The Problem with ETFs
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Trying to get around their own bad stock picking (a good idea) people have started buying Exchange Traded Funds, known as ETFs, which create a “basket” of stocks from a certain sector (a better idea — but with qualifications to follow).
The question is: Is this really good “diversification”? Well, not if all the funds in the basket tend to move together, making their risk closer to that of an individual stock, which is just what this paper says they do.
Think of an Index fund of the Dow Jones Industrial Average. And think of the first half of this year. Not a smart buy; and all of the stocks subject to the same wild mood swings of Wall Street.
It’s still most likely better, over the long run, than any dumb-ass stock picking you might do on your own. But for significant diversification, you’re going to want to look further afield. Think: precious metals, currencies, real estate investment trusts.
It’s a very good trend that more people seem to be accepting that they can’t “beat the market” based on an overly optimistic view of their own stock-picking prowess. But, at the same time, they need to avoid coming up with a lazy alternative that subjects them to the same kind of risk they were trying to avoid in the first place. Diversify, yes. Just with ETFs, probably not.
HT: The Wallet
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I think ETFs cut in a different way than you think. The classic, conservative, index investment is a Total Bond Market Index balanced in proper portion with a Total Stock Market Index. This was a buy and hold philosophy and that’s important. More on how ETFs change that below.
This is a slight variation on Bogle’s classic Vanguard SP500 strategy. How much bonds? I’ve always thought that “your age in bonds” was solid (a 50 year old is 50% in bods), and later more aggressive measures, like “110 minus your age in stocks” or “120 minus your age in stocks” to be way too risky, build by people with experience only in long bull markets.
Now, ETFs can still be use with those conservative strategies, and for the long term. In my mind the neuro/behavioral impact of them is that since they are so easy to trade, they are seductive to traders. They don’t encourage (their marketers certainly don’t encourage) conservative use.
Finally, on diversification outside stocks and bonds … some insured bank CDs and some real estate seem reasonable, but I think the siren call there is to strange asset classes that haven’t really stood the test of time. A commodities play (ETF or not) might look good in recent-past data mining, but I think many of them tend toward craziness.
I mean, who can look at a 30-year gold chart and think that they’ll really know when to get in and out?
(In case it wasn’t clear, I think that narrow sector ETFs are for gamblers, and the blurring of them with the broadest index funds is a disservice to the latter.)
[...] I think they are often dangerous and misused, but I’ve seen critiques which missed on why. [...]