Are ETFs dangerous to your wealth?

Can you feel it comin’?

As I write this post, I’m listening to the new Velvet Years EP from Blue Eyed Jesus.  While the title song deals with a sort of revolution of a very different nature, the “revolution” concept seems appropriate when considering the impact ETFs have and will likely continue to have on the way people invest.

In late 2010, total assets invested in ETFs crossed $1 trillion.  Even when measured against the debt of the US Government, that’s a big number.  Furthermore, in ETFs 2.0, a report by Bank of New York Mellon, it is estimated that these assets will double by 2015.  Other estimates come to similar conclusions.

Is this a good thing?

Generally, the assets that ETFs are attracting are coming at the expense of traditional mutual funds.  As covered in What is an ETF and why should you care?, ETFs have some advantages over standard mutual funds.  Investment professionals have been using ETFs more and longer than retail investors.  That includes independent, fee-only advisors looking for low-cost ways to get exposure to appropriate asset classes for their clients.  These advisors are typically holding positions for a long time, and merely rebalancing on a pre-specified schedule.  It also includes high-volume traders who are chasing trends and moving in and out of positions many times in a day.  It also includes plenty of operators that fall somewhere in between those approaches.

In other words, it is much more important to consider how these investments are being used, instead of what they offer.

Industry Heavyweight weighs in

According to a number of sources, Jack Bogle doesn’t think much of ETFs.  That is interesting, because you may know Bogle as the founder of Vanguard, a company that recently saw its ETF assets exceed 200 billion dollars.  It is also particularly interesting to me, because many advisors rely heavily on the use of ETFs in making recommendations for clients’ portfolios.

Bogle’s position is well-documented, as one of his virtues is that he voices his opinions in no uncertain terms.  The video is representative of his view of ETFs.

I think you have to look a bit more closely at what Jack Bogle is saying in order to discern his point of view, and determine whether or not ETFs make sense for your portfolio.  His basic claim is that ETFs are now the favored tooled of active traders, and active trading is a losing proposition.  This is true for professionals who are trading for their own accounts, and it’s also true for advisors who use these tools irresponsibly in the management of their clients’ funds.  When used prudently, though, they remain a good way to get where you’re going from an investment perspective.

One development that exacerbates the problem and furthers Jack Bogle’s argument is the proliferation of what I’ll call specialty ETFs.  I have to confess, when I hear about a “new product development” or “financial innovation”, the hairs on the back of my neck stand at attention.  There have been a lot of these kinds of “advancements” in the world of ETFs recently.  Highly leveraged funds are a good example, where you can bet for or against a market index, and gain or lose a multiple of its performance in a given day.  For instance, the ProShares UltraPro Dow30 is designed to gain or lose 3 times the performance of the Dow Jones Industrials on a given day.  In case it’s not obvious, that means that if the Dow loses .5% tomorrow, an investor in this fund should expect to lose 1.5%.

Another ongoing development that concerns Bogle is the proliferation of narrowly-defined bases for ETFs.  Bogle’s vision for an “index” fund assumed the use of broad-based indexes, at least as broad as the S&P 500.  These days there are many very specialized ETFs, such as the First Trust NASDAQ® Clean Edge® Smart Grid Infrastructure Index Fund.  The logic behind these is easy enough to see.  In this case, if you have an investment thesis that says the Smart Grid is a good place for your money, this narrowly-defined index makes some sense.  However, Bogle’s position – and I think the data supports him on this – is that trying to time the success and failure of narrow sectors or countries or other limited collections of securities is a losing proposition.

The case of a recently barred Morgan Keegan broker provides an extreme example of the threat that ETFs can pose in the hands of unsophisticated – or malicious – operators.  This broker used extremely risky products that made no sense for the clients involved, and he clearly had bad intent.  Again, though, ETFs were merely instruments used to perpetrate fraud.  Did they make it easier for this broker?  Yeah, probably.  And that is undoubtedly part of Jack Bogle’s point.  But that doesn’t mean we should throw out the baby with the bath water.  Did this “advisor” perpetrate this fraud solely because of the existence of ETFs?  I have to believe he would have found an alternative way to defraud his clients if he didn’t have the convenience of ETFs.

Back to the original question

Can ETFs be dangerous to your wealth?  Absolutely.  So can mutual funds, stocks, bonds, gold, real estate, CDs and any other instrument you can use to invest your money.  The key is to develop an investment plan, choose the investment instruments that most effectively help you fulfill that plan, and stick to it.

About Kevin O'Reilly, CFP®

Kevin O'Reilly, CFP®, is a financial advisor who specializes in working with parents of twins and triplets. Have a financial question? Ask Kevin!

Subscribe to Updates!

Subscribe to Multiples & Money! (your information will be kept completely private)

,

Comments are closed.