ETF’s – The Saga Continues

Exactly seven years ago, in August 2003, an article titled “The Mutual Fund Insurrection” appeared in this column. The opening paragraphs read as follows: “Despite its popularity with investors, the mutual fund industry is ripe for innovation and change. The miserable performance of the vast majority of actively managed funds has been fully recognized by investors who are moving to low cost index funds. Another further transformation is now afoot. A new breed of funds is proliferating at a rate that is certain to shake up an industry badly in need of revivification. Don Phillips, the CEO of the mutual fund reporting organization, Morningstar, has stated, ‘The mutual fund industry is ripe for reinvention. The cost of owning stocks has plummeted, but the cost of owning mutual funds has remained stubbornly high.’

The “new breed” of funds referred to in that column was indexed “Exchange Traded Funds” (ETF’s), and pertinent here is the fact that at the time the above article was written, despite the overwhelming evidence that indexing had been proven to be more successful as an investment strategy for the average investor, lower performing actively managed funds were then, and still are, considerably more popular than index funds. Even so, recognition of the advantages of indexing was beginning to intensify seven years ago and has since accelerated significantly. Aiding that acceleration has been the incredibly fast growing popularity of ETF’s, a newer incarnation of index funds.

One definition of insanity is “doing the same thing over and over again, and expecting different results.” Attributed to several people including Benjamin Franklin and Albert Einstein, that saying could well apply to those investors committed to actively managed mutual funds. Each year Standard & Poor releases a report that compares average actively managed fund results in each of the nine Morningstar fund categories to that of its corresponding index fund. By and large, each year, the numbers prove the predominance of indexing as a strategy. More importantly, to get a better appreciation of the long-term implications, five-year results are also posted.

Over the last five years (ending in 2009) the S&P 500 Index has outperformed 60.8% of actively managed large-cap U.S. equity funds; the S&P Mid-Cap 400 Index has outperformed 77.2% of mid-cap funds; and the S&P Small Cap 600 Index has outperformed 66.6% of small-cap funds. The five-year data results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active fund managers have failed to beat benchmarks. With investors relying on actively managed funds facing an absurdly low 30 percent probability of successfully outperforming an equivalent index fund, the “sanity” adage mentioned above seems particularly appropriate.

The 2003 Viewpointe article then maintained that, “The last major structural change in the industry was the recognition of indexing as a superior strategy to the use of actively managed funds. It would appear that another innovational mutation is taking place that could transform investment strategy in a dramatic, if not revolutionary manner. Readers might recall a recent article that referred to the legendary economist Joseph Schumpeter, and his theory of ‘creative destruction.’ The more modern version of this theory is termed ‘disruptive technology,’ whereby an existing technology or product is overwhelmed (and often eradicated) in the marketplace by a new and superior technology or product. Such a product, partially driven by technology is broadcasting a wake-up call to the mutual fund industry.” The product referred to was the then relatively new Exchange Traded Fund (ETF).

Coincidentally, on April 10 th, 2010, an article in The New York Times titled “The Low Cost Power of Exchange Traded Funds” concluded, as I did seven years ago, that (and I quote) “E.T.F.’s are a disruptive technology similar to the digitalization of music. E.T.F.’s are disrupting mutual fund vehicles.” The article continues, “What’s so disruptive is that E.T.F.’s trade throughout the day unlike mutual funds; that makes E.T.F.’s useful for professional investors, including mutual fund managers. Even more disruptive, maybe, is that E.T.F.’s can often replicate mutual fund portfolios, actively or passively managed, at considerably less cost.”

This most significant advantage of ETF’s is then described as follows: “Total expenses, including management fees and costs for marketing, trading and legal and regulatory compliance, are 1.26 percent for the average actively managed mutual fund, according to Morningstar. For index mutual funds, the corresponding figure is 0.99 percent, while the average E.T.F. is run for just 0.57 percent of assets.”

The Times article continued: “There is another cost advantage to E.T.F.’s that leads analysts to predict continuing expansion: taxation is less severe. ‘E.T.F.’s are substantially more tax-efficient than mutual funds,’ wrote the president of a highly respected financial planning firm. ‘That is especially true when the portfolio follows indexes dominated by large companies like those of the Standard & Poor’s 500 or the Russell 3000. If you’re invested in an S&P or Russell 3000 E.T.F., there is no tax consequence until you sell. In an equivalent mutual fund,’ he added, ‘you may have tax consequences if you just sit there and hold it and haven’t done anything. An E.T.F. is almost like having money in a retirement account.”

In November 2004, another article in this column also dealt with ETF’s, in part emphasizing the difficulty the vast majority of investors face in attempts to beat the market. Here was the argument forwarded: “It is estimated (calculating from statistics provided by the National Association of Security Dealers) there are around 750,000 people registered to sell stocks and bonds in the U.S. What percent of that number are truly capable, can validate successful performance records, and are truly qualified to handle your hard earned money? Is it 90 percent or 10 percent? And even if that number was knowable, what are the odds of your choosing one from within the capable and successful group? As any gambler will tell you, “If you don’t know the odds — don’t bet!”

The Viewpointe article continued, “So, we come back to index funds, investment vehicles that will assure that you don’t beat the market. What’s so great about that feature? Well, it also assures that in the long run, you won’t do worse than the market, and will do virtually as well as the index against which the fund is bench-marked, a feat that only a minority (and a small minority at that) of actively managed mutual funds and financial professionals can achieve.”

Despite the tax and cost (expense) advantages listed above, as well as the fact that ETF’s enjoy all the other features available when trading other instruments on the stack exchanges such as selling short and placing limit orders, until recently they have suffered from one handicap; an impediment that was discussed in the July 2010 issue of Money magazine: The fact that commissions are imposed when buying ETF’s. The headline read as follows: Is the Mutual Fund About to Be Replaced?

While that question reaffirmed the notion that the powers of Schumpeter’s concept of creative destruction was alive and well, it was the sub-headline that clearly indicated that the wheels of disruption were still turning. It read: Commission-free trades on rival products could slam the doors on traditional funds. The key (magic perhaps) words here are “commission-free.” In November 2009 Schwab removed trading fees on its line of ETF’s. In May, Vanguard then followed by eliminating commissions from every one of its 46 ETF’s. Not to be undone, Fidelity recently embarked on a system of commission-free trades on 25 Blackrock iShares ETF’s.

The distinct advantages of ETF’s have not gone unnoticed in the professional financial industry. Among a recent survey of Registered Investment Advisors by Charles Schwab, a full 79% say they now look to ETFs as their top investment vehicles for their clients. Another survey revealed that ETFs remain the preferred investment vehicles for advisors surveyed, with 36 percent planning to invest more in ETFs during the next six months.

Popularity growth in ETF’s has also been remarkable. Exactly five years ago in November 2005 a Viewpointe article on the subject cited figures from July of that year. At that time there were about 180 ETF’s available with a total asset value of $252 billion. Through June of this year those numbers have surged dramatically. Assets of all ETF products under management now total $788 billion, a 30% increase over last June. There are now 1009 ETF products compared to 837 last June.

Despite the impressive growth curve, a word of caution has been expressed by no other than John Bogle, the former Vanguard legend who created the first index mutual fund in 1975. While admitting that buying and holding a market based ETF is an “intelligent” strategy, he emphasizes that “trading and speculating” through exchange-traded funds “is an insane way to invest,” He maintains it is especially imprudent for longer-term investors, referring to “extreme” ETF’s offering derivatives, short selling, “leveraged and inverse” securities, and some that promise to double and triple returns on moves in the Standard & Poor’s 500 Index and other benchmarks. The average investor is best advised to diversify with ETF’s that mirror the major indexes such as the S&P 500, the Dow Jones Industrial Average, or the Russell 3000.

There is no question that ETF’s are a disruptive technology challenging traditional actively managed mutual funds. Only time will tell whether their creation will cause those funds to eventually self-destruct.