Don't Diversify: Why You May Want To Avoid ETFs

 |  Includes: SPY, VTI
by: Ugly Duckling


Undiversified portfolios increase your chances of outperforming the market.

Buying ETFs guarantees that you will own underperforming companies.

Hedging can often be a good substitute to diversification.

Lower fees are a farce. Fees are subjective and can be close to nothing.

Some ETFs don't even track correctly.

The Pitch

ETFs and mutual funds have been all the craze for the past few years and it's starting to annoy me. While these funds may be great options for the uneducated client, or the client who adequately manages his/her own portfolio, the educated investor guarantees himself one thing only with such investments: Mediocrity.

It All Starts With Math

You probably learned in high school that if a random variable is an extrema in the set and the outcome of your first experiment, expanding your sample size will cause the experimental outcome to regress to the mean. In short, your only chance of beating the market is to focus your portfolio on a few companies. If you have only one company in your portfolio, you have a 50% chance of beating the market and by a greater margin than if you have a handful of assets.

Saving the Bathwater With the Baby

Some things are obvious to me. The sky is blue, David Einhorn is a better poker player than me, and Caesars Entertainment (NASDAQ:CZR) is hurtling towards bankruptcy. I'd sooner buy the Brooklyn Bridge than Vanguard Total Stock Market (NYSEARCA:VTI), which owns shares in Caesars. In fact, when you buy an index fund, no matter what, 50% of your companies will underperform the index. Why not stick to one or two companies which you think might outperform that index?

Risk Management

So you want to manage risk? Any manager who tells you that the only way to manage risk is via diversification is simply WRONG. While diversification does mitigate risk to a degree, there are two reasons why he is wrong. Firstly, there are as many ways to manage risk as there are investors in the market. Secondly, he probably is defining risk in terms of market volatility.

Let's address the second issue first. We are investors and not traders. We are holding companies throughout cycles. Market volatility is just random noise in the graph, not significant risk. Stocks go up, stocks go down. So what is risk? Risk can take many forms. Risk is that Apple (NASDAQ:AAPL) will invent a smartphone and make your Nokia (NYSE:NOK) worthless. Risk is the chance of you not being able to pay off your debt obligations like Lehman Brothers. Risk is the federal government shutting down your business, like what will hopefully happen to Herbalife (NYSE:HLF). Market volatility is what risk is not. Market volatility is what gives us the chance to buy companies on the cheap.

So, how are you going to manage risk? Options work well. You could always sell calls or buy puts against your position. Relative value trades work. Pair trades work. Holding a bundle of cash also can be considered a hedge. Pick your poison and stick with it.

Low Fees?

Article after article lauds the relatively low management fees associated with ETFs and some mutual funds. You know what's even lower than the annual expense ratio of 9 basis points for the largest ETFs such as SPDR S&P 500 (NYSEARCA:SPY)? Commissions for long-term investors. Let's say you employ a buy-and-hold strategy for a five-year term, you will pay the same commission but you will end up saving over 50 basis points in management fees. According to the Wall Street Journal, the average ETF carries an expense ratio of 44 basis points. Assuming the markets return 11% a year, you are giving away 4% of your profits.

For The Unintelligent Investor

If you don't have the time or skills to actively invest, at least do yourself one favor, make sure your ETF actually tracks what it's supposed to. There are all too many which don't and it's a shame to come up with a correct prediction and to still lose money on it.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.