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13 July 2017
Exchange-traded funds, or ETFs, have become a huge part of the market, and with good reason.
The funds are a quick, inexpensive way to get exposure to an underlying index—anything from the S&P 500 to very narrow indexes in specific sectors like technology or emerging markets. They're great for achieving a diversification that can lower portfolio risk.
Because they're bought and sold like stocks, they're easy to trade. And they allow investors to manage their tax consequences better than they can with mutual funds. ETFs now account for 30% of the trading volume in stocks, twice the level of a decade ago.
I regularly use ETFs in constructing and updating client portfolios. But it's not a good idea to create a portfolio that consists only of ETFs, or index mutual funds, for that matter. Here's why.
First, ETFs work best in a rising market. We've been in a bull market since 2009, a period during which most ETFs have done well for investors. But ETFs offer little or no protection during a period of sustained market decline.
That's because ETFs' holdings don't change when market conditions change. An S&P 500 fund will reflect that index even when the S&P is plunging. It won't adjust by, say, adding bonds or foreign stocks to the mix. ETFs are like corks on the water, rising and falling with the tides. In a word, they're dumb.
That's why my clients' portfolios include individual stocks and bonds, which I buy and sell based on market conditions and on the strength of the companies behind them.Individual securities let you be much more nimble in seizing opportunities and avoiding trouble. But they also let you take advantage of mispricings that are created by ETFs and other passive index funds.
When investors buy or sell an ETF en masse, the fund must buy or sell blocks of the stocks or bonds that make up the index they follow. ETF companies buy or sell the cheap and expensive stocks alike, with no analysis of each stock's fundamental strength. They don't consider whether they should buy or sell selectively.
Essentially, they throw the babies out with the bathwater. And that creates an opportunity for investors to find bargains.
Not long ago, I noticed that the price of bonds issued by chipmaker AMD were soaring up and down without any apparent rhyme or reason. There were no major changes in the company's condition or sales outlook. Eventually I learned that the price fluctuation was due to ETFs' indiscriminate selloff of the bonds in the manner I described above.
I bought a block of the AMD bonds at a very low price, and my clients made some good money off of it.
Another drawback with ETFs is this: If an investor only owns ETFs or index mutual funds, they are guaranteed to do no better than the market. ETFs, after all, are built on indexes that encompass big swaths of the market.
Example: If my clients' bond holdings between 2009 and 2013 had been only ETFs, they would have lost money. But, by buying and selling individual bonds in that period, we earned yields north of 10%.
So an important question for those who are deciding whether to invest in ETFs alone, or ETFs plus individual stocks and bonds, is this: Do you want to match the market, or do you want to beat it?