What About ETFs?
In my previous post, readers commented about the usage of ETF and how it could be combined with the barbell strategy I was advocating:
I started to write a complete response and realized it should instead be a new public post, because it is more complicated than it looks like.
For reference, these are the initial comments I am talking about:
Quick ETFs Recap
Accessibility
First, I rarely comment about ETFs or use them myself, because I am an EU citizen. As a result, a large part of the ETF universe is unavailable to me. At least my broker does not provide them.
This is because of EU law requiring specific documentation from ETFs, and most US ETFs do not have them.
EU ETFs are fine but much less diverse, and rarely match the sort of niche strategy I prefer.
In practice, it is a bit more complicated than that, but it is anyway quite a mess, and you never know when an ETF that looks interesting is actually available until you try to buy it.
Obviously, with many US readers, and bypasses available, this is not enough of a justification to not consider ETFs.
Why Using An ETF-Centric Strategy
When talking about ETFs, many people blend together entirely different concepts.
Pseudo Passive ETFs
On one hand, you have the broader index ETFs, some mimicking the S&P500 and such. Or many of the MSCI international equities indexes. These ETFs are often so broad that this is much closer to a fully passive investing approach.
I am fine with that, and actually think most people should just do that. Collect the average 4-7% returns from global stock markets, and focus on your job, family, etc…
But of course, most people are not subscribers to geopolitics/finance newsletters. Most people cannot put Ukraine on a map and even less discuss the subtlety of Nassim Taleb's insights. So such ETFs are actually pretty great for the average “investors”, but not for people actually dedicated to learning more about investing.
Active ETFs
At the opposite end of the spectrum, there are ETFs that are virtually impossible to distinguish from a managed fund.
One of the most spectacular examples in recent years is the constellation of ETFs from Cathy Wood’s ARK Invest.
These ETFs claim to represent a sector at first glance, but are “actively managed”. Meaning that they are funds with a specific mandate (tech, biotech, etc…) and whose returns will highly depend on the quality and timing of the stock picks.
These are barely worth calling ETFs, and I think this is somewhat deceitful to do so, something the regulators should have cracked down on if they had not been asleep at the wheel for the last decade…
Sectors / Thematic ETFs
Then there is the much more reasonable approach of sector ETFs. And if you have 100% access to the universe of US ETFs, you probably can find something to your taste. For junior gold miners, micro-cap tech, or Chinese biotechs, there is an ETF for everything.
This is what was discussed and what would make the most sense for my readers.
Pros And Cons
Pros
The obvious advantage is instant diversification. Each ETF will contain dozens of stocks if not hundreds.
The parallel to this intense diversification is highly reduced transaction fees. By buying one ETF, you avoid having to pass dozens of orders to achieve the same results.
Another underrated advantage is that by buying many stocks, you also have more chances to grab the rare one doing x10 or x100 over a long period.
Another great advantage is the lower mental charge, it requires a lot less time, decision making and overall effort to pick which one is the best among the dozen or so available ETFs in a given sector, compared to doing deep analysis on multiple companies.
Cons
Most of the cons are the other side of the coin of the pros. In my opinion, they are enough to make me avoid ETFs in most cases (I will go back later when I think ETFs are the right option).
Diworsification (credit to Peter Lynch)
The first set of problems stems from diversification.
First, by buying dozens of stocks, you necessarily buy some garbage as well. This problem is compounded by the fact that you are unlikely to have done due diligence on most of the ETFs holding. In that respect, most ETF holders are as passive and ignorant of their holdings as full-blown passive investors.
Once again, this is okay IF your strategy is to accept more moderate returns in exchange for not wasting your time. But this gets questionable if you are an active investor.
This is bad because active investors need to actually manage their portfolios.
Passive investors are told (correctly) to virtually never sell, as they are not qualified or knowledgeable enough to make good judgments, and will likely panic at the bottom.
Active investors need to know why a segment of their portfolio is down (or up) by 20% in a week. And judge if it reflects a fundamental change, or mere volatility to be ignored. Something always a lot harder to do well in real life, where fear and greed interfere with your best judgment.
If you do not know the companies you own, you cannot judge their fundamentals. So you cannot make a good judgment, because you simply do not have the data to do so.
So in my opinion, the greatest problem with ETF is that it inherently hinders your ability to trade properly as an active investor.
No knowledge about the stock’s fundamentals beyond the whole sector is like driving at night with the lights off.
Peter Lynch is famous for being a fundamentals-driven investor with hundreds of stocks in his fund.
He also had an entire team and was a notorious workaholic.
So if you do not have the resources and lifestyle of someone like Peter Lynch, you will not manage to keep track of over 50+ stock. Probably not even 20+.
Inherent Flaws
The second set of problems stems from how thematic ETFs are constructed. In theory, they are perfectly objective and neutral representations of an economic sector.
In practice, most ETFs are full of many biases. Many such biases are not out of incompetence, but out of marketing consideration of what people look for in an ETF.
Here are just a few I have noticed over the last few years by writing for a LOT of clients and having to find ETFs for articles I was paid to write:
Most US ETFs overrepresent US stocks compared to international stocks, increasing exposure way beyond what the market cap would justify.
Rear-looking selection.
Extreme cases are of course like the inclusion of Tesla and the exclusion of Exxon from the S&P500 in 2020. How did that headline age 3 years later? “Exxon Mobil replaced by a software stock after 92 years in the Dow is a ‘sign of the times“
But thematic ETFs are far from immune from this. By definition, they include the largest (not best managed) companies of a sector. Size is not quality!
This exposes investors to the ETF creator and manager skills.
Let’s be honest, the best minds in finance are most likely not working on ETF design at GlobalX but in some niche boutique hedge fund or family office outperforming consistently the markets.
Some great companies might be excluded because of excess volatility, too low market cap, or whatever criteria that has little impact on actual returns. Whole entire countries or continents are often excluded for no clear reason.
Poor balance: most ETFs’ top 5 holdings make up from 50-80% of the total ETFs. So in practice, the actual diversification is rarely happening. You do NOT get exposure to the sector but to the top 5-10 mega-caps in it.
Inaccurate descriptions: many ETFs’ holdings do not match the mandate advertised.
For example, virtually all China ETFs are in fact China tech ETFs. Most “Asia ETFs” are pretty much China Tech ETFs as well.
Most Healthcare ETFs are 90% top 10 big pharma, and so are most Biotech ETFs.
Most Energy/Oil/Gas ETFs are a proxy for the biggest Western oil firms.
Etc…
For long-term investments, it makes no sense to pay an ETF of 0.5-1.5%/year for what your brokerage account would hold for much cheaper.
Liquidity of the underlying stock can be a LOT lower than the ETF’s, especially small caps in a popular large ETF. This can lead to a “doom loop”, where a declining ETF share price can become self-reinforcing, and sales create more crashes of the underlying shares, which creates more sales.
This is also why the focus is on mega-caps. Maybe a forestry ETF would perform better with some small Polish forestry company. But it will never get included, because liquidity is too low for a large ETF, while still matching more investment firm sizes.
These flaws compound each other. Rear-looking inclusion AND too high concentration AND that concentration being centered on mega caps AND all the largest ETFs being clones of each other lead to herd movements in the market.
As passive or ETF-driven pseudo-passive investing becomes the majority of market activity, price discovery becomes less and less efficient. This means that movement in and out of a sector predominantly happens through ETFs and will affect just a handful of stocks.
I would be curious to see if this is not causing more volatility than a stock-picking strategy, something the “diversification” was supposed to avoid.
Using ETF Strategically
Why To NOT Use ETFs
Overall I have a pretty negative view of ETFs for a variety of reasons.
Some are general and true for 90% of my readers:
If you are an active investor, the pseudo-passivity of ETFs will make you a worse investor, bound to react poorly to market moves, both on the upside and the downside.
The diversification is partially illusory and could be reasonably replicated by hand-picking some of the industry-leading megacaps.
If diversification is real, it also exposes you as much to surprise winners as to a lot of sub-par companies, and which direction the balance will tilt feels hard to predict.
Far from neutral, ETFs mean giving up your judgment for the judgment of interns at one of the largest ETF firms.
Fees are a hidden killer of compounding returns, and long-term investing will not do well with ETFs compared to direct holding.
The most interesting cyclical sector will not have an ETF for the very reason that sector is hated.
There is no offshore driller ETF for example. There will probably be one in 1-2 years, after the sector has already gone up 5x-10x; ETF creations themselves are backward-looking. Find a sector WITHOUT ETF, you probably have reached a “safe” bottom.
Some are more personal:
I think a carefully hand-picked array of companies in one sector will outperform a broad generalist exposure.
So far, I am vindicated in that belief through buying stocks that are for some only NOW getting included in funds and ETFs, after a 2-3x run from when I covered them.
I also deeply enjoy doing it.
My daily work IS writing and reading about finance and stocks. Between personal research, this blog, and my clients, I give a quick or deeper look at tens of companies per week.
So the argument that the time used could be used to earn a better salary is not true for me.
I suspect it is not true either for semi-pro investors willing to read 3-5 substacks doing that preliminary filter for them and saving them enough time so they can do good stock picks themselves.
Remember, you only need 1-3 good stock picks per year to perform really well. Investing is the art of saying “next”.
When To Use ETFs
Besides the idea of creating a semi-passive portfolio (and being aware this is the goal, with the according expectations in terms of returns), a few other cases can justify the usage of ETF.
High Risks
Extremely risky sectors, for example, small biotechs or junior miners. When the failure rate is >80%, you need as much diversification as possible. The liquidity issue is still there, but it is not really realistic to go and buy 20 small caps just in the hope that 2-4 merely survive too much research work and too many trading fees.
These sectors tend to be money pits, but an ETF may be a way to survive.
Low Competition / High Regulation
Another example is when a sector is very uniform, with no clear competitive advantage for individual companies over each other.
This can apply to some commodities, or highly regulated sectors like utilities, hospitals, etc.
Real estate also comes to mind. If an investing thesis is only about a type of real estate in general (let’s say back in 2010), an ETF bringing together a dozen different REITs in that sector can make sense to simply play the sector as a whole.
Lack Of Knowledge
This is one I can see applying to myself for example about semiconductor manufacturing.
I have tried to understand the intricacy of the 5nm node for computer chips, EUV, lithography, etc… I am still struggling to see if Intel is at a too deep discount compared to TSMC, etc.
So if I felt I wanted to invest in the sector despite that lack of knowledge for fundamental analysis, I would probably resort to an ETF.
This is nevertheless far from ideal, and a rule of thumb would be that a sector I don’t understand that much is “un-investable” for me, instead of counting on an ETF to do the thinking for me.
This is because if I cannot analyze these companies, how can I even be sure that my sector-level thesis is right?
This is the same reason why I do not invest in banks and most software companies.
So overall, I think this is a potential reason to use ETFs, and one often pushed by ETF proponents, but it seems fraught with danger when applied to a real portfolio.
Conclusion
I am not hostile to ETF as a concept, nor do I think people using them, or advocating for them, are necessarily wrong.
It can be a good way for an investor to start stock picking, without having the proper level of understanding to fully analyze individual balance sheets for example.
It can also be a good way to get diversification and lower trading fees in specific cases.
I am a lot more skeptical of using this strategy by default as a replacement for stock picking and fundamental analysis.
Most of the arguments against timing the market or stock picking come from studying the aggregate of fee-collecting fund managers moving as a herd, or clueless retail investors. Is it really surprising they underperform the market when they either have no real incentive for original ideas or do not have enough knowledge to do so?
I believe that for the 5-10% of the population willing to spend time actually learning and reading about investing AND are able to have independent thoughts, using ETFs might become a source of underperformance.