Opinions on ETFs (2018)

Based on current market situation (2018) and what I read, ETFs are good for most of the average investors aiming for low fees, high diversification and simplicity. Nevertheless, ETFs are financial products and far from perfect. It’s better to know the risk of investing in them.

Some ideas to understand first.

(1) Beat the market: “To beat the market, you need to take more risk than the market. More risk equals more chance to lose money and gain money.”

  • Problem is -10% lost is not equal to a 10% gain. Because the new based value you use to calculate the new return is lower. Therefore, it’s better to not lose money.
  • Example:
    • At $100, lose 10% = $90.
    • Take the $90, gain 10% = $99
    • $100-$99 = $1 “missing”

 

(2) What is “market”? Basically an index of stocks pooled together selected by different criteria.

  • What is S&P 500 index? The most popular index. It’s a strategy where the portfolio holds 500 stocks, which are weighted based on their Market capitalization.

Investopedia: https://www.investopedia.com/terms/s/sp500.asp

 

 

Problem with Index ETF:

  • (1) Behavioral finance: Our worst enemy is ourselves. We try to time the market by trying to buy low and sell high, while we could just stick to the strategy. Trade to rebalance the portfolio and win on average. ETF investing requires discipline.

 

  • (2) Affect the fundamental of investing itself:
    • Value investing: Invest in companies you believe will perform better in the future. In an efficient market, people would sell bad companies (decrease value) and buy good companies (increase value).
    • ETF investing: Invest in market equally; just follow a strategy (e.g.: S&P 500 Market cap bias). The strategy doesn’t care if companies are good or bad. Higher market cap will have higher % allocation.
    • “If everyone invested in index funds the market will not work because there won’t be anyone to set rational prices based on business fundamentals. But luckily there are many different players in the market, which makes this scenario virtually impossible.”

 

  • (3) Bias on stocks not in stock exchange: Index ETF will not hold stocks outside of index.
    • If more people buy ETFs, then…
    • (1) Stock trading inside of index will be overvalued.
    • (2) Stock trading outside of index will be undervalued.
    • (3) In a market crash, stock trading outside of index will be less affected (Hedge idea).

 

 

  • (5) ETF, the product itself: There could be a discrepancy between the index and the value of the ETF.
    • Explained how mutual funds works: https://www.youtube.com/watch?v=S5ZTpOviR0E
    • Explained how ETFs works: https://www.etf.com/etf-education-ce.html
      • “Creation and Redemption” : There might be a “delays” for the ETF value to equal “Fair value” of the index it tries to replicate. For bigger and liquid holdings like large companies ETF, it’s less of an issue.
        • But for small caps or illiquid holdings in ETF, it will be a challenge. The best example is a high-yield bond ETF. It’s hard to find the exact bonds in the market to buy and short-sell it, because it’s not as “available” as stock.
        • For an index that have too many holdings, it will be challenging for the “Designated broker” to buy all the required stocks to make a bundle of ETF unit, which will leads to higher tracking error.
    • Tracking error: ETF value does not equal the index they try to replicate.
    • “Synthetic ETF”: The ETF holds asset that will replicate the returns of the actual asset.”
    • “Active ETF” : Similar to active mutual funds, but with lower fees.
      • Mutual fund manager can trade the asset within the fund anytime during the day and the price of the NAV will be updated at the end of the day.
      • But for ETF manager, they need to “communicate” what’s in the “ETF bundle” they want to create to the “designated broker” to make that bundle, which create delays, so it’s not optimal for active management.
      • Because it’s “actively manage”, it will trigger more trading fees, taxes, and charge higher MER. It’s better to just stick with Index ETF or actively manage mutual funds.
  • (6) Securities lending risk: The ETF provider is in the business to make money too. Charging low MER they will focus their business on other revenue stream like “Securities lending”. It can “lend” securities to “Short-seller” for interest, but there is a risk associate to it.

I still believe ETFs has its place in a portfolio. It just depends on how you use it and for what purpose.

SimpleMoneyInvesting.