Exchange-Traded Funds: Dumb Money?

ETFs, the new and trendy way to invest, are backfiring as a road to riches because some investors are overtrading the funds.

An ETF is like handing an arsonist a match

.”

— from “Is John Bogle Wrong about ETFs?”

John Bogle, former chief executive officer of Vanguard, has a way of shaking things up. He certainly has been since 2007 in regard to exchange-traded funds (ETFs). Bogle brought into question the wisdom of owning this beloved entity, something few others have challenged.

ETFs, the new and trendy way to invest, aren’t working for everyone, according to Bogle. He says they are backfiring as a road to riches because some investors are overtrading the funds. This leads to diminished profits because the trading costs of active buying and selling diminish the return to less than it would have been with a buy-and-hold strategy. This concept was based on a study of 79 ETFs over five years to 2009 and reported in a webinar to the Journal of Indexes. Bogle continues to espouse this point of view.

In the study, Bogle found that of the 79 ETFs, “68 had investor returns that were … short of the returns earned by the fund themselves.” While investor returns do tend to lag behind the fund they own, Bogle was astonished by the degree for ETFs. The negative gap for investors varied from 0.4% to -17.95% per year.

An ETF can be loosely defined as a mutual fund that trades during the day rather than at the end of the day. Traditionally, they are index funds rather than actively managed funds. The benefit is that they offer a basket of stocks that can be traded like a single stock so the owner doesn’t have to wait until 4 p.m. to buy or sell. This is unlike mutual funds, which trade only at the end of the day.

An advantage of ETFs is that capital gains are not taxed until a position is closed. This means that ETFs are not required by law, like mutual funds are, to distribute capital gains every quarter. A downside of ETFs is that the costs for trading a small number of shares can be larger than a mutual fund.

My take on ETFs is that they not only have a place in the market but are positive for it. One reason is that they can be purchased at a secure price during the day. Likewise, they can be sold for a definite dollar amount. The trick is not to buy and sell in small quantities, which will rack up substantial fees. Trading costs might be less for mutual funds, but their price per share is not completely transparent until they are traded at the end of the day.

Additionally, in the past I have had trouble redeeming a large number of mutual fund shares, presumably to preserve the financial health of the mutual fund and prevent a “run on the bank” if many other investors sold shares at the same time. This does not happen with ETFs.

So, although John Bogle may be wrong in part in my opinion on this stand, he is right too. Trading a few shares at a time with ETFs would no doubt be more costly than doing the same thing with mutual funds. And, just like excessive trading of mutual funds can lead to losses because of trading costs, it can with ETFs too. The difference, of course, is that it is easier to trade often with ETFs because it can be executed during the day, not just at the end.

Thus, the statement, “An ETF is like handing an arsonist a match.” Most people, of course, act more responsibly.

Read more:

How an Economist Changed Public Policy for the Better

Safer Bets for a Fragile Market

Where Has All the Money Gone?