Mutual Funds? They're So '90s; Let Us Sell You An ETF Instead

Includes: SPY, VTI
by: Peter F. Way, CFA


Like was done with the Mutual Funds in the '90s.

You should still have most of that capital. Too bad it didn't grow the way you thought it would. (But its fees did grow the way they thought possible.).

The ETFs won't be so expensive to own; there are fewer places to hide fees.

But they may perform about as well – unless you let them entice you with special claimed investment twist, like they did with the Mutuals – twists that rarely performed.

You'll need their help, because now there's over 1400 ETFs, not just tracking stock indexes (are there 1400 of those?). "Active" ETFs even look a lot like Mutual Funds.

'Gator got your Granny? - or your capital?

Please don't make the same mistake again. The folks who made themselves a nice lifestyle selling Mutual Funds (and keeping control of your investment capital) have invented new, shiny products to sell to working stiffs who are too busy to learn a second career of investing.

If you're on the wrong side of this victor-victim confrontation, just remember why ETFs came into existence over 20 years ago. To provide an easy-to-enter, easy-to-exit, low-cost way to invest in a widely-diversified package of 500 stocks, whose price is mostly moved by all the big-name, productive, solid companies. And you not having to spend much time thinking about it.

SPYDRs were (ARE) the holy grail of the "passive investing" movement, an investment philosophy that may be well-suited to large numbers of investors.

The cost of not having time to learn

We have written a number of articles stressing how precious is time, time to do everything, including live life. These comments are not a put-down of learning, of passive investing or of anyone's choice of how they feel compelled to make time trade-off choices.

But all choices have costs, and the better choices usually are lived with as a result of being well-informed before decisions are made. So, to offer more perspective, here are some comparisons between active investing, passive investing and ignorant investing (my definitions).

Passive investing typically involves choosing some investment medium into which one can place capital, either only initially or periodically, and keep it there without disturbance over long enough time periods so that the notion of a "buy and hold" philosophy is an appropriate description. The usual investment objective is to meet some requirement for liquid capital availability at a time distant in the future.

The price paid for the strategic decision is the acceptance of some average rate of return subject to (hopefully) temporary reductions in capital value that may not occur at a time that will interfere with the intended mission. In return for the acceptance of an average rate of return and possible untimely interference with liquidity, there is an implied benefit of good odds for success in the accomplishment of the mission.

Cup... and lip

What could go wrong? Any pessimist friend will start on his/her litany for you. But you are the one that afterward has to live with the complaints, perhaps from others, more importantly from yourself. Which is why you get paid the big congratulations for making the right choices, only known for sure after the fact.

Let's look at what is (has been) an average return on a large set of stocks over considerable periods of time relevant to your situation. Forget centennial-length histories, medical science hasn't got us there yet.

We mentioned the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) earlier, which has a price history back to 1993 (7873 calendar days), or 20+years. Another broader ETF with history is the Vanguard Total Stock Market ETF (NYSEARCA:VTI), which has been around since mid-2001 (4814 calendar days), or about 12 years. Over its total life, SPY has provided an annual rate of return (including dividends as adjusted for by Yahoo) of +9.3%. Not bad, but it paid to be in early.

That's because when we look at VTI and SPY during VTI's lifetime, VTI (according to the same authority) provided an annual return of only +6.7%, and SPY in the same period, only +5.8%. The difference in returns between SPY and VTI is usually attributed to smaller-cap stocks and categories excluded from inclusion in the S&P 500. As to the appropriate time period, many forecasters would be likely to give more relevance to the more recent one, acknowledging that better outcomes have been known to have happened in a different era.

Okay, so the baseline for judging cost in choosing the passive investment path might reasonably be +6% to +6½% per year. How much better must active investment do? Lots of published studies (often of mutual fund managers and their products) say that over 80% of actively managed portfolios do worse than the market averages.

The principal place where the results of the less-than-20% winners are found is in their online and in-print drumbeats of how smart they are, typically with figures for 3-year or 5-year measures in the low-double digit teens. As has been well documented by endless academic studies, repeat appearances in consecutive years for these "winners" (as specific funds) are extremely rare.

Instead, fund families (each with hundreds of specific funds) hope that you will associate the firm's name in their advertising, rather than that of the particular named (often very narrowly-focused) fund.

All leading those who champion passive-investing to assert, Borg-like, that "selection of specific issues or moments to act are futile."

The opposing active-investment camp tends to respond with "Well, how do you explain Warren Buffet and Peter Lynch" and others who are smart and able enough to avoid the interfering glare of publicity.

But before we go to that side, let's complete the appraisal of the quality of those +6-6½% annual returns. What is incomplete so far in only looking at the quantity of returns is a measure of the risk taken to obtain the returns. Forget measuring uncertainty, which is what statistical standard deviations do.

Uncertainty is not risk. Uncertainty contains risk, but it also contains happy surprises, that other tail of the bell-shaped "normal distribution" curve upon which the standard deviation measure relies. Are you really terrified of an unexpected acquisition of one of your stocks tomorrow at a price 40% above today's? You know it happens.

Let's not get into why the professional investment community has for decades embraced this erroneous notion of "uncertainty as a proxy for risk". That is a story for another day.

Instead, let's look at the real nature of investment risk, which is loss of capital (and potentially, of time). Whether that loss is permanent or temporary depends upon what alternatives the investor has to weather a period of capital value impairment that may be temporary in nature. If those alternative resources of liquidity are adequate to span a period of capital value recovery, then the risk has been avoided and can be ignored as noise. What the resources are is not important to this discussion; how long the attack on capital liquidity can be withstood is what is important. If insufficient resources force untimely liquidation of assets, then the true risk has to be recognized as a loss of capital.

So, a part of our measurement must include the possible time span of the risk threat to be withstood. Another measurement part is the size of the potential capital loss that may be forced into the reality of recognition; bye-bye $.

We approach this problem historically by looking at the way market prices for each specific asset (SPY and VTI) have behaved during pre-defined threat periods. We arbitrarily take 3-month and 6-month periods as larger times than a capital attack can be withstood. Longer periods may well be tolerable and could be examined, but we do not want to get into a discussion here of how to set what may be appropriate.

Each day, we look out over the entire threat period to find the maximum end-of-day [eod] price drawdown from the current day's eod price. We take the geometric mean of all those price-change threat maxima, minus 1, as the potential risk exposure for the stock or ETF. The table below shows what that has been for both SPY and VTI.

Click to enlarge

To begin with, since these results may likely upset some most cherished stock investing illusions, let's understand exactly what data is being used and where it has come from.

Yahoo Finance provides price history files for several thousand stocks and ETFs, showing daily dates, opening prices, high and low intraday prices, closing price, daily volume of trading and adjusted price. The adjusted price is the then current close price adjusted for splits, dividends and capital structure events having an impact on comparability of prices subsequent to that date. They are the source for all data in the table above.

The dates selected were caused by the initiation of trading in the ETFs, and the date of the analysis, with an intent to be as complete as possible.

All SPY price calculations were based on closing prices. All VTI price calculations were based on the "adjusted close" price to provide for a 2-for-1 split on the ETF mid-stream of this analysis.

All monthly calculations presumed 21 market days, 63 for 3 months, 126 for 6 months and 252 for 12 months.

The results and their implications

Diversification works, so when an investment depends on the combined prices of 500 components, it's not likely that big price losses will be seen. At least not in only 3 months, especially averaging all daily 3-month holding periods of a 20+ year span. That's the reassurance the -5.3% reinforces for investors seeking safety.

But what may be forgotten is that the longer one stands around holding the football, the more likely it is one will be tackled. Doubling an investment holding period in SPY to 6 months doesn't double the size of the hazard, but another doubling to one year puts the typical loss exposure up to over -10%. And that's every single day's next full-year risk of a double-digit price loss.

Want to try holding SPY for a full two years to make the chances better? The potential punishment price rises (historically) to losing 1/6th of your capital. Does this still sound like a great safe investment?

It's not what anyone told you, is it? A sound bet on the best companies, lots of 'em, in the broad market. Sure, there will be ups and downs, but being a long-term investor is the conservative way to invest. Or is it? What has been the corresponding price gain returns that make taking chances like these worthwhile? Oh, that side of the trade-off!

Off to the right on that same top-line of worries are the payoffs, averages of all possible holding periods of the same length as the risk calculations. Let's see. 3-months' gains average +1.7%. Can that be right? The risk exposure is 3 times as big as the payoffs?

Well, that's why you don't want to be a short-term trader/speculator, right? No, you're an investor, and investors are in it for the long pull. See, the 6-month numbers are better, with +3½% gains. But the risks are still more than double that encouragement.

Long term, that's the strategy. One-year payoffs in SPY have averaged +7%. For over 20 years. Dammit though, the risk average keeps rising, and it's still one and a half times the price return. Two years? Returns continue to be smaller than risks. What's going on with these crazy numbers?

Is something wrong here?

Only with what you have been told.

You have been told risk is something that it isn't. Something that won't be measured in terms that can logically be compared with returns. So no direct comparisons are ever made, only obscure ones that are presented in ways that urge you to believe that you have a meaningful measure of risk vs. return. Somehow, done that way, it rarely seemed so foreboding.

Both risk and return can be measured in like units of gain and like units of pain. Positive percentages and negative percentages. For the same length holding period involvements. Direct, simple, understandable comparisons.

If you think that the 20-year SPY data is uncomfortable, let's look at the more recent 12-year comparisons of VTI and SPY. The short story is that the reward-risk situation and its implications are worse.

The risk exposure numbers are larger, the return numbers are smaller. You know which way that puts the reward/risk ratios.

The only plus comes from better price gains in the VTI due to the inclusion of investment segments excluded by the S&P 500 index, ones that have performed better in recent years. That allowed two-year holdings to be an almost even stand-off between risk and return.

But does that make a 50-50 coin-flip a wonderful, conservative investment strategy?

Not for most thinking investors.

What to do about this?

We have, some time ago, evolved a way to identify true measures of risk, and ways to incorporate them into the investing decision process. You may have as well. There are many smart folks in the investment business.

Unfortunately, there are far more investors who have not taken the time or effort to think clearly or intently about this. We believe we can be helpful in offering a framework to help them think through what their investment situation most needs and what it will best benefit from.

Part 2 of this exploration will take the discussion further, explaining how active investing makes decisions that can avoid the sterile time periods, or even worse, the negative damaging experiences that cripple "long-term investment" and create insufficient middling average results.

And how to avoid ignorant investing, of the kinds that no one should do.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.