The Taylor Frigon Advisor: The ETF industry and their promise of easily adding alpha to all

In several previous posts, we have argued that the "intermediary" structure inherent in the "wealth management" industry constitutes a huge problem with respect to long term returns achieved by investors served by the industry.

The crux of the problem is that investors seeking professional assistance typically receive that assistance from an intermediary who does not select individual investments in good businesses himself -- instead, he funnels the investor's capital to someone else who is selecting those business investments (by using mutual funds, separately-managed accounts, index funds, exchange-traded funds, or other investment vehicles where the capital is actually matched to the individual stocks or bonds).

More and more often, intermediaries are relying on exchange-traded funds -- or ETFs -- as their vehicle of choice for the investment of their clients' capital. The reasons for this phenomenon are multiple.

First, ETFs are constructed differently than mutual funds, which enables them to avoid some of the drawbacks to mutual funds which we have noted in numerous previous posts (one of the most important drawbacks of funds to wealthier investors are their tax consequences, which ETFs generally sidestep).

Second, ETFs are mostly constructed to mimic a market index or some portion of a market index. This appeals to those who believe the common argument that "you can't really do better than the index," relieving the intermediary of the burden of arguing against all those studies which show that few active managers consistently outperform their benchmark index (see for example the "performance" link in this presentation from iShares, the first and one of the largest merchants of ETFs). By using ETFs, intermediaries can use "index-fund" arguments while avoiding the drawbacks of the mutual fund structure discussed in the first point.

Third, and perhaps most seductively, ETFs offer the intermediary the promise of "adding alpha" while avoiding the difficulties of actual analysis of individual securities (such as stocks and bonds) -- a process that involves evaluating individual business prospects, balance sheets, earnings reports, management teams, cash flows, and a host of other factors requiring ongoing diligence and research. ("Alpha" is a modern portfolio theory term for the measure of a portfolio's "risk-adjusted return" in excess of the return of the overall market -- we've discussed previously that the modern portfolio theory belief that riskiness can be mathematically quantified and portfolios can thus be evaluated for their "risk-adjusted return" is based on a false premise, such as this post in which we note that this opinion is also shared by the insightful Professor Amar Bhide of Columbia Business School).

We've argued elsewhere that we disagree with the "indexing" argument, which forms an important part of the ETF story. Even more concerning about the ETF phenomenon, however, is the blatant inherent contradiction between the second and third points above.

In other words, the ETF argument contains these two contradictory premises:

1. Active managers who select individual securities cannot "add alpha" consistently enough to make it worth your while.

2. Using ETFs, we can add alpha!

That this is exactly what the growing ETF industry, including the intermediaries who use ETFs, are saying to clients is clear from ETF marketing material. For example, this iShares example shows their "Asset Class Illustrator Tool" with which the intermediary can project the increased returns and "lower risk" that can be achieved by "blending in" a variety of different indexes and market sectors into a portfolio of ETFs. Section number three on the second page of that shows the intermediary how he can show client "Jane Doe" a projection that illustrates her portfolio's increased return and lower volatility (or "risk") versus the index (in this case, the S&P 500 index).

This ability to beat the market (with lower risk) is supposedly accomplished by "overweighting" and "underweighting" different sectors, geographies, and asset classes that are expected to outperform or underperform in the near term (see another description of this concept from ETF marketing material here). It's amazing that the same people who point out how difficult and rare it is for active portfolio managers to beat the market using a portfolio of stocks also argue that they themselves can beat the market using an actively managed portfolio of indexes (it's even more amazing that investors don't notice this contradiction).

We have previously laid out our reasoning concerning the problems with constructing a portfolio by overweighting or underweighting this or that sector (or geography, or growth / value style category, or market-capitalization category, and so on).

There are real tools for evaluating an individual business -- including measuring a host of data from its financial statements, SEC filings, management history and business activities -- while there are no such corresponding metrics for conducting true due diligence on a sector, or an index, or a basket of securities grouped by market capitalization. Thus, the kind of overweighting and underweighting described in ETF literature necessarily relies much more on gut instinct or feelings about what will outperform next than on fundamental business analysis.

Furthermore, empirical research such as this study from index-fund advocate John Bogle illustrates that -- far from adding performance and reducing risk -- investors and their advisors who are using ETFs fall into the same trap that characterizes mutual fund investment behavior and which causes investors to consistently underperform the track records of the ETFs themselves! This finding exactly parallels the problem we discuss in "Investor Behavior . . . or Advisor Behavior?" and it should not surprise our regular readers.

We believe that investors should be wary of the increasingly common pitch for using ETFs instead of investing directly in well-run businesses that have good management teams operating in promising fields of growth.

For later posts on the same subject, see also: