Index and Sector ETFs: Mutual Funds: Speculation X3

How many of you remember the immortal words of P. T. Barnum? On Wall Street, the incubation period for new product scams may be measured in years instead of minutes, but the end result is always a greed-driven rush to financial disaster.

The dot.com meltdown spawned index mutual funds, and their dismal failure gave life to “enhanced” index funds, a wide variety of speculative hedge funds, and a rapidly growing assortment of Index ETFs. Deja Vu all over again, with the popular ishare variety of ETF leading the lemmings to the cliffs.

How far will we allow Wall Street to move us away from the basic building blocks of investing? Whatever happened to stocks and bonds? The Investment Gods are appalled.

A market or sector index is a statistical measuring device that tracks prices in securities selected to represent a portion of the overall market. ETF creators:

  • select a sampling of the market that they expect to be representative of the whole,
  • purchase the securities, and then
  • issue the ishares, SPDRS, CUBEs, etc. that speculators then trade on the exchanges just like equities.

Unlike ordinary index funds, ETF shares are not handled directly by the fund. As a result, they can move either up or down from the value of the securities in the fund, which, in turn, may or may not mirror the index they were selected to track. Confused? There’s more — these things are designed for manipulation.

Unlike managed Closed-End Funds (CEFs), ETF shares can be created or redeemed by market specialists, and Institutional Investors can redeem 50,000 share lots (in kind) if there is a gap between the net-asset-value and the market price of the fund.

These activities create artificial demand in an attempt to minimize the gap between NAV and market price. Clearly, arbitrage activities provide profit-making opportunities to the fund sponsors that are not available to the shareholders. Perhaps that is why the fund expenses are so low — and why there are now thousands of the things to choose from.

Two other ETF idiosyncrasies need to be appreciated:

a) performance return statistics for index funds may not include expenses, but it should be obvious that none will ever outperform their market, and

b) index funds may publish P/E numbers that only include the profitable companies in the portfolio.

So, in addition to the normal risks associated with investing, we add: speculating in narrowly focused sectors, guessing on the prospects of unproven small cap companies, experimenting with securities in single countries, rolling the dice on commodities, and hoping for the eventual success of new technologies.

We then call this hodge-podge of speculation a diversified, passively managed, inexpensive approach to Modern Asset Management — based solely on the mathematical hocus pocus of Modern Portfolio Theory (MPT).

Once upon a time, but not so long ago, there were high yield junk bond funds that the financial community insisted were appropriate investments because of their diversification. Does diversified junk become un-junk? Isn’t passive management as much of an oxymoron as variable annuity? Who are they kidding?

But let’s not dwell upon the three or more levels of speculation that are the very foundation of all index and sector funds. Let’s move on to the two basic ideas that led to the development of plain vanilla Mutual Funds in the first place: diversification and professional management.

Mutual Funds were a monumental breakthrough that changed the investment world. Hands-on investing became possible for everyone. Self-directed retirement programs and cheap to administer employee benefit programs became doable.

The investment markets, once the domain of the wealthy, became the savings accounts of choice for the employed masses — because the “separate accounts” were both trusteed and professionally managed. When security self-direction came along, professional management was gone forever. Mutual fund management was delegated to the financially uneducated masses.

ETFs are not the antidote for the mob-managed & dismal long term performance of open end Mutual Funds, where professionals are always forced to sell low and to buy high. ETFs are the vehicles of choice for Wall Street to ram MPT mumbo jumbo down the throats of busy, inexperienced investors… and the regulators who love them because they are cheap.

Mutual fund performance is bad (long term, again) because managers have to do what the mob tells them to do — so Wall Street sells “passive products” with controlled content that they can manipulate more cheaply.

Here’s a thumbnail sketch of how well passive ETFs may have performed from the turn of the century through 2013: the DJIA growth rate was about 0% per year, the S & P 500 was negative; the NASDAQ Composite has just recently regained its 2000 value.

How many positive sectors, technologies, commodities, or capitalization categories could there have been?

Now subtract the fees… hmmmm. Again, how would those ETFs have fared? Hey, when you buy cheap and easy, it’s usually worth it. Now if you want performance, I suggest you try real management, as opposed to Mutual Fund management… but you need to take the time to understand the process.

If you can’t understand or accept the strategy, don’t hire the manager. Mutual Funds and ETFs cannot “beat the market” (not a well thought out investment objective anyway) because both are effectively managed by investor/speculators… not by professionals.

Sure, you might find some temporary smiles in your ETFs, but only if you take your profits will the smiles last. There may be times when it makes sense to use these products to hedge against a specific risk. But stop kidding yourself every time Wall Street comes up with a new short cut to investment success.

There is no reason why all of you can’t either run your own investment portfolio, or instruct someone as to how you want it done. Every guess, every estimate, every hedge, every sector bet, and every shortcut increases portfolio risk.

Products and gimmicks are never the answer. ETFs, a combination of the two, don’t even address the question properly — AND their rising popularity has raised the risk level throughout the Stock Market. How’s that, you ask?

The demand for the individual stocks included in ETFs is raising their prices without having anything to do with company fundamentals.

What’s in your portfolio?

How will ETFs and Mutual Funds fare in the next correction?

Are YOU ready.

Mutual Fund Mania – Choose wisely during RRSP season!

Usually the first vehicle of choice for new investors is a mutual fund. In days of yore, which in the investment industry is more than five years ago, investors usually bought equity funds but in more recent times balanced funds have grown more popular and even bond funds have attracted money.

Oftentimes, the first mutual fund experience is a disappointing one. There’s a reason for this. People intuitively want to be associated with success, so their first mutual fund will have these characteristics:

  • A great track record of top quartile performance over at least three to five years.
  • Billions of dollars invested in it, so it is “safe.”
  • Offered by an investment firm with a long and “distinguished” history.

Many years ago, there was much less data readily available and few statistical tools at one’s disposal, but I was curious and decided to examine a group of funds over time to see what their performance looked like. What I discovered is represented in the chart. There were no exceptions; every fund in my sample followed this same pattern.

It doesn’t take a mathematician to interpret a picture. If you invest in the fund when it’s a dog (ranks very poorly compared to other funds), the odds are great that given time it will be a top performer soon enough.

The problem is that most investors will pick a top performer. However, the top performer will soon become a dog, and the investor will be unhappy.

A great track record might actually guarantee poor performance.

When it comes to your money, intuition sucks. You “intuitively” steer towards something that “feels good.”

There is enough publicly available data nowadays to help you find a few funds that suit your tastes and examine their performance patterns. What suits your tastes may include funds that are easy to buy in and out of, those you have read about in the press, whose portfolio manager sounds smart on TV, or you may prefer socially responsible funds. When one of the funds that does occasionally perform very well has been in a slump over the past year or two, buy it. After the performance has improved over the course of a couple of years and you’re happy with the results, consider selling (or redeeming) it when the fund is in the top of the rankings (or wins an award) and buy a different fund that is in a temporary slump.

Being a curious sort, I once had the urge to see if award-winning funds followed the same pattern. After all, if someone wants a top-performing fund, wouldn’t they head straight for the ones that have just won awards for their outstanding performance?

I looked at the award-winning funds in any given year, and then checked their performance just one year later. Rather than examine every category (there are just too many nowadays) I stuck to basic Canadian equity, U.S. equity, small cap, international equity. Included were “thematic” funds popular at the time, such as ‘precious metals’ and the ‘dividend and income’ funds. Here are a couple of examples of what I usually found:

Results:

  • 100% of the winners were either 1st or 2nd quartile funds. The next year, 88% of these had fallen to 3rd or 4th quartile.
  • All the former 3rd quartile funds (dogs) rose to 1st quartile (stars) in the following year.

Winning an award (being a top performer) is not an indication of how that fund will rank in terms of its future performance, even in the following year. In fact, the odds are awfully good that your 1st or 2nd quartile pick will be below the median or worse one year later. Interesting! If there’s a lesson, I suppose it’s simply that funds should be bought because they meet your objectives, not because they’ve been performing well recently.

It’s not important to understand why this roller coaster occurs for mutual funds, it just does. Markets change, so, for example, when a growth fund invested primarily in technology stocks suffers, it’s no doubt because the upward trend in technology stocks, or their popularity among the herd, has either stopped or deteriorated. Apple is a prime example in the news right now.

Portfolio managers are just people working for people. I’ve witnessed the following scenario occur time and again:

  • Fund performance begins to soar.
  • Fund attracts lots of new money.
  • Marketing folks want more and more time from portfolio manager for meetings.
  • Money pours into the fund in droves.
  • Portfolio manager’s head swells (the “I’m a genius” syndrome).
  • Performance begins to deteriorate.
  • Money leaves the fund in droves.
  • Portfolio manager has to sell the fund’s best stocks (there are still buyers for these).
  • Performance sucks, and it takes two to three years for things to get back to normal.

Size really doesn’t matter…unless the fund is humongous.

A thinking person should be able to figure out that it doesn’t take a big fund or a big fund company to provide good performing funds. Think about it. Do you shop at the big box stores because the level of service is better? Is the quality of the merchandise better? No. You shop there because the economy of scale for the store allows them to buy products at a lower cost. They can order in bigger volumes and squeeze their suppliers. They then pass these savings to their customers.

Larger financial institutions enjoy similar economies of scale. Of course, the transactions and administration costs of the bank or insurance company are lower, and these benefits might come your way in the form of lower fees and expenses, but we’re not talking about buying lawnmowers. Rates of return on funds managed nimbly and intelligently can make those fees and expenses pale by comparison.

Bigger is safer possibly when you’re banking, but legitimate capital management companies are structured so that they never really touch your money. The custodial (where the money is physically held) and administrative (recordkeeping) functions are usually provided to these firms by big banks or huge financial institutions anyway—for safety and regulatory reasons and it makes the potential for fraud near impossible.

The reason why large financial services companies got into the fund management business was simply economics. They were providing banking, custodial, and administrative services to mutual fund and other asset management companies anyway, so why not also earn management fees by offering their own mutual funds and private wealth management services?

Take it from someone who knows from experience. Managing a massive quantity of money in one fund is much more difficult for a portfolio manager. You can only buy big companies. A portfolio manager will try to buy the best big companies, but since everyone else with big portfolios is doing the same thing, it’s not like you can outsmart them. It’s sort of like playing poker with jacks, queens, and kings being the only cards in the deck. If the three other players see three kings on the table, everyone knows you still have one in your hand.

Applying some discipline is important when directing your savings and will spare you much grief. For several years since the financial crisis, investors have swarmed into bond (see chart – it shows the net Sales of bond mutual funds) and balanced funds because of their strong relative performance and are considered to be less risky. Even today buying into income-oriented funds ‘feels good’ – everyone else is doing it, past performance is good and the fright we all experienced during the financial crisis still stings a bit.

Equity funds have been avoided for years – constantly redeemed – despite the fact the stock market returns have been outstanding since the crisis more or less ended (or at least stabilized). Now that the past returns are looking better, investors will be shifting money out of the bond funds (and perhaps balanced funds as well) and chasing the top performing equity funds.

This is an inferior strategy. If you examine the best ‘rated’ funds you will find they hold more dividend paying and income securities and will likely drop in the rankings very soon after you buy them.

With RRSP season comes a plethora of marketing campaigns and firms will be pushing us to buy their best performing funds (we are so quick to buy what ‘feels good’). Since you won’t see many advertisements for those not doing so well today, but are likely to do very well tomorrow, it would be wise to do a bit of homework before buying in. Good luck!

Mal Spooner