IFA Radio's Episode 32

IFA Radio
Sunday, August 08, 2010

 

Study after study after study…they all say the same thing: Active Management does not work. It absolutely baffles me as to how anyone would actually choose to put their money in actively managed funds. I know why they do. They typically won’t read the books and literature that tell them how wasteful they are being. I suppose it’s more fun to dream. When the lottery gets up to $100 million and you buy a ticket, you know you have a better chance of being struck by lightning on a clear day than winning, but the dream of what could be…lightning striking in almost impossible conditions…is worth the risk of one dollar. Unfortunately, people put a lot more on the line than one dollar with active managers and their hope they can get 20%+ returns.
So what about the happy medium of buying indexes in the form of ETFs and trading those? People can get index funds and still try to find elusive deals. Well, if you have been listening to this show for very long you know that in the investing world it is almost impossible to have your cake and eat it too.
Now, ETF’s are certainly better than going and picking individual stocks.
I like to give a little background on why picking one stock is so dangerous.
Individual stocks and bonds contain both systematic and nonsystematic risk. If investors hold the market portfolio of stocks like the Wilshire 5000, they have eliminated nonsystematic risk and they have not concentrated their portfolio on fewer stocks than the market. Concentration risk occurs when investors try to pick stocks and bonds that they think will outperform the market. Concentration of investments is akin to speculation and adds risk, but provides no additional expected return.
Concentration risk comes from all active management strategies such as trying to pick stocks, timers, managers or styles. Look at the chart below.
 

 
So yes, ETFs are not completely evil, but they are not the ideal answer.
The ETFs come in at an average of around 15 basis points. That means they cost 0.15% per year. Index mutual funds cost a bit more and come in around 25 basis points (0.25% per year) if you count some of the small value and international funds. So index mutual funds are a little bit more costly.
But… 
In his Little Book of Common Sense Investing, Vanguard founder Jack Bogle weighs in mightily on the subject of ETF trading, He states:
  • "If long-term investing was the original paradigm for the classic index fund designed 31 (now 34) years ago, surely using index funds as trading vehicles can only be described as short-term speculation."
  • "If the broadest possible diversification was the original paradigm, surely holding discrete — even widely diversified — sectors of the market offers less diversification and commensurately more risk."
  • "If the original paradigm was minimal cost, then holding market-sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them, nor the tax burdens incurred if one has the good fortune to do so successfully."
  • "Typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market."
...and Bogle's parting shot on trading ETFs provides an ominous warning:
  • "I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting."
ETFs can be a tempting siren song. They are an easy way to jump in and out of index funds. Jack Bogle estimates only 20% of these ETFs are bought and held. That means they are being traded about as much as normal stocks which brings in the trading fees, the taxes and all the other silent partners that drain your portfolio.
 
 
If buy and hold is the best strategy as all the academic research indicates, you stand a greater risk to lose the hold portion of it when you buy ETFs.

 

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