ETF Store Insight

This Is What Change Looks Like

August 24th, 2016 by Nathan Geraci

Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.

Imagine our world just fifteen years ago.  There was no Facebook, iPhone, streaming movies on Netflix, Airbnb – the list goes on and on.  For many people, these products and services have simply become ordinary aspects of daily life.  You check Facebook on your iPhone, watch House of Cards on Netflix in the evenings (35% of all internet traffic in the U.S. during the evenings is Netflix!), and might even book an Airbnb room for your next trip (as 60 million users have done).  While you likely don’t think about it anymore, you would probably agree that each of these products or services have completely changed your life – mostly for the better.  If you say they haven’t, I would ask you to leave your smart phone at home for a day.

However, when game-changing new products and services are launched, they are often met with naysayers, controversy, and occasionally, a few glitches.  The proliferation of Facebook raised key questions over user privacy.  More recently, Facebook encountered controversy over whether they were manipulating their newsfeed.  The iPhone also became a hot button topic for privacy, with debate surrounding whether the Federal Government should be able to access your phone’s ever-expanding data.  Netflix?  They sparked a debate over net neutrality (i.e. your internet provider not charging you extra to stream movies).  Airbnb continues to battle various controversies including whether they should be subjected to the same rules and regulations as hotels and how they can ensure the security of host units.

Why do I bring these up?  Recently, Exchange Traded Funds (ETFs) have been receiving some negative press on three fronts:  the number and types of new ETFs being launched, whether ETFs entice investors to overtrade to their detriment, and trading issues with ETFs themselves.  Let’s start with ETF growth.

Currently, there are some 1,950 ETFs with $2.4 trillion dollars invested in them.  So far this year, nearly 150 new ETFs have come to market including the Janus Obesity ETF, the PureFunds Video Game Tech ETF, and the Sprott Buzz Social Media Insights ETF.  Critics are asking whether investors really need an ETF that seeks to capitalize on the country’s growing obesity epidemic or penchant for playing video games.  I think critics are asking the wrong question.

There are roughly 8,000 mutual funds available to investors and nearly 24,000 when you consider the various share classes, which are simply a confusing way to charge investors different fees.  In the U.S., there are approximately 3,500 publicly traded stocks on the major exchanges, including stocks held by the Janus Obesity ETF and the PureFunds Video Game Tech ETF.  My concern with media portrayal of ETFs comes down to three basic points:

  1. Where is the hand-wringing over the 8,000 mutual funds available? Do investors need the Highland Long/Short Healthcare Fund Class A with an expense ratio 1.78%?  Or the Absolute Capital Defender Fund Class A with an expense ratio 2.95%?  It has been well-documented that, on average, mutual funds charge higher fees to investors than ETFs.  They also lack the transparency and tax efficiency of ETFs.  Why isn’t the financial media focusing more on the ridiculous amount of mutual funds available and their multiple share classes?  Believe it or not, there is actually a website that keeps an “ETF deathwatch”, which tracks failed ETFs.  I am still waiting for a mutual fund deathwatch website, though Vanguard did have a great whitepaper a few years back showing nearly 2,400 mutual funds either merged or liquidated over a 15-year period ending 2011.

  2. As it relates to both new ETF launches and ETFs enticing investors to trade, I would note that all of the major financial media outlets continue to tout individual stocks. As a matter of fact, the majority of programming centers on which stocks to buy and sell.  Investors can and do trade individual stocks all the time – again, the same stocks held by the ETFs being launched.  I would much rather see an investor buy the PureFunds Video Game ETF than hold Electronic Arts or GameStop stock.  I like the diversification ETFs provide.  EA’s average daily trading volume is 3.2 million and GME is 2.8 million – clearly investors are trading these stocks.  I have yet to see The Wall Street Journal run an article on too many stocks available to investors.  Are these narrow ETFs for everyone?  Certainly not.  But neither are each of the 3,500 stocks.  Furthermore, I would agree that the intraday tradability of ETFs may entice trading, but this feature is OPTIONAL.  I would rather have the option, than not.  This comes down to investor education – more on that in a moment.

  3. As it relates to ETF trading issues, much of the focus is placed on how ETF traded during the Flash Crash and then again on August 24th of last year. ETF opponents love to peddle the narrative that ETFs are “risky” because of this.  What never seems to be communicated is that these trading issues only impacted investors who: 1) tried to sell during extreme market turmoil (rarely a good idea) and 2) failed to use limit orders.  The ETF industry is currently working to improve trading during times of market stress, though I would note that ETFs have held up wonderfully during several other periods of market stress and, in fact, operated as price discovery vehicles.  Nevertheless, firms like ours need to continue helping educate investors on best trading practices for ETFs.  Simply creating fear around ETFs is not education.

Now, I have been accused of being an ETF cheerleader, so let me take a step back for a moment.  Are there poorly constructed ETFs?  Absolutely.  Are there overly expensive ETFs?  You bet.  Are there well-constructed ETFs that average investors shouldn’t touch with a ten foot pole?  No question.  But I could answer the same for mutual funds, closed-end funds, hedge funds, annuities, private equity or private debt investments.  I could also make a compelling argument that most investors would be well-advised to steer clear of individual stocks and bonds (which have experienced their own trading issues at times, including and contributing to the Flash Crash and August 24th mini crash).  Also, frequently trading ANY type of investment will likely result in underperformance.

Bringing this full circle, no game-changing product or service is fail-proof.  Posting pictures on Facebook of your most recent late-night escapade is probably a poor idea.  Likewise, letting your kids watch Breaking Bad on Netflix.  How many times have you cracked the screen of your iPhone?  And next time you go on vacation, you should probably first check out the public reviews on your Airbnb.  You cannot shun responsibility for the products and services you use, no matter how fantastic and life-changing they may be.  There is still a level of diligence required.  ETFs are no different.  Also, innovation is typically an iterative process.  It is incumbent upon the game-changing product or service to improve as the market adopts them.  ETFs are no different.

The bottom line is this is what change looks like.  The mutual fund industry is fighting tooth and nail because as ETF industry veteran Matt Hougan recently said, “If mutual funds didn’t exist today and someone were trying to launch one, they’d be laughed out of the room”.  Mutual funds are trying to protect the billions of dollars in fees they charge.  Why is the media trying so hard to create fear around ETFs?  Because ETFs are now THE story.  Mutual funds, which were created back in the 1920s, don’t move the needle anymore with investors.  The media likes the hot, relevant story – which ETFs are.  Fear sells.  It’s why negative stories typically lead-off your evening news.  Combine a dying incumbent with a salacious media looking for clicks and you get negative ETF headlines.

However, I’ll continue to cheerlead ETFs because they have a lower average cost than mutual funds, are more transparent, and offer a more tax efficient structure.  You can also buy and sell shares during the day IF you are so-inclined, and you have a cornucopia of asset classes available for building a well-diversified portfolio.  There will always be some people who prefer surfing MySpace on their flip phone, while watching VHS tapes in a Red Roof Inn room, but that doesn’t mean you should listen to them for advice.  I believe embracing technology and progress typically leads to better outcomes – both in life and investing.