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Are ETFs Really A ‘Big Short’ Problem?

FYI | May 17 2017

By Peter Switzer, Switzer Super Report

Fund managers are worried about Exchange Traded Funds because they are losing business to these lower-cost alternatives. And they’re also worried because the media plays up ETFs as being the best investment option for busy people, who can’t do their own research or who don’t want to pay for advice.

Last week, an alarming media release alert was sent out with the warning that “Many ETF investors are unaware of a range of significant risks to their investments, according to a group of experienced traders.”

This is what the media release said:

“Gary Norden of Australian-based Organic Financial Group, Nam Nguyen of Canadian firm Harbourfront Technologies and Larry Gazette, a US based trader have between them nearly 80 years of market experience:

“Many investors wrongly believe that all ETFs are simple, passive structures with low risk,” says Gazette.

“In reality though, many have a range of weaknesses that can significantly hurt investors,” according to Gazette.

“Even though we have only investigated a small percentage of ETFs so far, we have identified a number of vulnerabilities,” said Nguyen.

“Timing when these vulnerabilities will strike is not easy, however, we are confident that we have a definable statistical edge in the set up for the trades we have already identified,” said Nguyen.

“The current market for ETFs, with huge amounts of capital chasing a relatively new type of structure, oblivious to its weaknesses, reminds us of the CDO market featured in The Big Short,” says Norden.

“Both our quantitative analysis and market experience tell us that the huge growth in ETFs will end badly for many,” says Norden.

“Opportunities like these do not come along regularly. We see this as a once in a decade opportunity to offer our investors a way to participate in the crisis that will engulf the ETF market,” says Norden.

This is alarmist and it’s unfair to compare all ETFs to Collateralized Debt Obligations, which were a prime cause of the GFC.

If your ETF is exotic, it could be linked to derivatives and these come with relatively more risk. But if the ETF is based on say the S&P/ASX 200 index, where the fund manager buys the 200 stocks when you invest in them, the only risk with these would be a crash, where everyone runs for the exits at the same time.

However, that always happens with a crash, though ETFs could result in more and faster selling when the ‘you know what’ hits the fan.

I’m going to test out this proposition with experts this week on my TV show.

But what about ETFs versus managed funds?

Back in 2015 Morningstar data showed that for the year through to October 31, roughly 58.6% of actively managed funds had failed to beat their benchmarks. And over the last 10 years, 73% of actively managed funds had fallen short.

So, on those numbers, there is a good argument for ETFs that copy the index but, simultaneously, there is argument for looking for the fund managers who consistently beat the index. Of course, they don’t have to beat the index every year but they need to do well over three, five and 10 years.

And they are there, but the smart wealth-builder has to go looking for them.

Warren Buffett has told retail investors that they are better off in ETFs but that doesn’t mean that a better strategy might be a core investment in a passive fund that mirrors a good market index augmented by a satellite strategy where you go looking for alpha or higher returns with a mixture of funds or individual shares.

Personally, I have relied on an ETF for the S&P/ASX 200 index, which I’ve bought when the index has slid to very low levels. So when I told you to “buy the dips,” that’s what I did.

I have also gone long my own fund because that’s how I always invest — buy dividend-paying stocks in companies where they grow their dividend.

Of course, my Switzer Dividend Growth Fund, or SWTZ, is an ETF but an active one and that’s because we believe that selecting companies that can grow their dividends   — 30 or 40 — actually takes a bit of human judgment.

We hope to beat the dividend-payment from an ETF based on the index, which has been around 4% plus franking. We hope to pocket 5-6%, with an extra bit from franking credits. And because we chase capital gain as well, we should get another lift when the market trends higher.

I think our fund and a market-index ETF gives a pretty good core strategy and for my own super fund, I’ve been buying good companies when the market has unfairly beaten them up.

Clearly, when CSL dropped to $95 on December 5 was a case in point and those who believe in this strategy would be very happy with their $134 share price right now.

The AFR recently looked at active managers versus ETFs and the story isn’t as bad as some might think.

“Over the past decade, the average annual return from the S&P ASX 300 Accumulation Index has been 4.1 per cent per cent, says Mercer, while the median annual return from an active manager was 5.7 per cent (after fees),” Phil Baker reported.

“The past five years shows that the median performance from local fund managers was 11.8 per cent per annum (before fees), compared to 10.4 per cent from the benchmark index.”

I think the age of the ETF is good for investors but they have not created an argument that says active managers should be condemned to the waste bin of stock market history.

My super fund this year has shot the lights out and it was part strategy on my behalf — going long BHP and Rio at low share prices, as well as investing in an IPO that beat expectations — but my commitment to ETFs has also given me a solid foundation. In addition, Donald Trump and the overall market’s response have helped deliver a great return for the past year.

That said, there have been recent years when the overall return of the fund was only OK because markets went sideways and my exposure to small cap fund managers, who beat the index, was too small.

There is a case for ETFs, direct shares and active fund managers and as Aristotle once advised: “Nothing in excess, except moderation!”

Peter Switzer is the founder and publisher of the Switzer Super Report, a newsletter and website that offers advice, information and education to help you grow your DIY super.

Content included in this article is not by association the view of FNArena (see our disclaimer).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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