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Don't Abuse the Benefits of ETFs

ETFs offer a number of benefits, but that does not mean we can ignore investing fundamentals.

Michael Rawson, 06/21/2010

While ETFs offer many advantages over other investment vehicles, there are a number of situations in which these advantages can be eroded through the careless actions of the investor. In this article, we take a look at some ways ETFs are used that are counter to sound investing principles. We encourage investors to adopt the use of ETFs in certain circumstances, but do not think that adopting this investment vehicle allows you to abandon the time-tested principles of sound investing. If and when you decide that ETFs are right for you, be sure to take advantage of the resources Morningstar has to offer, such as the ETF analyst reports, to help you find the right product for your needs.

Rapid Trading
Does the ability to trade ETFs on the market encourage high turnover? One of the disadvantages of mutual funds that inspired the idea of the ETF was the inability to trade at any point during the day. Mutual fund providers will trade with you at net asset value without charging a bid-ask spread or commission, but only once a day, after the market closes. Once-per-day trading discourages high frequency traders. In fact, some mutual funds even use redemption fees to discourage trading over periods as short as a few months. In contrast, you can trade ETFs as often as you desire--but do so at your own peril. Unlike with mutual funds, each time you trade an ETF you incur a commission charge from your broker, a bid-ask spread cost, and potentially higher tax costs. Perhaps more importantly, studies have shown that investors who trade more frequently earn lower returns. The return that an investor actually gets, rather than the buy and hold return, is a concept Morningstar measures through data called Investor Returns. The frequent trading of ETFs is a major reason for John Bogle's skepticism of the product.

Most Efficient Vehicle?
While the ETF is quickly replacing the mutual fund for stock indexes, the same is not true for bond indexes. While the stock market is highly liquid and stock prices almost never go stale, this is not true in fixed-income markets. Bonds often trade infrequently, and transactions still are largely conducted over the telephone. Perhaps more importantly, the asymmetric return pattern on bonds demands proper diversification. With bonds, the maximum upside we can expect is capped at maturity as a bond will pay only par plus the coupon. But if the bond defaults, the downside can be 100%. Thus bonds returns exhibit a negative skew. Just one default could cause a bond portfolio to underperform. Whereas active stock fund managers prefer more nimble, smaller portfolios, bond fund managers require the economies of scale of larger funds. Thus smaller bond ETFs may not be able to reach the scale necessary to achieve diversification. This has not stopped ETF providers from offering ever more bond ETFs, where they slice and dice the bond market into narrower segments. IShares iBoxx $ Invest Grade Corp Bond LQD holds 430 bonds and has just 10% of assets in its top 10 holdings, but iShares 10+ Year Credit Bond CLY further slices the corporate-bond market by maturity range, so it holds just 129 bonds and has 20% of its assets in just 10 holdings. My argument really applies only to the passive investor. It is important to make the distinction between a tactical and a passive investor. It may be appropriate for a tactical investor who has an informed opinion on a segment of the market to utilize a targeted bond fund such as CLY. Such an investor should have a well researched investment thesis and have an understanding of the difference between price and value. So although CLY may not be suitable as a sole bond holding in a portfolio, it still could be used as a satellite holding for those seeking to increase exposure to credit. Among bond funds that we recommend is Vanguard Total Bond Market ETF BND. It has more than enough scale, thanks in part to its pairing with its mutual fund cousin through a unique dual share class structure. PAGEBREAK

Probably the most egregious use of the ETF vehicle is embodied in leveraged and inverse products. While on the one hand, ETF providers clearly state that these products attempt only to provide a multiple of their index on a daily basis, their marketing of these products suggest that they can be used for asset-allocation or other non-speculative purposes. What they don't tell you is that the ETF is not the best vehicle for placing levered bets over time frames extending beyond one day. The volatility drag is a tremendous hidden cost which eats into returns. A large number of levered ETFs pairs (one promising 2 times returns and the other negative 2 times returns) have both lost money, for example, Direxion Daily Financial Bull 3X Shares FAS is down about 7% for the year to date, while Direxion Daily Financial Bear 3X Shares FAZ is down 22%. Despite the fact that the S&P 500 is negative for the year to date, ProShares UltraShort S&P500 SDS is down even more. Last year, Massachusetts Secretary of the Commonwealth launched an investigation into the aggressive sales practices of firms marketing leveraged ETFs. Perhaps these funds should come with a black box warning that they are really making a bet on the underlying volatility of the index.

Democratization of Asset Classes
New asset classes allow us to place bets where we never could before. But just because we can, does that mean we should?

Before the proliferation of commodity ETF, it was difficult for small, individual investors to allocate a portion of their portfolios to commodities. There was just not a convenient vehicle through which to invest, and storing commodities in small amounts is expensive and risky. Before ETFs, the most viable option for commodity investing was directly through the futures market or with a commodities trading advisor. But this either requires a futures brokerage account and a certain level of trading sophistication or results in high fees and lack of transparency when using an advisor. ETFs democratize investing in commodities by making it as simple as buying a stock. While there is nothing wrong with using commodity ETFs, the market may not be liquid or developed enough for everyone to rush in at once and allocate 5% of their portfolios to commodities, without causing temporary price distortions. There is some evidence that the demand for commodities from ETFs has distorted prices, resulting in strong contango which leads to a negative roll yield. More stringent position limits have been suggested in order to deal with such distortions. Additionally, ETF providers have suffered from unfortunate timing, launching a variety of commodity ETFs at the peak of a commodity bull market.

Another example of an exchange traded product opening up a new assets class are the VIX ETNs such as iPath S&P 500 VIX Short-Term Futures ETN VXX, which, one might assume, would behave like the VIX. However, because it actually tracks VIX futures, it has a volatility only half of that of the VIX. Investing in VIX supposedly can provide a good hedge against a market crash. But is this necessary for the typical investor? Wouldn't a more efficient approach to hedging a market crash be allocating a larger portion of a portfolio to bonds?

While there are no bigger fans of the ETF structure than the ETF team here at Morningstar, we do realize that they are not perfect in every situation. The ETF cost advantage, tax efficiency, and ease of trading often makes it a logical replacement for index mutual funds. That does not mean that these same benefits will translate to every asset class. Likewise, just because we can now daytrade our fund investments, does not mean that we should.

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