy: Warren Buffett openly recognizes the problem with technical analysis as evidenced by his statement, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” Legendary fund manager Peter Lynch adds, “Charts are great for predicting the past.” Most indicators are about as helpful as astrology, but in rare instances some facets can serve as a useful device (like a Lob Wedge in golf). #5. Panic-Sell out of Fear And Panic-Buy out of Greed: Emotions can devastate portfolio returns when investors’ trading activity follows the herd in good times and bad. As the old saying goes, “Following the herd often leads to the slaughterhouse.” Gary Helms rightly identifies the role that overconfidence plays when in investing when he states, “If you have a great thought and write it down, it will look stupid 10 hours later.” The best investment returns are earned by traveling down the less followed path. Or as Rob Arnott describes, “In investing, what is comfortable is rarely profitable.” Get a broad range of opinions and continually test your investment thesis to make sure peer pressure is not driving key investment decisions. #6. Ignore Valuation and Yield: Valuation is like good pitching in baseball…very important. Valuation may not cause all of your investments to win, but this factor should be an integral part of your investment process. Successful investors think about valuation similarly to skilled sports handicappers. Steven Crist summed it up beautifully when he said, “There are no ‘good’ or ‘bad’ horses, just correctly- or incorrectly-priced ones.” The same principle applies to investments. Dividends and yields should not be overlooked – these elements are an essential part of an investor’s long-run total return. #7. Buy and Forget: “Buy-and-hold” is good for stocks that go up in price, and bad for stocks that go flat or decline in value. Wow, how deeply profound. As I have written in the past, there are always reasons of why you should not invest for the long term and instead sell your position, such as: 1) new competition; 2) cost pressures; 3) slowing growth; 4) management change; 5) excessive valuation; 6) change in industry regulation; 7) slowing economy; 8) loss of market share; 9) product obsolescence; 10) etc, etc, etc. You get the idea. #8. Over-Concentrate Your Portfolio: If you own a top-heavy portfolio with large weightings, sleeping at night can be challenging, and also force average investors to make bad decisions at the wrong times (i.e., buy high and sell low). While over-concentration can be risky, over-diversification can eat away at performance as well – owning a 100 different mutual funds is costly and inefficient. #9. Stuff Money Under Your Mattress: With interest rates at the lowest levels in a generation, stuffing money under the mattress in the form of CDs (Certificates of Deposit), money market accounts, and low-yielding Treasuries that are earning next to nothing is counter-productive for many investors. Compounding this problem is inflation, a silent killer that will quietly disintegrate your hard earned investment portfolio. In other words, a penny saved inefficiently will lead to a penny depreciating rapidly. #10. Forget Your Mistakes: Investing is difficult enough without naively repeating the same mistakes. As Albert Einstein said, “Insanity is doing the same thing, over and over again, but expecting different results.” Mistakes will be made and it behooves investors to document them and learn from them. Brushing your mistakes under the carpet may make you temporarily feel better emotionally, but will not help your financial returns. As the year approaches a close, do yourself a favor and evaluate whether you are committing any of these damaging habits. Investing is tough enough already, without adding further ways of destroying your portfolio. Disclosure: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. 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