ETFs: High Tax, High Expense, and Inefficient

Co-Written by Lorraine Ell.

When ETFs came on the scene 15 years ago, they brought a brave new world of efficient markets with low operating expenses and minimal tax liability. While the largest funds like DIA and SPY are designed in the spirit of the original ETFs, to track the large indexes, most of the newer ones do not even come close to this original purpose.

If the Efficient Market Hypothesis (EMH) is correct, then only two ETFs are needed at most, a world stock index such as the Vanguard Total World Stock Index (VT) and a bond index like the Vanguard Total Bond Market ETF (BND), in a ratio that fits your risk tolerance. Anything more, if we are to be philosophically true to the EMH, tips into the realm of active investing.

Yet, the Vanguard Group, founded by index fund's chief guru Jack Bogle, has dozens of ETFs. Currently, 836 ETFs trade in the US going far beyond the major stock indexes to include sub-indexes, commodities, currencies, and most recently, actively managed ETFs. Many are leveraged and the traditional advantages offered by ETFs: transparency, simplicity, consistency, low turnover (fewer tax consequences), and low costs, are abandoned in the quest by their issuers, including Vanguard, to offer a more diverse line of products. Clearly, however, this is an effort to increase the issuer's revenues.

If active investing cannot beat the market and ETFs based on major stock indexes are the answer for the average investor, then what is the purpose of these specialty ETFs? It appears that ETFs, outside of the broad indexes, are for active investing.

Investing in more than two ETFs is active investing. Financial advisors sell services creating ETF portfolios using investors' perceptions that ETFs are better, safer, cheaper, and more tax efficient. Nothing could be further from the truth.

Take the DXD, Proshares Ultrashort Dow 30 that paid out a whopping $16 year-end distribution. Where is the transparency? What if you bought it unknowingly the day before that distribution? What happened to the tax efficiency advantage?

There are several gold ETF's, but do they buy futures or the physical bars locked up and insured in a vault? Do they track futures or physical delivery? Are they leveraged? You need to know this information before you buy.

What is in an ETF? Some smaller sectors funds have single stock positions of 20-30%. Low cost? Think again, some ETFs charge 1% or higher. The bottom line is that ETFs are no longer basic tools but complex devices that are new, untested over the long haul, and may have unintended consequences in the future.

As professional money managers, we use several of the more exotic ETFs and ETNs. OIL, DOG, and PST are our favorites right now because they compliment our stock and bond positions. We like OIL because we think that the correlation between money supply and oil suggests a price above 60 per barrel. We are long PST, because treasuries are in a speculative bubble.

DOG is an unleveraged hedge on equities, and it tracks the inverse of the DJIA closely over the long term. What is the catch? It is expensive at a .95% expense ratio, as compared to .10% or less for traditional broad based ETFs. The advantage to us is that no margin accounts are needed, any losses are limited to the amount of our investment (as opposed to an unlimited amount in shorting a stock or ETF), and we can move in and out of it without the hassle of borrowing stock and dealing with the SEC's new short selling rule of the week.

ETF investing can be treacherous. Caveat emptor.

Full disclosure: Portfolio, LLC is long PST, DOG, and OIL at the time of writing.

Comments

[donzelion:]

You write: "Investing in more than two ETFs is active investing." Perhaps one might separate ETFs by tax treatment (e.g., instead of VTI, buy a U.S. equities ETF and a non-US equities ETF, and place them in tax advantaged/non-tax advantaged accounts, respectively.

It's still a passive strategy, since one's market activity was conducted without reference to the market itself, but instead with a focus on taxes or other non-market factors, right?

Jan 08 10:53 AM

[bigmoney:]

>> If the Efficient Market Hypothesis (EMH) is correct, then only two ETFs are needed at most

the title of this article is alarming. ETFs should be compared to an alternative, such as mutual funds. An ETF sector fund, such as XLE is generally much cheaper than its equivalent mutual fund. And in many cases, there is no mutual fund equivalent at all.

"active investing" via ETFs is not necessarily bad, as one can concentrate on macro-economics more easily. For example, peak-oil believers can overweight the commodities sector. Deflationists can overweight long treasuries, etc.

Jan 11 11:56 AM

[rr0710:]

This article paints ETFs with a the brush the size of godzilla. There are thousands of investments with high expenses, high taxes and inefficient. ETFs, especially the passive ones involved with indexing, are generally passive and fairly inexpensive. If I invest in any two etfs I'm into active investing? Article is correct about caveat emptor based on the alchemy of certain ETFs, especially the highly leveraged kind, so the message is do your homework. Then there is a mention of ETNs which are different investment beasts entirely.

Jan 16 12:19 PM

[Lee Eugene ...:]

Why? Are you trying to limit the foreign withholding tax in an IRA that you can't get back? There is also and issue of late reporting and changes to 1099's with foreign etf's. However, I would say that it is not necessary to split them up. You would have to have a very large portfolio in order to take advantage of a tax play here.

On Jan 08 10:53 AM donzelion wrote:

> You write: "Investing in more than two ETFs is active investing."
> Perhaps one might separate ETFs by tax treatment (e.g., instead of
> VTI, buy a U.S. equities ETF and a non-US equities ETF, and place
> them in tax advantaged/non-tax advantaged accounts, respectively.
>
>
> It's still a passive strategy, since one's market activity was conducted
> without reference to the market itself, but instead with a focus
> on taxes or other non-market factors, right?

Jan 16 05:51 PM