ETF skepticism

abnormalreturns
July 13th, 2006

Our continuing coverage of the ETF marketplace has attracted some attention so we feel that we should further clarify our position on the topic. We may have led some to believe we were “anti-ETF.” That is far from the truth, we prefer to think of ourselves as simply skeptical. Random Roger, to whom we link often (and enthusiastically), posted on the subject of the growing ETF marketplace. He makes an excellent point (among others) that ETFs are a relatively new and growing product and that there will inevitably be some funds that don’t gain acceptance. Roger believes that this should not distract us from the growing usefulness and diversity of ETFs.

We agree wholeheartedly with that sentiment. For instance not that long ago we were intrigued by an innovative currency ETF that would make available an institutional strategy to individual investors. ETFs are filling the needs of investors in many ways. The inverse ETFs are a good example of a fund filling a need for investors with retirements accounts that do not allow short selling or options transactions. The new commodity funds have made available instruments that were previously difficult to access. While many investors may never need these funds they are still useful additions to the marketplace.

The once cozy and quaint ETF world has become a bazaar where a number of fund sponsors are jockeying for shelf space and mind share. Some ETFs will be of use and succeed, others will as noted earlier die on the vine. Investors need to realize that the fund sponsor’s agenda is not necessarily your own. In many ways it is very much opposed.

In our opinion ETFs for whatever reason are garnering disproportionate media attention. That is surely due in part to the rapidly growing asset base of ETFs. We commented earlier on the “free advertorial” one ETF firm received in the pages of the Wall Street Journal. One could speculate that many of the new ETF strategies if launched in the form of a closed-end or open-end mutual fund would attract far less attention. If this is the case, then it is no wonder that firms are flocking to the world of ETFs.

It is in this context that we have been writing about the ETF marketplace. When we see that the hype has become seemingly one-sided, we naturally feel compelled to take the other side. Investors need to be aware that once ETFs ventured beyond their indexed, broad market, low expense origins they became just like every other financial product. Investors should apply the same level of skepticism towards the latest and greatest ETF strategy than they to do to any other. As always, back-tested returns do not guarantee future results.

We have previously used the analogy that ETFs are tools. If you look in your garage there probably are number of tools out there that are seldom, if ever used. The same goes for the ETF marketplace. The majority of investors will never need, nor use, the majority of ETFs. Well-designed (and maintained) tools and ETFs are valuable instruments if used correctly. However when they are operated improperly by inexperienced users they can just as easily be dangerous.