Clearing Up ETF Misinformation

Journalists and bloggers have it hard because they have to wake up every day and explain things they can't possibly be experts in.

But ETF investors have a problem when inexperienced reporters publish inaccuracies which are immediately broadcast by equally inexperienced bloggers. Take Wall Street Journal reporter Eleanor Laise's well-meaning "Before You Drive That Hot ETF..." on June 4, which was then repeated uncritically by an equally well-meaning Tom Lydon here on Seeking Alpha on June 7.

Let's sample a few of these pearls of wisdom from this now widely quoted article:

1. "ETFs are cheap -- but aren't always the cheapest investment option."

No, they are only the cheapest option 99% of the time! The Journal itself notes that ETFs average .5% in annual fees (the rate weighted by actual dollars invested is less) whereas for mutual funds it's over 1.4%. Yes, there are a few extremely restrictive tax-managed ETFs which can, net of all fees and taxes, eke out a tad more efficiency than the cheapest ETFs. But at .07% annual fees, broad market ETFs are already scraping the barrel. And, yes, some niche, trading or semi-active ETFs charge more than .5% - because they deliver extremely specialized exposure.

2. “ETFs have layers of complex trading costs.”

As do all stocks and all funds which own them. ETFs' low cost comes in part from gathering a basket of stocks in one in-kind trade from specialist firms. Mutual funds must make separate transactions for each and every stock on their purchase list with each major cash infusion. ETFs' one wholesale trade is efficient, while mutual funds pay substantial bid-ask spreads on all their little trades and suffer cash drag and impact costs. At least the retail ETF purchase creates an explicit bid-ask spread for a known price, while the mutual fund delays all this until the end of the day when everybody arbitrageurs jump in to front run trades at the last bell. The real question is which fund performs best net of fees and taxes, and observers agree that ETFs do with few exceptions.

3. “The variety of ETFs on the market means investors have plenty of choice – and plenty of room for confusion.”

And there is no potential for confusion with mutual funds, individual stocks or just about any other investment vehicle? Clearly ETFs are less confusing than the far more numerous mutual funds and individual stocks. No more than a few ETFs represent each asset class, holdings are public disclosed at all times, and accurate representation of asset classes makes asset allocation a cinch with just a few ETFs. There are only hundreds of ETFs versus tens of thousands of mutual funds and stocks.

4. “An index-tracking fund doesn't always track its index well.”

Especially when it's not designed to! A pundit is quoted disparaging a telecom sector ETF for diverging from its target index (where AT&T has a 50% weighting) when the ETF was simply following SEC diversification rules and its own published operating guidelines. Apparently ETFs are to blame for following the law and following the prospectus!

5. “Some ETFs may be fit for hedge funds and other high rollers, but not for small investors.”

Why is this ETF-specific? Many stocks, mutual funds or just about any other investment vehicle are not fit for small investors. ETFs designed for hedge funds and short-term traders (high rollers being found mostly in Vegas) describe their risk in excruciating detail in the prospectus. The implication is that somehow ETFs are riskier than other vehicles.

This year has seen a severe degradation in the quality of information on ETFs in the press. ETFs are complicated. Investors need analysis and reflection, not innuendo and inaccuracies, so that they can deploy them appropriately.

Comments

[Tom Lydon:]

Will- Thanks for your comments and for clearing up any confusion regarding the validity of ETFs. I probably should have done better research when posting a summary of this WSJ piece. At least I can tell my mother I was "well meaning". Best, Tom Lydon, ETF Trends

2007 Jun 11 10:54 PM