href="#i000001870000.png"/>Source: Bloomberg
This chameleon nature of ETFs is also making it difficult for companies and desks on Wall Street to figure out where to put them. The ETF desk could be part of equities or fixed income or even derivatives. Some are starting ETF-specific desks. The entire financial system is trying to figure out how to adapt to the “disruptive technology” that is ETFs.
Democratic
ETFs are democratic in two ways. First, they have democratized investing by providing retail access to many asset classes, countries, and strategies.
ETFs have also democratized things by providing this access at the same cost. For the first time ever in the history of investing, big institutional investors and small retail investors are using the same investment products and paying the same expense ratios. Unlike mutual funds and SMAs, which have a fee system equivalent to a regressive tax – the less money you can invest, the more you get charged – ETFs are like a flat tax. So my Aunt Joyce investing $1,000 in an ETF gets charged the same annual expense ratio as would Yale University’s endowment or a hedge fund investing $100 million.
In this way, you could argue that ETFs are like the Sam’s Club of funds. Just as Sam’s Club offers wholesale prices on everything, similarly ETFs are priced about the same as the institutional class of a mutual fund. This fairness provides a philosophical undercurrent that is totally in tune with the times and something that has made them a big hit with millennials who generally like fairness and transparency while distrusting anything Wall Street.
While democratization is heartwarming and great for the little guy, how does this benefit institutions? The benefit to institutions is simple: more liquidity. That’s ultimately their favorite thing about ETFs. With retail and advisors using ETFs alongside institutions, they both benefit the increase in liquidity because it brings the bid/ask spread down and makes it cheaper to trade. This advantage is unique to ETFs relative to SMAs and mutual funds – the more users of the ETF, the better the user experience, be it a retail of institutional one.
No Emotion
Making an investment strategy is easy. Sticking to it is hard. This is because things change. Portfolio managers can get swept away in trends, groupthink, and fear and emotion. An ETF is immune to all that, and this is an advantage. This is a trait the ETF shares with index funds.
An ETF is programmed to do nothing but track the index. They are like those spider robots from Minority Report that mindlessly fulfill their duty. ETF portfolio managers follow the rules dictated by the index to deliver index-like results. The holdings and allocations inside the ETF are generally outside the control of subjective, emotional, vulnerable humans. The ETF isn’t reading the Financial Times or watching CNBC. It doesn’t even have a Twitter account. It just does its best to follow the index returns by adhering to the index rules. Ironically, this robotic, passive functionality is highly useful to someone who is actively managing money.
This advantage relies on the indexes having solid rules that they stick to. For the most part, indexes simply do not change their rules even when the pressure builds up because of some hot trend.
“If we have some rule and we change it overnight, we have riots on our hands. There are situations that naturally happen in the capital markets, which put those rules under pressure, but they are relatively rare. People like what we do to be stable and reliable, and we can’t just change the rules on them at the drop of a hat.”
Passive Investing
Lack of emotion is related to the overall move to passive investing. More and more people are losing faith in a manager’s ability to pick winning securities. And why shouldn’t they – it is very difficult to beat the market.
This dips into a concept known as efficient market hypothesis, which is that at any given time the market has already priced in all the available data, and thus it is nearly impossible to know more than the market. This is not a hard concept to fathom when you consider all the manpower dedicated to analyzing securities. For example, Amazon alone has 40+ analysts covering it. These are people that do nothing but look at Amazon and the industry it operates in. Many U.S. stocks have 40+ analysts, as shown in Figure 1.3.
Figure 1.3 Total Analyst Recommendations for Large U.S. Stocks
Source: Bloomberg
The broad analyst coverage makes it difficult to gain any kind of an edge. Other areas such as fixed income and emerging markets may have less coverage and may present more opportunity for a stock picker. And that’s why in those areas – plus fixed income – you will find institutions tend to go active, while going passive with U.S. equities.
Just look at the top 5 funds in the world (including ETFs) as shown in Table 1.7 and you will see that literally all of them are passive stock index funds.
Table 1.7 The Top 5 Largest Funds in the World
Source: Bloomberg
Index investing gets associated with Average Joes using their 401(k) plans. But some of the most successful people in the financial industry who know the most about Wall Street are index investors when it comes to their own personal money. I call them “celebrity indexers.” They include Jack Lew, Janet Yellen, Michael Lewis, and Ben Stein. We know this from what they’ve said in interviews or their financial disclosure documents. Heck, even Bernie Madoff endorsed index investing from his jail cell as the least likely way to get ripped off.
But perhaps, the most famous fan of indexing is Warren Buffett. Here’s what Buffett said in a recent letter to shareholders about what he would invest in right now:
What I advise here is essentially identical to certain instructions I’ve laid out in my will. My advice to the trustee could not be more simple. Put 10 % of the cash in short-term government bonds and 90 % in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, individuals – who employ high fee managers.”3
Buffett specifically points to pensions and other institutions. Given who is saying this, you have to wonder why institutions don’t just follow the Oracle of Omaha and use the Vanguard S&P 500 ETF (VOO) and the iShares 1–3 Year Treasury Bond ETF (SHY), two very liquid ETFs with a blended fee of 0.06 percent a year. Not to mention a 10-year annualized return of 7.5 percent, right in line with the bogey most institutions are trying – but typically fail – to hit. I will be referring to this mini-portfolio as the “Buffett Special” throughout the book.
Flexibility
Flexibility is huge to institutions. This is what the book is about. See, there are many ways ETFs can be used besides a long-term investment. This book covers about a dozen of those usages. You can go long or short with an ETF. You can use them as portfolio adjustment mechanisms. You can do tax-loss harvesting with them. You can use them as placeholders or lend them out to generate income or use options with them. The list goes on.
“We use ETFs in a lot of different ways here. And flexibility
