By Jim Wiandt
Another wise guy takes pot shots at all ETFs and finds an audience in a sea of misinformation.
Yesterday, I was forwarded a blog that was published on Seeking Alpha (where we sometimes publish our own blogs). The author of the article is a certain bow-tie-wearing blogger named Neil George.
Here is a link to the blog—“Why ETFs Are A Scam”—in its entirety. It's really must-reading.
The article is so full of misleading information and flat-out factual errors that it is hard to know where to begin.
Let’s start with the first line of the email from the person who forwarded the blog to me (a friend who I know buys ETFs and works around the ETF business). He says, “This guy has some valid points.”
Unfortunately, when I forwarded it around to my email colleagues, my first line was, “This guy is a nut case.”
Because I honestly believe that George’s blog post, and his line of thinking in general, is symbolic of a grave danger to the ETF industry, and one that is largely not being addressed.
We’ll get to that in a minute, but first let’s address the crazy parts.
After a 300-word intro that complains mostly about how much ETFs advertise, Mr. George starts his campaign of obfuscation:
"An Exchange Traded Fund might have a great name on the outside – but most investors will never, ever be able to find out what’s actually inside them.
That’s because the folks that build and run ETFs will only release what’s really in them to the specialist traders that sign on to make markets in them."
This is not just wrong; it’s insane. George is taking the most transparent fund structure in the world and saying it’s a shadowy scam. To me, that’s like saying “Up is Down. Up is Down!”
I get, er, all the holdings.
In fact, I can do this for every single plain-vanilla equity, bond or commodity ETF listed in the United States. That means that, for more than 700 of the 800+ ETFs in existence today, you can access the exact holdings of the funds, full stop, on a daily basis.
The only funds that lack this kind of full disclosure are the leveraged, inverse and inverse-leveraged ETFs. I would argue that these are more accurately called exchange-traded products (or ETPs) rather than exchange-traded funds (or ETFs). While not inaccurate, there's more information investors could get—counter-parties, settlement dates, etc.—and swaps-based funds could use some improvement on that front. But those are a real minority of ETFs, and they are ETFs that exist on the extreme edge of the product structure; the vast majority provides full disclosure.
For all plain-vanilla, non-leveraged ETFs—which is to say, for the vast majority of ETFs—full and obvious disclosure is the rule of the day.
The blog goes on from there:
"While ETFs trade on exchanges and folks think that they’re buying or selling at the net asset values of the moment – the truth can be far and away different.
That’s because throughout the day, few folks actually know what’s inside the ETF’s underlying assets, which are embodied by what are called “Creation Units.” Each Creation Unit is what is used to deliver an ETF share to the market. And, each share of an ETF actually is just a share in the underlying real basket of assets.
Those assets can vary widely throughout the trading day and are not usually made up of actual stock shares – but rather a series of options, swaps, forwards and a host of other derived securities, in amounts and proportions that only the specialists and the managers of the ETF know about.
Traders in the know love these things because they get to trade against the underlying basket of assets. They get to buy, sell, short and everything else that can enable them to arbitrage against the secret baskets of assets behind every ETF."
I’m not sure I can even follow the logic of those paragraphs, but I can do so enough to tell you that it’s faulty.
The assets of an ETF do not vary throughout the day. They are what they are. And they are by and large not “a series of options, swaps, forwards and a host of other derived securities… that only specialists and the managers of the ETF know about.”
They are, instead, almost always the actual underlying shares. To use the examples listed above, IYF owns 1,413,796 shares of JP Morgan (NYSE:JPM), GWL owns 126,422 shares of BP and VV owns 2,103,793 shares of AT&T (NYSE:T). You want more detail than that?
The blogger seems to conflate creation units—which are the baskets of securities used to create new shares in an ETF—with the actual holdings of the ETF. But it almost doesn’t matter. The creation baskets for anything I would call an ETF are essentially identical to the actual underlying holdings of the fund, which as I said, are fully and freely disclosed. If you care enough to want the actual creation basket data, you can get that from NSCC for a fee.
(For the record, the swaps-based ETFs use cash creations and redemptions.)
The blog takes a turn for the worse in the next section, which George titles “Severe Underperformance Against Benchmarks and Alternative Vehicles.”
"While the performances of ETFs can track underlying indexes – they often underperform. And when you match up many ETFs against closed-end funds focused on the same or very similar markets, ETFs tend to lag."
Now he’s gone off the deep end. After railing about transparency and NAV-tracking, he suggests closed-end funds as an alternative? Closed-end funds? Now there is a structure that does get in the way of accurate market returns.
Closed-end funds disclose their holdings on a quarterly basis with a 60-day lag, and the funds regularly trade at huge discounts (and sometimes premiums) to net asset value with no effective arbitrage mechanism regulating that gap.
By comparison, ETFs have full disclosure and a functioning arbitrage mechanism that keeps the share price within a tight range of the NAV.
As for tracking error, those are also miniscule as a rule for ETFs. A Morgan Stanley report published in February showed that the asset-weighted average tracking error for ETFs in 2008 was 39 basis points, for instance. Not bad after you consider almost any alternative (mutual funds, variable annuities, closed-end funds, managed futures, hedge funds, you name it) have expenses greater than that!
George goes on to write about a few specific examples of how ETFs under-perform, citing in particular an inverse ETF from ProShares and the US Oil ETF (NYSE: USO). Here’s what he writes about USO:
"[H]ow about when you wanted to trade oil on its recent near term rally over the past few months?
The US Oil ETF (USO) that’s supposed to track the performance of the underlying price of West Texas Intermediate Crude is pitched as the way to cash in on that particular commodity.
So, while crude has nearly doubled since later February, the ETF has lagged big – by nearly 62 percent."
Alas, George is missing a critical word: futures. USO is designed to track the movements of crude oil futures. And that makes all the difference.
There have been some issues with USO (as you can see in the blogs between Matt Hougan and I on the subject) but the bulk of what he’s talking about is just how futures work. Contango and backwardation can cut both ways on relative returns (and have). It’s a phenomenon we’ve been writing about for at least three years now; so forewarned should have been forearmed.
George seems frustrated that USO does not track the spot price of oil, but how does he propose to invest in the actual spot price of crude? By storing barrels in his backyard?
This is all about understanding the markets and products you’re in.
All in all, George’s post would be laughable, save for the fact that someone I respect forwarded me the message. And if you check out the comments section on Seeking Alpha, you’ll see that the post elicited a wave of “you tell 'em” comments, showing that he has truly struck a chord.
That makes me very nervous indeed for the ETF business. Nut jobs like this guy, who is conflating all products into “ETFs” being bad, can absolutely gain currency. For an industry and products that are by and large a model of low-cost transparency, what he is saying is truly akin to saying “up is down.” But that won’t matter if people start to believe it.
The ETF industry needs to do a better job getting out in front of these issues, separating plain vanilla ETFs from these more exotic ETPs, and making sure that these false statements are quickly rejected.
There are issues around the more exotic ETFs, and the fact that investors like Mr. George do not understand these products shows that the industry has work to do on the education front (and we'll keep doing our part here).
But we shouldn’t let that trickle over into the simpler ETFs, which represent the vast majority of assets and that perform exactly as you might expect. I reiterate my belief here that ETFs are the single most important product development since the invention of the mutual fund, and have democratized investing far more than industry-godfather Nate Most ever could have imagined.