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Dispelling ETF Fiction

Outsourcing America

Dispelling ETF Fiction

By Ronald DeLegge, Editor

July 3, 2007

 

SAN DIEGO (ETFguide.com) - Itís not hard to be confused by the rapid ascent of the exchange-traded fund (ETF) marketplace. In just one year the number of funds has shot from 267 to well over 500.

 

All of this has set off a wave of controversy, debate, and criticism about the state of the ETF marketplace. Iconic figures such as John Bogle, Warren Buffett, and William Bernstein have expressed their cynicism about ETFs. Other naysayers abound, and a loud coalition of those with an anti-ETF bias are making their way into the media.

 

Many important questions are raised: Have ETFs become a speculative mania? Do ETFs induce investors to self-destruct? Is there an ETF bubble?

 

Curiously, a basic understanding of ETFs eludes even those at the highest levels of contemporary finance. As a result, people are led to draw wrong conclusions.

 

Arming and defending yourself against ETF fiction is a definite must. If you donít, making prudent and wise investment decisions will be near impossible.

 

Hereís a brief sample of the financial fiction thatís floating around:

 

FICTION #1 - ETFs encourage investors to become hyperactive traders

Intraday liquidity is an important product feature of ETFs. It gives investors a flexible exit strategy by allowing them to buy and sell shares when the financial markets are open for business.

 

Interestingly, individual stocks also have intraday trading just like ETFs. Should we make the case that stocks should be completely avoided because they trade daily and might induce investors to needlessly trade? Making a similar claim against ETFs is irrational and misleading.   

The fact is many investors with chronic behavioral problems were that way long before ETFs arrived on the investment scene. Dumping on ETFs is misplacing the blame. Should we fault automobiles for car accidents? How about blaming fire for burning people? Knives for cutting people? Likewise, saying that ETFs induce investors to self-destruct is absurd.

 

FICTION #2 - ETFs are a bad choice because of the growing number of poor ETF investment options

One gander at the mutual fund marketplace reveals a true lesson in financial clutter. Counting the maze of share classes, there are over 20,000 mutual funds to choose from. How about the 9,000 or so hedge funds? By comparison, right now there's roughly 530 ETFs.

 

Even though the ETF market is headed for the same overcrowded destiny as the others, the clutter is arguably worse elsewhere. Instead of proving that all ETFs are bad, it proves that investors need to be discriminatingly selective. 

 

Favoring funds based upon traditional indexes with rock bottom costs and having a long-term outlook never hurt anyone. This is exactly the sort of high value proposition many ETF families offer for anyone smart enough to notice.

 

FICTION #3 - The ETF industry markets and sells ETFs the wrong way, therefore ETFs are bad

Itís unreasonable to judge the investment merit of ETFs by the marketing behavior of fund companies. ETFs should be evaluated by the underlying securities they hold and the investment strategy they follow.

 

If the ETF industry wants to ape the mutual fund industry by mislabeling funds and launching new products with questionable investment merit, so be it. However, broad generalizations and sweeping statements that paint the entire ETF market as ďgoodĒ or ďbadĒ is unfair and counterproductive.

 

I wish I could say my list of financial fiction was exhaustive, but itís not.  

 

In summary, ignore the trumpet blows from those that demonize, mischaracterize, and stereotype ETFs.

 

The growing number of ETF choices calls for diligent evaluation and discriminating selectivity.

 

Hasnít it always been this way?

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