How
many of you remember the immortal words of P. T. Barnum? Of
Yogi Berra? On Wall Street, the incubation period for new
product scams may be measured in years instead of minutes,
but the end result is always a lopsided, greed-driven, gold
rush toward financial disaster. The dot.com melt down spawned
the index mutual funds, and their dismal failure gave life
to "enhanced" index funds, a wide variety of speculative
hedge funds, and finally, a rapidly growing number of Index
ETFs. Deja Vu all over again, with the popular ishare variety
of ETF leading the lemmings to the cliffs. How far will we
allow Wall Street to move us away from the basic building
blocks of investing? What ever happened to stocks and bonds?
The Investment Gods are not happy.
A market or sector index is a statistical measuring device
that tracks the movement of price changes in a portfolio of
securities that are selected to represent a portion of the
overall market. Index ETF creators: a) select a sampling of
the market that they expect to be representative of the whole,
b) purchase the securities, and then c) issue the ishares,
SPDRS, CUBEs, etc. that you can trade on the normal exchanges
just like ordinary stocks. Unlike ordinary index funds, ETF
shares are not handled directly by the fund, and as a result,
they can move either up or down from the value of the securities
in the fund, which, in turn, may or may not mirror the movements
of the index they were selected to track. Confused? There's
more… these things are designed for manipulation!
Unlike managed Closed-End Funds (CEFs), ETF shares can be
created or redeemed by market specialists, and Institutional
Investors can redeem 50,000 share lots (in kind) if there
is a gap between the net-asset-value and the market price
of the fund. These activities create demand in order to minimize
the gap between the fund net-asset-value and the fund price.
Clearly, these arbitrage activities provide profit-making
opportunities to the fund sponsors that are not available
to the shareholders. Perhaps that is why the fund expenses
are so low… and why there are now hundreds of the things
to choose from.
Two other ishare/ETF idiosyncrasies need to be appreciated:
a) performance return statistics for index funds typically
do not include fund expenses… it should be fairly obvious
that an index fund will always under-perform its market, and
b) some index funds, ishares in particular, publish P/E numbers
that only include the profitable companies in the portfolio.
How do you feel about that?
So, in addition to the normal risks associated with investing
in general, we add: speculating in narrowly focused sectors,
guessing on the prospects of unproven small cap companies,
experimenting with securities in single countries, rolling
the dice on commodities, and hoping for the eventual success
of new technologies. We then call this hodge-podge of speculations
a diversified, passively managed, inexpensive approach to
21st Century Asset Management! How this differs from how the
dot.com mess started is a mystery to me. Once upon a time,
there were high yield junk bond funds that the financial community
insisted were appropriate investments because of their excellent
diversification. Does diversified junk become un-junk? Isn't
"Passive Management" as much of an oxymoron as "Variable
Annuity"? What ever happened to the KISS Principle?
But let's not dwell upon the three or more levels of speculation
that are the very foundation of all index funds. Let's move
on to the two basic ideas that led to the development of plain
vanilla Mutual Funds in the first place: diversification and
professional management. Mutual Funds were a monumental breakthrough
that changed the Investment World. Hands on investing (without
the self-centered assistance of the banks and insurance companies)
became possible for absolutely everyone. Self directed retirement
programs and cheap to administer employee benefit programs
became doable. The investment markets, once the domain of
an elite group of wealthy entrepreneurs, became the savings
accounts of choice for the employed masses. But only because
the Funds were relatively safe with their guarantees of diversification
and professional management! ETFs are just not the answer
to the problems we've experienced lately with traditional
Mutual Funds. (Those problems are a function of Fund Manager
Compensation, conflicts of interest within Fund Sponsor Organizations,
the delivery and pricing system for the funds, and believe
it or don't, the self directed retirement programs themselves.)
Here's a thumbnail sketch of how well the major Passively
Managed Indices have done since the turn of the century: For
those six years, the DJIA growth rate averaged Zero % per
year, the S & P 500 averaged Minus 2% per year, and the
NASDAQ Composite averaged Minus 8% per year! How many positive
sectors, technologies, commodities, or capitalization categories
could there have been? Go ahead, add in 1999 just to make
yourself feel better and you'll come up with +2% per year
for the DJIA, Zero % annually for the S & P, and a stellar
–1.5% per year for the NASDAQ. Now subtract the fees…
hmmmm. Again, how would those ishares have fared? Hey, when
you buy cheap and easy, it's usually worth it. Now if you
want performance, I suggest you try management. Any management
is better than no management, so long as you are receptive
to the strategies or disciplines employed by the manager.
If you can't understand or accept the strategy, don't hire
the manager. During the past six years, there have been more
advancing issues than declining ones on the NYSE, more stocks
achieving new highs than new lows. Why did you lose money?
Sure, you might find some smiles in an ishare or two, particularly
if you have the courage to take your profits, and there may
be times when it makes good business sense to use these products
as a hedge against a specific risk. But please, stop kidding
yourself every time Wall Street comes up with a new short
cut to investment success. Don't underestimate the value of
experienced management, even if you have to pay a little extra
for it. Actually, there is no reason why you (and I mean every
one of you) can't learn either to run your own investment
portfolio, or to instruct someone how you want it done. Every
guess, every estimate, every hedge, and every shortcut increases
risk, because none of the crystal balls used by those creative
product hucksters works very well over the long haul. Products
and gimmicks are never the answer. ETFs, a combination of
the two, don't even address the question properly. What's
in your portfolio?
Steve
Selengut
http://www.sancoservices.com
http://www.valuestockbuylistprogram.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor:
The Book that Wall Street Does Not Want YOU to Read",
and "A Millionaire's Secret Investment Strategy"
