Some may wonder why iconic active money manager Warren Buffett likes to tell people to buy low-cost index funds to participate in the stock market.
His advice has to do with minimization of costs, which adds a lot to performance over time. Still, I have never heard him say anything about buying a lower-cost index exchange traded fund (ETF), which is a passive investing vehicle similar to an index fund. An ETF provides daily liquidity, whereas index mutual funds only get their net asset value (NAV) updated after the close of trading.
While on the surface ETFs may look superior to index funds because of this intraday pricing — and, hence, they have seen massive growth, to the tune of $3.6 trillion in assets in the U.S. and much bigger globally (see chart[1]) — under the surface, this intraday pricing “advantage” of ETFs can get really ugly.
There is no hard-and-fast rule in separating the good and bad ETFs, especially with new issues coming out every month, but after spending 20 years in this fascinating world of finance in various roles, I can tell you from experience that no more than a third of ETFs fall into the “OK” category. The rest are like a shell-game scam. (For more on this issue, see “This is what happens when Skynet from ‘Terminator’ takes over the stock market[2].”) And, no, market regulators have not done nearly enough to address these problems, which are growing bigger by the day.
High-frequency trading
Michael Lewis, who became a best-selling author with his tell-all books about the world of finance, gave a “60 Minutes” interview when promoting his book on high-frequency trading (HFT) called “Flash Boys: A Wall Street Revolt.” At the onset, the interviewer asks him: “What’s the headline here?” Michael Lewis responded: “Stock market’s rigged. The United States stock market, the most iconic stock market in global capitalism, is rigged.” (The video[3] is available on Youtube.) While Lewis’ book covers HFT, all the issues outlined in this article stem from that kind of computerized trading, as it is HFT that makes ETFs possible.
There are numerous ways to “shave” nickels and dimes with bid-ask spreads, tracking errors and the like, so in the majority of cases the arbitrageurs are the ones that make the money at the expense of individual investors. As a rule of thumb, the more liquid the ETF is when it comes to daily volumes, the more likely it is that tracking errors and bid-ask spread problems will be smaller, even though highly volatile market environments — like those in August 2015 — showed that even liquid ETFs can have some very serious problems. (See MarketWatch: “ETFs suffer from a ‘chessboard’ problem.[4]”)
ETFs, ETPs and ETNs
I often get this question from clients: “What is an ETP, and what is the difference between an ETN and an ETF?”...