ETFs: Yes, They Have Their Drawbacks Too

Despite the title of this post I'm sure that most people that have read my stuff know that I am a huge fan of ETFs. They allow people willing to spend the time to build very sophisticated portfolios that by and large avoid single stock risk. The broader funds allow for simple and cheap beta for people who for whatever reason do not build portfolios with narrower funds in the capacity I write about.

All that noted, there are drawbacks to the product -- every product has drawbacks. One written about previously is that it can be more difficult to capture a good dividend yield. Some of the "dividend" ETFs are (were?) heavy in financials and quite a few of the WisdomTree funds have very lumpy dividends.

Look at the dividend stream for the WisdomTree Intl Energy ETF (DKA), which most clients own. First of all, the 7% you might see at ETFconnect is wrong because just this year WisdomTree switched to quarterly payouts from annual. So the "7%" is picking up the one annual payout for 2008 plus the two quarterly payouts thus far for 2009. The dividend paid in March of this year was $0.09 and the June div was $0.43. There can be two reasons for the lumpy dividends. One is that many foreign companies pay dividends once or twice per year instead of four times. Another issue for WisdomTree has been that share creations or redemptions have impacted the payouts in the past and this could be an issue at anytime in the future.

Anecdotally it seems like less of an issue now than it used to be, but grain of salt that one.

This brings us to the other drawback implied in the title of the post. Yesterday after the close, as I usually do, I looked at how the various stocks and ETFs I own for clients did, and I noticed an odd quirk. I should note that I have a quote-widget on my desktop where I have programmed in the SPX, all the big SPX sectors (proxied with an ETF) and a couple of other things, which hopefully allows me to have a sense of what is going on during a given session.

The healthcare ETF I follow for this purpose is the iShares Health (IYH) which is a domestic sector fund. That fund was down 0.14% which not surprisingly was better than the SPX's 0.81% decline. The quirk I noticed is that three of the five stocks I own in the sector were up on the day, smoothing it out better than the ETF would have.

To be crystal clear, one day means absolutely nothing, one day is a quirk and anyone with a diversified portfolio of 30-50 stocks had names that were up yesterday. But it does raise an interesting issue. In just owning one ETF to capture the sector, there is no chance of adding value over a more reasonable period of time by picking a stock. There is also no chance of lagging by picking a stock either.

In using an ETF for a sector you are giving up the chance to outperform at the sector level. This potentially becomes a smaller issue the narrower ETFs become. For many people, this opportunity cost is probably small consideration, but it is a drawback. For example, one health name I have owned for years now, and disclosed many times before, is Teva Pharmaceuticals (TEVA). This is far from an obscure name. It has outperformed IYH dramatically for 5yr, 2yr, 1yr and YTD according to the chart on Yahoo Finance, but has lagged for the last six months and I did not look at any shorter time periods.

Picking a big theme like generics and picking one of the largest stocks in a market (Israel) is a long way from uncovering a hidden gem or adroitly picking a stock. I realize not everyone will or should pick stocks, but that does not mean you should not fully understand the drawbacks of the products and strategies you use.

Comments

[Robert Mart...:]

Roger,

I'm also a fan of ETFs for tactical moves in a portfolio. Low taxes, low costs--what's not to like?

ETFs are also an inexpensive way to generate alpha by making sector bets and thematic plays. As you noted, generating alpha from stocks like TEVA has its rewards, but alpha has its price: Either you spend time researching the stock or you pay someone else to do it.

ETFs allow you to pay pennies for beta, and conserve your research dollars for true market alpha.

Rob

Sep 02 03:10 PM

[hatarakiman:]

I only bought SPY and TIP, sometimes MDY, IWM for avoiding wash sale rules for my friends(clients).
I sold a couple of calls (deep otm) on it.
No individual stocks, that's too risky for retirees.
Actually most people put money in CD after they "learned" some experience from the market crash. 2 to 3% higher return than CD will satisfy most people's investment goal. There are products like LIBOR plus 3% or LIBOR plus 5%. It's a good benchmark actually.

Sep 04 10:51 AM

[BerkeleyBob:]

I think ETFs are a cheap and cost effective way to diversify. I like, and have made gains, holding a country-specific ETF (EWZ) and recently added EWC. Also hold two gold-related ETF's, GLD and GDX. Collectively, the ETF's do not represent much more than 10% of the portfolio... and do not think individual stocks are "too risky" for retirees.

Sep 04 12:35 PM

[LKofEnglish:]

Interesting battle I think brewing between ETF's and Gold with both having very similar attributes. Also interesting in how the CFTC is "complaining" about "speculative ETF's." As if the traders aren't! Clearly this "faith no more" in active management has been a boon to the ETF space and should put it on the glide path to future must have investment tools for the forseeable future. But there is the "alpha" problem as you so ably point out. Was 100% in index funds in response to 9/11 and boy was I glad for that after this latest Wall Street thievery (which i still can't believe the morons in Congress buy into and literally GIVE the thieves ALL the taxpayer money.) Still, changing my tune now that the corruption is so rampant and in the open among nearly all politicians. Simply put there are companies that are far better run that our country (and every other large country in the world for that matter) so I'm changing my tune and putting my faith in individual stocks and municipal bonds at this time thus lessening the percentage in my in the index world. Still see it as the anchor in the portfolio, however.

Sep 04 02:19 PM

[aarc:]

I prefer SSO than most other funds.

SSO is a 2x ETF for the SnP500. It only has 1.48% yield but should double in price incremental or decremental percentages than that of the main index on the daily basis.

That way, I will gain a little dividend but a huge price appreciation over the long term due to it's 2x nature. Furthermore, I assume that over the long run, the effect of price compounding will be the bigger factor towards SSO going much faster than a linear 2x performance.

Assuming SPX and SSO goes back to their Oct 2007 highs at the same time:

- SPX would appreciate 137% from the low of 667 to 1576.

- SSO would appreciate 617% from the low of 14.16 to
the high of 101.48

That would result in 4.5x ETF performance for SSO instead of just being a 2x ETF. That is the nice effect of price compounding over the long run. The 2x performance is good only for daily runs upside or downside.

I expect the last high of Oct 2007 will be recovered in less than 5 years after the bottom has been set. If the SPX 667 is the true bottom; then we should be at 1576 or higher no later than March 2014.

SPY on the other hand would appreciate same as the SnP500. So even if SPY can provide 5% dividend; it can't possibly perform as good as SSO, being a 1x ETF.

How many high dividend funds will be able to perform better than SSO over the long run? And then, you will have to re-invest the dividends back into the fund in order to take advantage of compounding.

Investing in SSO is less of a hazzle since there's not much need to re-invest the tiny dividend percentage accruals each year. Let the 2x price appreciation alone do the compounding. And it does it in the daily, weekly, and monthly, quarterly and yearly basis, etc. Millineum, if you will.

As SSO price doubles and quadruples and what-have-you, the monthly dividend acruals will also get bigger and bigger in dollar terms and will accelerate a lot faster than a normal 1x high dividend fund. Over a longer time period, the monthly or quarterly acruals of SSO can become much bigger than that of high dividend fund on a dollar capital basis due to the multiplying effect of price appreciation assuming constant yield percentages.

Unlike fixed dividend funds, SSO yield applies to the most current share price and will more likely can go up a few percentage digits or points every year as the economy recovers and more companies make more money. While that of a high yield fund with fixed dividend will have a lower percentage of future share prices as the share price increases.

Since the companies in SnP 500 who provide dividends will declare different rates at different times, the yield of SSO will be constantly changing and unpredictable.

Since SSO has no long term history; I will have to assume that it will not give me instant gratification vis-a-vis quarterly dividend acruals unlike high yield funds with 3, 7, 10, or ever 15 percent dividend yields at the present. They are able to achieve high yields due to the annihilation of their share prices while their dividend dollar amount per share remains basically the same. Many have even reduced or cut off their dividend allocations for varied reasons but mainly caused by this recession.

But 5 years, 10 years, 20 years from now, SSO might as well keep me happy every month with huge monthly acruals (as compared to today's money, inflation will make it small) at least as compared to fixed dividend funds with shrinking dividend percentage of future appreciated share prices in a healthy economic environment.

No need to do stock or fund picking. The 2x factor will more than exceed any stock picking achievements in most cases.

Price compounding exagerates the price appreciation or destruction over a longer period of time. SSO suffered 87 dollar loss from its high of $101.14 to $14.18 in less than 2 years. I doubt if many investors who bought at the highs will have the stomach to buy it again even at current prices of 30 dollars.

So the disadvantage of SSO is that it will suffer mightily during downturns unlike fixed dividend high yield funds that seldom go crazy during panic times. They did this time, anyway. But not as bad as SSO. Thus making them extremely attractive with high fixed yields to current share prices. That will change in the future as their prices appreciate and the yields on the most current future prices dwindle.

Investors with weak intestinal fortitude better not look at SSO price during meltdowns if they want to keep it over a long period of time. And never ever try to use margin with SSO otherwise it can easily destroy margined accounts in a short period of time if we have another prolonged meltdown.

Sep 05 02:04 AM

[andruomail:]

Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors
sec.gov/investor/pubs/...

Sep 06 02:11 AM

[RECESSIONPROOF:]

stocks are real thing, futures are real thing but etf is something unreal

Sep 06 04:00 PM