Invasion of the "Mutant" Indexers?

By: Tyler Mordy | Tue, Jun 19, 2007
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John Bogle, perhaps the most ardent proponent of low-cost investing and routinely referred to as the father of indexing, recently labeled exchangetraded funds as "mutant" index funds. His latest book, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns, tags the exchange-traded fund as a "wolf in sheep's clothing" which threatens traditional indexing by facilitating speculation, encouraging excessive trading and endorsing a risk-taking investment culture.

What may surprise readers is that we agree with much of Bogle's analysis. Many ETFs have indeed encouraged speculation, led to performance chasing and ultimately harmed investors. And many more investors will make imprudent decisions through an investment in an ETF.

But Bogle's criticisms against ETFs center around longer running problems within investing in general - excessive trading, ignoring risk, inadequate diversification and inappropriate asset allocations. In other words, Bogle simply highlights common pitfalls that have always plagued investors. ETFs themselves can hardly be blamed.

ETF Misuse Not Harmful for Long Term Investors. Bogle indicates that although ETFs were originally created for the long-term investor, most users today are hedge funds, active money managers or traders. In fact, he estimates that long term investors only hold about 20% of assets in the more broadly diversified ETFs.

Annual turnover often exceeds thousands of percent (turnover for the popular NASDAQ Qubes is reported to exceed 6,000% per annum). State Street's flagship ETF, the "Spider" (AMEX: SPY), typically has a daily turnover of more than $10bn ... likely the world's most actively traded security.

In general, higher trading has been associated with lower returns. But does turnover really harm the long term ETF holder (i.e. a holding period of longer than a few months)? Certainly turnover within the ETFs' underlying securities may cause undesirable tax consequences. However, most (certainly the traditional market capitalization based ETFs) have very little underlying turnover - tax efficiency is one of ETFs' core benefits.

But another key benefit is that ETF unitholders are actually insulated from the trading activities of other shareholders since they are exchange listed. Another investor's buy or sale does not trigger tax consequences for existing unitholders. Pooled and mutual funds, on the other hand, face negative tax consequences both when the portfolio manager trades in the underlying securities and when existing shareholders make redemptions from the fund.

Not All ETFs are Created Alike. Bogle points out the latest ETF launches have been dominated by leaders in the most recent bull market - small-caps, resources, real estate and emerging markets. He further criticizes ETF providers for creating narrowly-based ETFs that lack diversification and betray their claim of low fees. Recent issues of ETFocus have voiced similar criticisms. There have been some opportunistic ETFs which have clearly violated the low-fee, diversified traditional ETF structure.

But at what point does the central message of ETFs become diluted? Without question, the arrival of ETFs has dramatically altered the investing landscape for the better and leveled the playing field for individual investors - a few ill-advised ETFs should not detract from the positive benefits of this radical shift.

In a February 9, 2007 Wall Street Journal piece, Bogle highlighted only 12 of the then 690 ETFs as useful investment instruments, as the others did not track broadbased segments of the market (he accuses approximately $390 billion of the $410 billion in US ETF assets as speculative investments... a "vast departure" from the original benefits of the traditional broad index fund).

On this point, we flatly disagree of course. One of the revolutionary aspects of ETFs has been accessibility to sophisticated markets traditionally reserved for high networth or institutional sized portfolios. Investors now have access to a larger set of worldwide investable opportunities at a far lesser cost. Witness recent launches granting investors the opportunity to divert holdings from conventional investments into asset classes with more attractive valuations and greater growth prospects (with access to the important non-correlated investment categories).

Behavioural Biases Still Prevalent, But Don't Fault ETFs. One of Bogle's sharpest criticisms is that since ETFs trade intraday (unlike index mutual funds), they are ripe for abuse and encourage short-term speculation. But doesn't the same hold true for all available investment classes? Can an investor not equally speculate on Google stock versus a single country ETF?

In fact, speculation based on a broad, diversified ETF may be less tempting than single stock securities, where individual company news often leads investors to be overly active. History shows that investors continue to repeat the same behavioural errors they have always made. The usual suspects are chasing hot trends and trading more frequently than prudent.

Mounting evidence from the field of behavioural finance confirms that investors are often their own worst enemies. In a 1989 study, Robert Shiller and John Pound found that investors monitored recent individual stock purchases for more than a half-hour per day. One can only imagine the increase in monitoring time (and, hence, trading activity) since the online trading revolution of the 1990s. Another study in 1998, by Brad Barber and Terrance Odean, analyzed the trading habits of over 60,000 investors over a six year period. They concluded that there was a direct correlation between trading volumes and performance: those who traded the most fared the worst. Specifically, the investor group with the highest trading volumes underperformed the index by 500 basis points.

That is not to say that trading positions or rebalancing will not add value. But ETFs can mitigate many of these behavioural errors and introduce a more disciplined framework for the implementation and rebalancing process. Holding a diversified basket of securities -- where single company risk is reduced -- can decrease monitoring and trading frequency, and will help investors focus on more important drivers of long term performance such as asset mix. ETFs also achieve instant diversification, remedying another typical investor snare of holding too few stocks (and underestimating the individual stock's beta with the broader market).

Vintage Bogle ... Remixed. John Bogle has had an immeasurable positive impact on the investment industry. In true form, he is correct to highlight important disclaimers when using ETFs, emphasizing maintenance of low fees and avoidance of excessive turnover and performance chasing.

But his view of ETFs misses the mark on many counts. In his recent Wall Street Journal article, Bogle confesses that, if used appropriately, ETFs are "solid competitors" to index mutual funds and will provide the same diversification at lower costs.

Bogle created the world's first index mutual fund in 1975. Over thirty years later, with ETF providers innovating and gaining market share, he protests, "what have they done to my song, ma?" Mr. Bogle: you didn't lose your song -- they just came out with a better remix. And out of due respect, Mr. Bogle, we promise to "stay the course" and use ETFs appropriately for client portfolios.



Tyler Mordy

Author: Tyler Mordy

Tyler Mordy
Hahn Investment Stewards & Company Inc.

Tyler Mordy

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
Ontario: The Exchange Tower, 1800-130 King St. W., Toronto, ON M5X 1E3
British Columbia: P.O. 2609, Station R, Kelowna, BC V1X 6A7
Phone: (888)-957-0602

Tyler is regarded as a leading expert in the burgeoning field of exchange-traded funds (ETFs) and writes an influential, bi-monthly publication called ETFocus. He is a recognized innovator in the design and application of actively-managed ETF portfolios. Tyler's expertise is widely acknowledged, and he has been interviewed by several notable publications including The Wall Street Journal's - Smart Money and City Wire - Guide To Exchange Traded Funds.

Tyler Mordy is a portfolio manager and Director of Research at HAHN Investment. Since joining the firm in February 2003, he has made key contributions in the development of the firm's proprietary portfolio systems. A member of the HAHN Investment Committee, he is engaged in top-down strategy, investment policy and securities selection.

Previously, Tyler began his career at Deutsche Asset Management in London, UK. He earned his bachelor's degree in both Mathematics and English Literature at the University of British Columbia. Mr. Mordy is a CFA charterholder.

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