Wednesday, September 29, 2010

The Old Mutual Fund vs ETF Argument or An Investment Stranger than Truth

Mark Twain once submitted an essay to a contest about the art of falsehood.  In it, he suggested that only children and fools tell the truth, citing what he thought of as an old proverb.  What really dismayed him wasn't the actual lie, he described that as: "as a Virtue, A Principle, is eternal; the Lie, as a recreation, a solace, a refuge in time of need, the fourth Grace, the tenth Muse, man's best and surest friend, is immortal, and cannot perish from the earth while this club remains" , it was instead the ability to deliver in a successful way. A noble art he called it. Which makes theETF lie all the more true.

What do we know about ETFs? We know they are low cost. But perhaps not as low cost as they might seem.  For the investor moving millions of shares, or even thousands, the costs are just as low for them as it is for the investor owning a single share.  They are basically index funds.  But they are also stocks.  And the lie that owning a single share is just as costly as owning a million or so is told so often, individual investors often become dismayed, even disillusioned by the security when they purchase or sell it.

ETFs are not meant to be a buy-and-hold investment. This is actually a truth designed to look like a lie. Folks who buy ETFs intend on selling them, sometimes at the close of the trading day only to buy them again at the beginning. You can do this when the quantities are huge.  But when they are small, you are left with some tough decisions.  Wait it out and hope that the big investors jump back in or sell on the movement?  Either way, you have bought and are left holding.

ETFs have made the market more democratic and safer. On the other hand, ETFs are responsible for the flash crash where the Dow dropped a 1000 points and regained 650 points. Perhaps not directly, but indirect selling in those ETFs and of those ETFs created more volatility than was needed. According to Chuck Jaffe at Marketwatch: "Many ETF investors set stop-loss orders — pre-scheduling a sale to protect profits if the share price drops to some pre-determined level — but that didn’t minimize their pain in the flash crash, as the market busted many of those orders, flying past the limits because there were no buyers at those prices." The truth was that just because you have something to sell, there will be buyers.  The lie: someone always wants what you have unless everyone is selling the same thing.

ETFs are not mutual funds. Except when they are. If it looks like a basket of stocks or bonds or whatever is popular and you can't afford to buy each and every company in the sector, you look to make a purchase as a group. That is a fund with a mutual benefit.  The fund goes down and everyone loses except when the smart ones get out first. And that is the peril with a fund acting like a stock and trading openly throughout the day.
Some folks just know more than you do and benefit from that. No, they are necessarily seers or prognosticators or even forecasters.  They are just intuitive and quick and you are at work and busy and about to lose more than you thought you could.

Markets are not scary, therefore ETFs aren't scary - its investors who are scary.  Investors often don't have time to be scared before they are scarred by their own inaction. ETFs create volatility because that is how they are designed. Suppose you knew that something big was about to happen in technology or pharmaceuticals. You being a smart investor wouldn't look for an individual stock; you would buy a basket. And soon as the news panned out, or didn't, out you would go.

ETFs in your 401(k) are a good idea. Perhaps one of the single biggest lies being told by retirement planners.  They tout the low-cost, the employee demand and anything else they think the poor guy or gal in HR or in the CFO's chair wants to hear.  But ETFs in a 401(k) drips commissions and fees to the plan sponsor and gives the employee the illusion of doing something they really aren't doing.

The ETF lie is true. Odysseus told numerous fictions to a wide variety of people, each crafted to the circumstance of the one receiving the falsehood. The Greeks may have given the liar his due, even their admiration of a lie well-told. But when it comes to your portfolio, when it comes to your circumstance and your willingness to hear what you need to hear, the ETF is crafty fiction indeed. Good for some who understand it. But for those who think they do, it is simply a deception.

This article originally appeared at and was written by Paul Petillo

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