Too Much of a Good Thing

September 17, 2013

How did the mutual fund (and increasingly ETF) industrial complex mess this one up? 

Our managed account clients and Powerfund Portfolio followers already know we rely on a mix of traditional open-end mutual funds and exchange-traded funds, as well as the occasional closed-end fund. 

We also use a mix of actively-managed funds (funds in which the manager selects holdings and changes the positions around from time to time) and passively-managed index funds. The ETFs are generally index funds, but the open-end funds can be either.

In the future, we expect to see more actively-managed ETFs. One example that we recently added to our model portfolios is PIMCO Total Return ETF (BOND), an actively-managed ETF similar to the PIMCO Total Return open-end fund, and sort of like the old Harbor Bond fund we owned for years in our model portfolios.

ETFs have two main advantages over open-end funds: fees and taxes. (Some would argue tradability is the key advantage, but for fairly long-term investors like you, we find the ability to buy and sell during the day less important than funds with low fees that trade once daily like mutual funds).

ETFs are also usually cheaper (although not always, when compared to similar open-end index funds.) Most have some tax benefits (some have tax negatives, but that’s a complex discussion for another day) in that you generally don’t inherit other investors' taxable gains at the end of the year. Since we tend to buy out-of-favor funds that have limited gains (if not losses) on the books, this has never been a huge benefit to us, but it’s a nice perk.

The case can also be made that poor bond and stock picking leads not only to underperformance of the index, but also higher trading commissions and related costs as well as another level of tax inefficiency compared to low-turnover index funds. 

With such advantages, you'd think ETFs would be killing old-fashioned, expensive mutual funds, performance-wise. Think again. We run a huge mega-database each month to calculate things like our MAXratings and to identify the most attractive (generally less popular) investment areas. In addition to our regular calculations, we also look at composite performance data. 

Each time we  evaluate the thousands of open-end funds vs. hundreds of ETFs,  the average mutual fund beats the average ETF. The ETFs are cheaper, and most have less turnover. Why is this do ETFs consistently lose to their more expensive cousins?

It's not due to the clear benefits of ETFs. It's the result of the same old problem that's nagged this industry and investor returns since long before we started MAXfunds in 1999 and began discussing it: investors  flock to ill-timed investment ideas.

ETFs provide the perfect vehicle for all of the hot money, performance, theme, and idea-chasing. The fund business knows this, so they spit out dozens of ETFs each month as a quick way to test the waters for demand. This trendy fund incubation used to take place in the mutual fund arena (we know, we covered new fund launches daily back in the…day). Now it's almost solely in the ETF space. 

Wall Street sells ideas. Solutions to fears.. Investment firms try to grab your attention with an idea that helps you a) make money than a U.S. stock index or b) avoid the losses of stocks in a down market. And then they try to provide a product or service that capitalizes on that idea. 

Unfortunately, these ideas are often either solutions to yesterday’s problems and opportunities or just low-probability future events. Think Internet and growth funds in 2000 or emerging market, value and dividend, or currency funds in 2006. 

There are now more ill-timed opportunities in the ETF space than in mutual funds, which explains their poor performance. Many ETFs are decent funds with low fees, but they originated at a time when underperforming the S&P 500 was all but guaranteed. Or they offer diversification that you don’t need – in oil and other commodities, precious metals, etc.

If you owned a portfolio that held nothing but every new ETF launched in 2008 that still operates today, you would have underperformed the S&P 500 every year, and by double digits for the last three years. Over half of your massive portfolio of over 150 funds would STILL be in the red today even though bond and stock indexes (with dividends) are both well higher than they were at any time in 2008. This underperformance can’t be blamed on a disparity of risk - the ’08 class of  ETFs have higher volatility on average than the S&P500 over the last five years. More risk and less return.

If you had bought 2008’s new mutual funds , you would have beaten the S&P 500 in 2009 and underperformed by only by single digits in subsequent years, AND 40% of them  are  lower volatility than the S&P 500. 

If you bought every ETF when it was launched in the last 10 years that still exist today only about 60% are actually above water at all since inception. Of the thousands of often crummy and expensive mutual funds launched during this period, 85% of them have made investors money from day one. 

Areas that have actually performed well over the last decade-plus, like Internet and biotech ETFs, are relatively small and don't see a lot of new product launches (since their ill-timed launches in the 1990s). Yet there are many ETFs with over a billion in assets that haven’t performed well. PowerShares DB Agriculture (DBA) has $1.5 billion and has a -6.29% annualized five year return with a negative -17.55% one year return. Sectors that have performed well recently, like airlines, see their few ETFs close for lack of interest, as the recent shutting of Guggenheim Airline (FAA) shows. With ETFs, we see concept chasing more than performance chasing.

This isn’t entirely new, and isn’t just something that takes place at the flavor-of-the-month fund shops. We once owned American Century Global Natural Resources (BGRIX) in a model portfolio and watched it die for lack of assets in 2002 – right before global and natural resources as a concept started killing the S&P 500. 

The same happened to Vanguard Utilities (VGSUX,) which somehow became collateral damage to the whole Enron and WorldCom debacle, proving  to investors that utilities were not safe anymore…right before they proved to be quite safe again.

Bottom line? The inherent structural cost advantage of ETFs is far outweighed by the inherent disadvantages of ill-timed and otherwise bad investment ideas. We’re still going to use ETFs, but are increasingly looking at this fast-growing world for signs of what not  to do.