In Defense Of ETFs: Can You Do Better?

by: William Darusmont

Summary

ETFs may be bundles of stocks but they are not homogeneous.

For the average investor they can be a useful tool.

Are ETFs right for you?

Note: This article is the second part in a series on ETFs. It is somewhat a counterargument to Brad Thomas' excellent article on ETFs; I think there is a danger of lumping them with REITS since they are a very different animal than most stocks.

In ETFs versus mutual funds, ETFs win hands down. In focus groups, the number one reason for this was tax efficiency. Anyone who has owned a mutual fund has seen a capital gain declared, usually in October, adding insult to injury when the fund is plunging and investors are fleeing it. But there are other significant factors in tax efficiency, mainly 'harvesting' losses. Several of the iShares (Barclay's) ETFs have never had a capital gain or they have been small. This is because of the use of Approved Providers (APs), who make markets in the stocks, some of whom will be 'long' while others 'short' the underlying securities in the ETF. This creates a balance in favor of the investor, whether buying or selling shares.

One of the best examples of benefiting from ETFs when entering or exiting from a large position: a large investor wanted to put several millions into emerging markets; the APs filled the order in one day without moving the market. Remarkable.

A chief beneficiary of ETFs is the DIY (Do It Yourself) investor Thomas discussed in his article. How many times have you decided on a sector…say biotech…and got that right but picked the wrong stock? Given the low success ratio in the industry and long lead times, buying the sector may be beneficial. No 'three baggers' but not losing your shirt either, unless you were wrong about the sector too.

You could, of course, buy your own basket but really, what do you know that the market doesn't? Trust an analyst? Most likely it will be one from a brokerage with a large following. You could be jumping in after the run has been made. Also, be aware that most firms have several analysts, and they focus on sectors. Now if you were an analyst and had a sector you didn't like, might you not choose the less likely to fail, rather than pan the entire sector? There can also be conflicts with management due to client relationships.

I believe the articles on Seeking Alpha are more valuable because you know whether they are long or short, and can therefore weigh the article for value. For one thing, the comments can be critical and allow you to make a better decision.

Brad Thomas chose a very specific sector for his article, REITS. The REIT index funds or ETFs can have any number of REITS in them that are not going to benefit with the rest of the group at times, or are going to lead the way. But over a cycle the winners or losers won't necessarily be consistent.

There are two key reasons for manager underperformance: high fees and failure to invest dividends in a timely manner while waiting for the cash to build up to a level that is suitable to their block size. This is solved with dividend reinvestment which you, the investor, can choose to use or to not reinvest if you are having concerns about the stock/sector.

If you are a new client there is a third reason: managers are a) lazy, and b) generally 'dump' the securities in the account that don't match their strategy. Recently a former client took a new manager who generally kept my picks and made moves slowly into year-end and the first quarter of this year. However, they dumped Western Resources (NYSE:WR) which is now close to a buyout agreement. Understood, since they get no credit if it goes up but are subject to blame if it goes down. The 'laziness' comes from not caring whether some of the stocks are extremely overvalued and should not be purchased. They just do it.

I ran across this with a former employer after listening to two iShares presentations and participating in a focus group. I suggested that when there is a new account, buy the stocks that look like they still have upside and place the rest either in an S&P Index ETF, and draw down on it as opportunities appear. After all, for most the S&P 500 is the benchmark. If not, use an ETF that matches that benchmark.

Before making a presentation I ran my proposal by two members of the five member investment committee. When one other member said, "We are paid to manage money, not to delegate to other managers", I said, "No, we are paid to get the best returns for the client." Furthermore, we know exactly what is in each ETF. Unfortunately, the other two members I had briefed sat with heads bowed and didn't say a word. I left the firm a short time later.

What else do you need to know about ETFs besides fees? First, before placing an order, check the bid/ask spread; (do this with any stock now that high frequency trading rules). If the spread is say, 20 cents, either walk away or try to get in the middle. You are likely to be disappointed however as I have had it happen where instantaneously, the bid jumps to my level and the offer rises equally. Pull the bid and in ten minutes it may return with no shares having traded. (This applies to any stock, especially preferreds which should not be traded on a market order or within half an hour of the open or close!)

So, are ETFs right for you? Some are and some may not be. I avoid ultra-short funds as they are primarily a trading vehicle and have come under scrutiny by the SEC over suitability issues. They move very rapidly and can create a trap. Not to mention high fees and overall expense ratios.

Lastly, and very importantly, in portfolio management, like poker, the game is really 'bet management.' That means not being in a hurry to buy or to panic sell. Portfolio diversification is key to bet management. To do this with ETFs means studying the members so that you don't cancel much of the diversification you sought in the first place.

Around the turn of the century (21st not 20th!), a friend worked at Citigroup. Knowing of my interest in ETFs he sent me research from a new ETF team of analysts the bank had set up. I was shocked to find that Citi was in every ETF that they recommended! I told him about it and how it was doing a disservice to clients and a few weeks later the team was disbanded. I am sure I wasn't the only one who noticed it.

With ETFs as with any security, know what purpose it serves in your portfolio. I read comments by people bullish on a stock all the time on SA, especially when the article is critical of a stock and several people object, but not with valid arguments but rather their own unsupportable claims. Those are easy to identify and they have a right to state their beliefs, but not by being unfairly critical of the author. He is only expressing his opinion for you to 'take what you like and leave the rest.'

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.