ETFs: Too Much Of A Good Thing?
Did you know that ETFs have been around since 1993? The Wall Street Journal had done a story last year on ETFs that caught my eye. I was looking to learn more about ETFs, and the WSJ article (where I got the chart in this article) gave a good historical summary of ETFs for the un-initiated. I’m not sure if the 13 years is supposed to be too long or too short. But the recent explosion of ETFs has prompted me to revisit the story again.
When it comes to watching over the financial industry, Canadian financial columnist Rob Carrick echos my sentiments exactly when he say “The cuter the investment industry gets in developing a product, the warier you should be about buying it.“. I’ve written before about ETFs becoming so “cute” that they’re barely recognizable! Are ETFs destined to suffer the same fate as did mutual funds?
Am I An ETF Hater?
During my daily scan of financial media, I have a tendency to find ETF-bashing articles more interesting. The personal bias comes from the fact that I have decided broad diversification will not be my overriding plan for my own portfolios. Nevertheless, I have always indicated that diversification serves its purpose well when used for the right purpose, towards the right audience. Therefore, I want to clarify that I am not attempting to discredit ETFs, rather to shine a light on how the financial industry can turn a good investment vehicle into something terrible, just like the mutual fund explosion in the late 1980s, early 1990s.
It’s Not Only WSJ, Or Myself …
TheStreet.com recently weighed in with their own article about the ETF explosion. Jen Ryan notes that we have already surpassed the number of new ETF fund launches in 2005 with a full quarter remaining in 2006. For those who loved to compare that there are thousands of mutual funds versus hundreds of ETFs, keep in mind that the mutual fund industry did not get there overnight. I don’t see ETF launches stopping in the near future, do you? If everybody thinks ETFs are superior to mutual funds, who’s to say that ETFs won’t eventually eclipse their numbers?
And just like plain old vanilla mutual funds got “cuter”, new ETF launches are targetting more obscure indexes, revealing more tricks up their sleeves. I don’t quite get it. Investing in ETFs is supposed to achieve market-like returns in a low-cost manner that can beat most active fund managers. But what advantage would there be to invest in a sector-specific index; a sector that is prone to wild swings, volatility, and fluctuations by its nature? Does investing through ETFs help mitigate any risks?
ETFs are supposed to be passive, tax efficient. But more and more companies are calling their products ETFs because they know those 3 letters will attract investor capital by themselves. Many of these new products have high turnover rates, rendering them less tax efficient — and more expensive. Sounds like actively managed mutual funds renamed as ETFs to me! These ETFs are coming into the space, simply because ETFs are hot and trendy.
As a contrarian rule of thumb, I don’t like investing in anything “trendy”. Be careful that diversification doesn’t turn into “di-worsification”.
