Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets

Linked above is the latest whitepaper from Taylor Frigon Capital Management, entitled "Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets," published on August 27, 2015.

In it, we compare the massive growth of exchange-traded funds (ETFs) within financial markets to a runaway "toxic bloom" of algae within a body of water, citing evidence which suggests that ETFs by their very nature may have extremely damaging effects on financial markets, impacting everyone who relies on those markets, whether investors in ETFs or not.

Back in July we published a post discussing several longtime concerns we have had regarding ETFs, especially in light of some high-profile comments by well-known investor Carl Icahn, who was himself raising a warning about ETFs (and specifically about ETFs designed to try to track inherently illiquid securities such as high-yield bonds).

At the time we wrote that July post on ETF dangers, we decided that we should also publish a more extensive "whitepaper" discussing the specific aspects of ETFs which we believe are potentially hazardous, and providing some explanation of just how ETFs are basically structured.  

A big part of the reason for writing such a paper: we don't believe investors in general have a very good grasp of exactly what an ETF really is, and how it is related to the so-called "basket of securities" to which it purports to provide investment exposure. 

In fact, we actually believe that very few financial advisors who employ ETFs as part of the strategy that they recommend to clients fully understand ETFs, or understand the fact that the only linkage between the price of the ETF that they recommend to their clients, and the market value of the "basket of securities" that the ETF is supposed to be tracking, consists of the willingness of certain big financial firms to engage in arbitrage-driven trading activity.

Just as we were completing this paper, and before publishing it today, new evidence emerged which illustrated this phenomenon rather dramatically. During the plunge of the US stock markets at the open on Monday, the price of many ETFs plunged far more than the drop in the market value of the securities that they were supposed to be tracking, coming "unhinged" by a wide margin and causing serious consternation among those who owned shares in those various ETFs (here is a story discussing this ETF disconnect in the Wall Street Journal -- and there are many others).

The drop was so severe -- and the "gapping downwards" so rapid during the day -- that many investors and financial advisors who had placed stop orders and market orders to sell had those orders execute at percentages below the price they thought they would get for the trade, by 20% or more in some cases. The fact that many financial advisors placed stop-loss orders on these ETFs, and the fact that some are quoted in that article as saying the price drops and gapping of the ETFs that they saw that day "don't make any sense," tends to confirm the allegation that many financial advisors do not actually understand the principles of arbitrage and liquidity upon which ETFs by their nature must depend in order to keep the price of the ETF in line with the price of some basket of securities.

When liquidity becomes scarce -- or when the big Wall Street firms who are authorized to make those arbitrage trades for the ETFs decide to "step aside" and not make those trades (for whatever reason, usually because they see that there is not enough liquidity) -- then the price of the ETFs become unhinged in exactly the manner that was witnessed on Monday. 

In other words, that kind of "gapping" makes perfect sense: it is a product of the well-known laws of supply and demand, and is generally the way that prices will move in a market from which liquidity vanishes.

We believe that the tremendous growth of ETFs poses significant hazards -- and academic papers cited in the above whitepaper suggest that these hazards may in fact impact the wider market and not just ETFs. 

We believe that understanding how ETFs work is an important step towards trying to address some of these hazards.

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A Hissy Fit In The Market

The market opened this morning in a very chaotic manner which is indicative of the kind of reaction that comes from a market which is dominated by trading and non-economic decision-making versus investment based in business fundamentals.  Quite timely given our commentary recently about the disfunction caused by the ETF phenomenon.  Incidentally, even the talking heads on CNBC were referencing the potential that ETFs could be at the heart of the "dislocation" that seemed to be occurring in the trading apparatus this morning.  

Who really knows?  And that is not comforting!  

However, it is not as if we haven't seen panic-type markets before.  We experienced the one day drop of 22% in the DJIA in 1987 and the wild swings in 2008-2009; much more severe than today's move.  And since then there have been several "headline events" such as the Greece debacle, Dubai Ports World, disruption in Cypress, geopolitical tensions in the Middle East, just to name a few.  This underscores the need to be centered on a long term investment approach, similar to that which we provide.  One which is based in sound fundamental research and is not dependent on the move in stock prices on any given day, week, month, quarter or year, for that matter!

Ironically, this down move across the board is happening at a time when we think some of our most important themes are showing signs of kicking in after being on hold for the last couple of years.  These would include the transformation towards virtualization across the data center universe, the advent of sensor technology in wearables and the "Internet of Things" (IoT), the transformation of the enterprise into a fully cloud-based platform, and others.  

These are just some of the business innovations that we are focusing on at this time.  We expect that regardless of where the markets ultimately settle today, this week or this month, these trends are and will continue to be powerful drivers of business and ultimately portfolio returns in the years ahead.

That said, we have warned in previous commentary that the market may throw a "hissy fit" when the Fed decides to finally raise the target for the Federal Funds Rate from zero.  This may be that "fit"!  Followers of our commentary know that we have been advocates for raising rates for some time and it would seem the Fed is finally ready to acquiesce.  While it is impossible to say that when the Fed meets in September they will definitely raise rates, it is likely to happen by the end of the year.  Will there be more market turmoil when the event finally comes to pass?  Possibly, but likely the "return to  normalcy" that a Fed rate hike would bring will ultimately allow the market to move higher as it turns its focus back to business, where it belongs.

Whether or not recent market weakness is solely due to the expected actions of the Fed, or China's so-called meltdown, not all that unusual for a market that has had a meteoric rise in just a matter of months, the key is to be centered and still in volatile times, and even look to buy great businesses while they are on sale!

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Carl Icahn says what he means on a very important subject: all investors should pay close attention

We have been concerned about the rapid rise in popularity of exchange-traded funds (ETFs) for a long time.  Over ten years ago, at a conference on the topic of ETFs, we were given a book that explained how they worked and how to use them in strategies; the book was almost 700 pages long.  It struck us that any investment vehicle that took 688 pages to explain was problematic.

This past Wednesday, July 15, there was an extremely interesting conversation at the "Delivering Alpha" conference in New York City, hosted by CNBC and Institutional Investor, in which investor Carl Icahn raised some extremely important points about ETFs which we believe every investor should consider very carefully.

During a panel which was apparently going to be about "investor activism," Carl Icahn made some very hard-hitting remarks about dangers posed by ETFs (exchange-traded funds) and most particularly the danger that ETFs may be seen by many investors as offering a degree of safety and a degree of liquidity which they do not possess.

This subject is one of tremendous importance because ETFs have grown to be an enormous segment of the global and US investment markets in both stocks and bonds and also in commodities. According to the Investment Company Institute, there are about $2.7 trillion invested in ETFs world-wide, about $2.0 trillion of which are in ETFs based in the US.

Therefore, when Carl Icahn (whose professional investment career started in the year 1961, and whose company Icahn Enterprises manages over $24.5 billion in assets) says that he believes ETFs are perceived as having a level of safety and a level of liquidity which they do not possess, we believe investors should pay very close attention to what he is saying.

While the discussion between Mr. Icahn and BlackRock CEO Larry Fink included a debate about whether higher interest rates are going to negatively affect high yield bond prices, that was really a sidelight to what we feel is the more-important discussion about the perception that ETFs are safe, liquid investments that are inexpensive and “easy” for the average investor to “own."

It is this last point that we feel is the most important, and wasn’t directly addressed by Mr. Icahn -- although he did make reference to the fact that in order to discuss what's going on inside an ETF he "could get into some arcane stuff" -- is that the “investor” is really not “owning” anything when “investing” in ETFs.  At its core, the ETF is just another form of derivative.  If there is anything the 688-page book taught us it is that it is not the average investor, but rather the supporting banks that can “ask for their shares” at any time from the funds.

As advocates of true price discovery, it occurs to us that the farther away the so-called “investor” is from the ownership of the investments they think they are making, the more potential pitfalls there are when times get tough.  This is why an investor with the stature of Carl Icahn making points about the pitfalls of ETFs is worth noting.

You're welcome to skip down and watch the videos at any time -- here, in a list format, are some of our thoughts and comments about this very important subject:

• We have in fact written about our discomfort with the ETF trend in the past. See for instance this blog post entitled "The ETF industry and their promise of easily adding alpha for all," from back in 2009, which we believe is just as relevant today as it was when we wrote it six years ago.

• At Taylor Frigon Capital Management, we invest in companies directly, by owning individual securities issued by those companies. This means that we are obviously biased in this argument, because we compete against investment advisory services using ETFs. But we could have chosen to use ETFs if we wanted, and after significant analysis decided that, at best, the underlying complexity was problematic, and at worst, the ETF is a potential time bomb that may have systemic implications if they continue to grow without adequate understanding on the part of investors as to exactly how they work.

• While we don’t likely agree with Carl Icahn on everything, we do invest in individual companies on behalf of our clients, including some companies in which Mr. Icahn, through Icahn Enterprises, is a very large shareholder, such as Apple (AAPL) and CVR Energy, Inc. (CVI).*

• We also believe in investing in those companies directly for both our clients and ourselves.

• We believe that Carl Icahn is doing the investment community a great service by forcefully calling attention to what he believes is a potential problem: the fact that investors may be mistaken in attributing to ETFs a level of safety and liquidity which may be unwarranted (specifically with regards to ETFs which own an inherently illiquid and sometimes risky investment: high-yield bonds). Note that Carl Icahn says in some of the video segments below that he feels some remorse for not being more outspoken about concerns he had prior to 2007 and 2008 about a different category of pooled investment vehicles, but that he wants to say now very clearly that he perceives some potential problems of a very serious nature (while not specifically predicting any sort of immediate crisis).

• Although Carl Icahn did not specifically say it -- and this post is not intended to imply that he did -- we believe that some of the same criticisms that he applies to high-yield bond investing through ETFs can be applied to many other types of investing through ETFs. Specifically: just as Mr. Icahn is saying that investors in high-yield bond ETFs feel a certain "distance" from the underlying security (in this case, high-yield bonds) and don't feel that they need to perform the kind of individual due diligence on each individual security connected to that ETF, and just as investors in those high-yield bond ETFs feel that the ETF makes high-yield bond investing more liquid and more safe than individual high-yield bond investing (but the reality may in fact be quite the opposite), we believe that investors in almost any kind of ETF including those which invest in stocks end up distancing themselves from attention to the specific business factors of the business in which they are investing. And we believe that this can be a dangerous pattern, no matter what the underlying investment happens to be.

•  We also find it interesting that some of Mr. Fink's comments in the video can be seen as indirectly or perhaps unintentionally providing support for the point we just made. For instance, in the very first clip beginning about 10 or 15 seconds from the start of the clip (before Mr. Icahn even begins his hard-hitting criticism of ETFs), he says (as a function of how much his investment management firm manages in index funds):

So, we have to own companies that are poorly-run, and companies that are well-run. We own all the companies [expansive hand gesture]. Unlike active investors -- and a lot of our money . . . we manage active, too -- our investors can't sell those stocks if they hate the company. We're only . . . we have to own the stock whether we like it or not, and the . . . so, we have a much greater responsibility in working with companies, and hopefully over time working with the companies to build the proper returns that we expect from them. And then sometimes, we will even agitate, but we will do it privately and quietly. [Punctuation in the above quotation uses ellipses to indicate a pause or a change in direction of the sentence, and not to indicate words omitted from the quotation: no words were omitted from the quotation in the clip, as we hear the audio].

• We find that admission to be a pretty good description of what we believe is the core problem with the whole category of index and ETF investing. The premise on which these forms of investment are built is inherently opposed to the kind of scrutiny of the underlying investment (whether it be a stock issued by a company, or a high-yield bond) that we believe is the very heart of responsible investment.

There is much more that could be said about some of the many important related subjects raised during this exchange between Carl Icahn and Larry Fink. However, we believe that this one central issue -- about the perceived safety and liquidity in an investment vehicle which makes up an enormous percentage of the global investment landscape -- is the issue that investors should take the time to consider very, very carefully.

Towards the beginning of his own remarks, at the start of the second video segment, Carl Icahn says: "And I really mean this -- I'll just say what I mean. I'm too old not to say what I mean, and I don't hold back."

No matter what your opinion of Carl Icahn or of what he says after that, you have to respect him for making that statement, and then for very bluntly "saying what he means" because it is what he believes investors need to hear, and what investors need to know.

And when someone with as much market experience and success as Carl Icahn has, sits down and very plainly tells you that he is going to freely say what he means, we think investors should pay attention. And we applaud him for doing it.

video one http://video.cnbc.com/gallery/?video=3000397684


video two http://video.cnbc.com/gallery/?video=3000397844


video three http://video.cnbc.com/gallery/?video=3000397885



video four http://video.cnbc.com/gallery/?video=3000397886




video five http://video.cnbc.com/gallery/?video=3000397882



video six http://video.cnbc.com/gallery/?video=3000397887

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by BlackRock (BLK). At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL) and by CVR Energy (CVI).

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Why Employers are Rethinking Turnkey 401(k) Plans

Turnkey retirement-plan programs sounded like a great idea.

When fund companies and other big firms started offering them in the 1990s, employers were promised solid employee benefits delivered with groundbreaking simplicity and low cost.

What was not to like? Plenty, it turns out.

Turnkey plan providers like to boast about the number of funds they make available to employees. The typical plan now has hundreds of options. Yet this abundance hasn’t benefitted the typical employee: To the contrary, it’s led to employees feeling overwhelmed.

Too many choices have led to paralysis, with employees simply leaving their contributions in cash. That’s certainly not going to help them earn the returns they need to retire one day.

Second problem: Turnkey providers are failing to educate plan participants. Employees need a clear understanding of setting goals and investing properly to achieve them. And since they’re bombarded with daily headlines about the markets and investing, they need to be continually reminded about the difference between impulsive trading and sound long-term investing practice. That’s rarely, if ever, taking place. We’ve even heard of employees making daily changes to their 401(k)’s, a practice that usually backfires badly.

Finally, turnkey plan providers were supposed to help plan sponsors stay on top of their administrative responsibilities. All the feedback we hear from small and mid-size employers is that it’s not happening, and that important tasks are regularly falling through the cracks.

All of that helps to explain why some employers are seeking out alternatives to the giant turnkey plan providers. They’re taking a closer look at companies like Taylor Frigon, where our team offers something very different from the industry norm.

Our investment lineup for 401(k)s consists of just four funds: a growth strategy, an income strategy, a default strategy featuring a conservative balance of investments, and a money-market fund. The size of our menu is a direct reflection of our conviction that managing risk and capturing growth is best achieved by holding a moderate number of carefully chosen investments. (Read more about diversification here.)

This compact fund menu not only simplifies investment decision-making for plan participants, but it virtually eliminates the temptation to jump from fund to fund.

Then there’s education. To give participants a real shot at successful retirement investing, personal and ongoing education is essential. We personally visit clients at least twice a year, explaining how important it is to avoid “playing the market,” and to invest in good companies for years, not quarters.

We’re proud that our education helps to counterbalance the hysteria that plan participants are subjected to from the financial shout shows, from print advertisements and even from their friends and neighbors. Investing is simple—it’s investors who tend to make it difficult.

On the administration front, we partner with third-party administrators to provide a high-touch, personalized level of service. Employers who hire turnkey providers too often find their “partner” is a bureaucratic machine that isn’t concerned with their peace of mind. While turnkey programs may charge less for administration, that advantage can be easily negated through penalties for compliance shortfalls.

No employer wants their plan participants to be confused and overwhelmed. And they certainly don’t need avoidable compliance headaches. This explains why more are considering leaving faceless turnkey plans and looking to get back to basics: A clear investment path, real education and solid support.

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How Diversification Became “Di-Worsification”

Charles Dickens once wrote that virtue, carried to excess, could become vice. 

If he were a modern financial expert, Dickens could be talking about portfolio diversification. Diversifying the kinds of assets you hold helps you to maximize potential gains and minimize risk. But when diversification is carried too far, it becomes “di-‘worse’-ification.” 

Having too many investments in a portfolio eliminates both the potential for extra gains and the protection against excess risk. And yet that’s exactly what countless investors, and even advisors, are doing. Building portfolios with hundreds and hundreds of individual investments, they’re champions of the idea that there can never be too much of a good thing. But they are dead wrong.

True diversification involves counterbalancing types of assets that behave differently in different market conditions. By investing in assets with less correlation to each other, we gain exposure to a cross-section of growth opportunities. And because all our eggs are not in one basket, our portfolios may be insulated against a crash in any one asset class.

Diversification isn’t just some kind of popular wisdom—it’s rooted in respected academic research. The Fundamentals of Investments for Financial Planning, published by The American College, explains that true diversification doesn’t require a myriad of investments: “Research has repeatedly shown that a relatively small number of stocks (about 30) is sufficient to obtain most of the risk-reduction potential of diversification.”

When a portfolio exceeds that number, diversification’s benefits vanish. Specifically, the portfolio becomes increasingly exposed to market volatility. In plain terms, the more of the market you own, the more your portfolio will simply mimic the market. Your optimized balance between risk and return will disappear, so that when markets go down, up or nowhere, your portfolio will do the same. 

Then there’s the matter of costs. The more securities or funds you own, the more you are paying in sales and management fees. Especially in today’s modest return environment, these fees can eat up a large percentage of your returns. What’s more, the complexity of over-diversified portfolios makes them difficult to analyze. Which investments are helping and which are hurting? With hundreds upon hundreds of possibilities, it can be nearly impossible to tell.

One reason over-diversification is so prevalent is that many advisors “diversify” their client portfolios using mutual funds. A typical advisor may recommend a large-cap fund, a mid-cap fund and a small-cap fund. He may balance out a “value”-style fund with a “growth” style fund. He may add additional funds to gain international and emerging-market exposure. 

With each fund holding 50 to 100 stocks, you may soon be di-worsified into a portfolio with thousands of individual securities. That becomes a recipe for mediocrity at best, and disaster at worst. 

At Taylor Frigon Capital Management, we adhere to diversification in its true sense—and to some people that seems radical. We manage just two strategies: our Core Growth Strategy, which currently has 38 holdings, and our Income Strategy, which current has 42 holdings. 

Together, these two simple, straightforward strategies contain about 80 securities. Each strategy is fully diversified and constructed to complement each other to offset risk and optimize reward.  

Our approach, using rigorous in-house research to identify a limited number of exceptional securities across industries and sectors, has been validated by performance. From its inception on January 19, 2007, through the first quarter of this year, the Core Growth Strategy has posted an annualized return of 8.34% after fees. By comparison, the S&P 500 has returned 6.87%, and the Russell 3000 has returned 7.19%.

Our Income Strategy, built to deliver consistent cash flow and dampen volatility, has returned an average of 5.29% per year over the same period, after fees. That’s competitive with the S&P 500’s return—with much less risk. 

Past performance does not guarantee future performance, in our strategies or in any investment (for our performance disclosure, please click here) . But we believe our streamlined strategies are a testament to the power of diversification at its best. Please feel free to contact us for more information.

Main Points: 

• • Excess portfolio diversification becomes counter-productive “di-worsification.”
• • Di-worsification eliminates the valuable balance of risk and return and exposes investors to increased risk.
• • Diversification is most effective when portfolios consist of 40 individual holdings. 
• • Excess diversification creates more risk, higher costs and more confusion.
• • Di-worsification often occurs when advisors recommend multiple mutual funds.
• • Taylor Frigon strategies have achieved strong results with “pared-down,” true diversification.

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