The Basic ETF Design Is A Tough Act to Beat

I have been recommending exchange-traded funds (ETFs) to my clients since the early 2000s. A lot has changed since then, but the basic investing proposition tied to these products remains compelling. There are more choices, of course, which makes selecting ETFs more hazardous. But carefully vetting of the possibilities still yields a deep pool of attractive investment products.

Twenty-plus years ago there were only a handful of these securities; individual securities and mutual funds were still the investment of choice for the vast majority of investors and their advisors. Since then, the popularity of ETFs has exploded.

By one recent estimate, the ETF market has surged to well over $4 trillion in assets under management. Although this is still considerably less than the total amount of mutual fund assets, the surge in ETF use is remarkable when you consider ETFs are less than 30 years old vs. the century-plus time line for mutual funds.

There are a number of reasons why I prefer investing in ETFs over individual securities and mutual funds.

  • Very low management fees. Some of the largest ETFs come with administration fees considerably less than one-tenth of one percent.

  • Often times ETFs invest in the stocks of a large number of companies, and thereby lessen risk through diversification.

  • They trade continuously throughout the day (in contrast to mutual funds, which only change hands at each day’s closing price) which makes them very liquid.

  • They receive favorable tax treatment. ETF investors only have to pay capital gains tax upon the sale of the ETF, whereas mutual fund investors are taxed whenever the fund realizes a profit on the trades it makes.

  • ETFs work extremely well with the tactical asset allocation strategies I utilize.

Early on, ETFs tracked well-established stock and bond market indexes, such as the S&P 500 index or Bloomberg Barclays U.S. Aggregate Bond Index. However, as the popularity of ETFs grew, so did the types of ETFs. Today, there are ETFs that target sectors of the stock market, like health care and energy. Others are focused on market factors (such as growth, momentum, quality, and value) and investment styles (such as ESG). There are also ETFs that make investment strategies formerly reserved for hedge funds available to the average investor, and at a much lower cost.

The variety of ETFs is likely to continue to grow, now that the SEC has recently issued new regulations that make it easier to bring these products to market. One of the most recent to the ever-expanding ETF universe are “thematic ETFs”.

Thematic ETFs hold stocks issued by companies that are trendy, whether due to some new innovation, favorable media exposure, or participation in well-liked industries or causes. These funds are marketed as a way for investors to gain exposure to companies whose stock price is expected to rise due the issuing company’s popularity, rather than based on the company’s fundamentals, like assets and profitability.

While thematic ETFs may be new, the playbook used to promote them is as old as the stock market itself. Stock jockeys have long peddled so-called “story stocks”: shares in a company with an appealing story that has yet to materialize in terms of profitability or revenue growth. Oftentimes, the pitch consists of a lengthy and complicated explanation of why the company is on the verge of a breakthrough. The underling thesis is that popular, high-profile stocks and market sectors outperform low profile ones.

Academics have studied popularity as a factor for generating alpha (market-beating returns). In general, the research suggests that trendy companies tend to underperform shares with relatively low publicity because trendy investments are usually priced at a premium. That translates into lower expected returns. That’s not to say that popularity can’t lead to expensive stocks running higher, at least in the short term. But, as anyone who has been watching the GameStop saga knows, sooner or later a stock’s price will reflect the real-life earnings power of the company who issued it.

Another gimmick that fund sponsors use to promote thematic ETFs: asserting that fund managers have an exceptional ability to spot companies and industries that are supposedly on the verge of the Next Big Thing. That may sound great, but in practice it’s another story, as The Wall Street Journal’s Jason Zweig reminds:

“I’ve got a tip for you. If you think you’ve spotted a theme that other investors haven’t fully appreciated yet, ask yourself how come there’s already a thematic fund for it.”

The key take-away: ETFs are not all created equal. Personally, I remain a fan of large, low-cost ETFs that track diversified and well-established indexes. They may not be trendy, but they are an exceptionally powerful tool for building and managing diversified portfolio strategies, often at extremely lost costs for investors. As my grandfather was fond of saying: “If it ain’t broke, don’t fix it!”

Thank you for reading.

Andrew J. Willms

President and CEO of The Milwaukee Company


The Market Commentator

In this week's podcast, tax attorney Peter Smiley and I discuss democratic proposals for changes to the tax code, how they would impact investors if adopted, and planning that could help mitigate some of the impact. Some of these changes could surprise you. You can give it a listen HERE.

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