ETF

Index bubble

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This passive investing/index bubble idea from a Michael Burry interview continues to circulate. The idea has appeal, not the idea that another recession is imminent, but the idea that we could accurately predict one coming, and that the cause could actually make sense to us. The argument is fairly simple. A larger percentage of people are buying index funds, especially the S&P 500, than ever before. Index fund investors tend not to analyze each company in the S&P 500, they simply buy the index which owns all of them. So Burry worries that since fewer and fewer people are conducting analysis on company fundamentals, the prices of these companies are going to be inflated by virtue of the simple fact that they’re included in an index, not because they’re good companies that people believe in. That makes sense. The question then, is how much analysis and trading do we need in order to maintain a decent level of price discovery in the market? If index funds stifle price discovery, how do we avoid a bubble? Here are a few responses:

  • Even a small amount of price discovery (studying fundamentals, making trades, supply and demand) makes a huge difference for prices to reflect value. We don’t need large swaths of the market conducting analysis.
  • If 100% of invested assets were in index funds the price discovery argument might hold some weight. You would have to assume that there would be almost no company fundamental analysis happening, not an unreasonable jump but still an assumption. However, the truth is that only about 45% of invested assets are in index funds, and there’s still a host of investors and dollars outside of passive index funds working to set prices.
  • Index investing actually adds data to the market, it contributes to price discovery. Instead of contributing data on specific stocks, it contributes to larger market sector data as people commit dollars to different indexes across the world, which is helpful market data.
  • Despite the growth of index fund investing, global stock trading volume has actually remained about the same over the last ten years. People use passive vehicles to actively trade. Many index fund dollars are in ETFs among the most traded funds on the market. Just because money is in index funds does not mean that it’s passive. The activity all contributes to price discovery.
  • Some passive investors (like us!) actually do use some fundamental analysis in constructing portfolios (structured funds). And even our passive investors occasionally make trades; in order to rebalance, when they make contributions or withdrawals, etc. Even the most passive investors contribute to price discovery.
  • If the market was losing efficiency and price discovery as a result of growing index fund investors, we would expect to see an uptick in active money manager performance. Active managers would find the mispriced companies in the index and reap corresponding rewards. But the data shows no improvement, active managers have performed slightly worse over the last three years than before.

Despite the uptick in index and passive investing, price discovery is as strong as it ever has been in the stock market. Michael Burry’s comments on the index bubble are interesting and even sound plausible, but upon close inspection look misguided. Passive investing is still the way to go, though you do have permission to dump those index funds.

Robinhood is dangerous

Link Joshua VanDykeLeave a comment

robinhood-for-webFirst of all, I don’t mean Robinhood the vigilante, the hero. Sure, was a criminal, but at least he was fighting against the bad guys. In an unjust agrarian society, his actions could be seen as defensible, but I digress.
I mean Robinhood the investment app. A few notes on its danger:

  • The Robinhood app is gorgeous. It’s so pretty it’s hard not to look at it. The graphs and charts are perfect, the animations and gestures are seamless, the design is minimal, it’s about as well designed as apps come. The old mantra ‘beauty is only skin deep’ applies here. The beauty draws you in but also masks some sordid parts.
    The beauty of Robinhood masks the fact that it’s essentially a place to gamble. Sure, you could call it sophisticated gambling, at least you’re not sitting in the smoky haze with eyes glazed over at a shiny slot machine, but it’s still gambling. The little news tidbits aren’t going to help you beat the market, nor will the pretty charts. The truth is that even professionals don’t beat the market. The beauty and ease just make it more tempting.
    Robinhood will you trade options, which is an even riskier way to invest, and even more likely to lose you more money. An option is just a leveraged bet on the market, like putting your money on 13 at the roulette table. It’s a terrible idea.
  • Robinhood offers free trades, perhaps its most alluring selling point. Purchasing stocks always involves fees, brokerage fees, trade commissions, transaction fees, etc. Brokers who conduct trades charge fees, usually per transaction. Robinhood is one of the few places where consumers can purchase shares without transaction fees. So it’s beautiful and free? Who says no to that?
    It’s not entirely free. There are regulatory fees on every trade which Robinhood does pass on to customers. These fees are typically fractions of pennies, and Robinhood rounds them up to the nearest penny, pocketing the round-up of course.
    Robinhood also generates substantial income from a practice called ‘payment for order flow,’ a controversial industry practice interestingly invented by Bernie Madoff. It basically means Robinhood sells the right to execute customer trades to third-party market makers who pay a small fee. Those small fees add up, and Robinhood relies on their high-frequency traders to make it work. Regulators don’t love it, in fact, other brokers and market makers have faced lawsuits over the issue. Robinhood’s dependence on this income could spell its downfall in the coming years.
  • Robinhood only allows you to buy entire shares, which are often pricey. At the time of this writeup Apple is trading at around $200/share, SPY (a very popular ETF that tracks with the S&P 500 index) is trading at about $300/share, Tesla is at $220, you get the idea. Not all shares are that expensive, but it’s tough to deposit a small amount and get trading, you need more money to buy full shares.
    It’s not like Robinhood couldn’t offer partial shares, other platforms do it. Robinhood doesn’t because this is another one of the ways they make money. Offering full shares exclusively means that you will usually have some leftover change in your account, and Robinhood earns interest on those leftover funds. It also encourages you to invest larger chunks of money, which means you’re likely to lose more money.

I’m not saying you’ll die young or retire destitute if you invest some money in Robinhood. But just be aware of what you’re doing. You’re gambling. For the most part, it’s best to stay away.

Be Wary of Investing Apps

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Investing today is easier than it’s ever been. One hundred years ago investing options were limited, there were no mutual funds, no ETFs, it was basically banks and single stocks. And even those few options were expensive and difficult to obtain. For most people, investing wasn’t a viable option. Today we’re drowning in all the investment options. It’s become so easy, so normal, you can download an app and own thousands of equities within minutes. The ease is good, and it’s good that more people are able to own equities (equities are the best passive wealth building tool in history) but there are also good and bad ways to own equities, and the ease seems to more often promote the bad ways.

Active investing is essentially gambling, even for professionals. We know the stock market moves relative to news and emotion, neither of which is consistently predictable. We also know that the current price of a stock is the best indication of its current value, stocks aren’t ever ‘on sale’ or ‘overpriced.’ So when an active investor buys or sells a stock share it’s just a bet, a bet that a specific company will either increase in value (in which case you’d buy) or decrease in value (in which case you’d sell). Successfully buying and selling stocks is tough, and no one can consistently do it well enough to beat the market over time, not even professionals. Research shows that the outcome of this active investing style is overwhelmingly negative. That’s part of the reason why we’ve seen a seismic shift toward more passive investment strategies over the last 20 years.

However, we’ve also seen the growth of in-app investing. I’m all for cool apps, and investing apps are among the coolest, but there’s an inherent problem in using an app as an envoy for your retirement. The fact that they are so easy to use is a temptation to actively use them. The fact that they look so nice gives the illusion that we’re doing something responsible with our money. Some offer worthless, even contradictory, commentary on market predictions. Some even promote super risky options (puts and calls) accompanied by incomplete (at best) information concerning the risk involved, and even how they work. Essentially, these apps promote a sort of sophisticated gambling, which is really fun, and really bad for your return probabilities. Apps that have claimed to stand for passive investing seem to be slowly moving toward an active style as well or at least offering it.

It’s probably best to treat investing apps like gambling apps since that’s effectively what they are. Don’t be duped by the bells and whistles, they offer an adrenaline rush and a lot of downsides. Most of us wouldn’t take our retirement fund over to the roulette table and put it all on red (talk about a rush!), so don’t dump your life savings into an app.

You should know something about ETFs

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First things first, if you’re unsure what an ETF (exchange-traded fund) is, let me explain broadly. An ETF is something you can invest money into, it’s an investment vehicle. Like mutual funds, ETFs provide a way for investors to own multiple companies through one fund. You might even have some money invested in ETFs through your 401k or other investment accounts.

ETFs have quickly become a very popular investment option in the US. We hear a lot about robo-advisors these days, their offerings consist almost exclusively of ETFs. In 2016, seven of the top ten traded securities in the US market were ETFs. Assets deposited and held within ETFs have grown substantially within the last 15 years:

Besides all that, ETFs are cool. They’re based on algorithms, you can buy and track them through really nice apps, they’re usually super cheap, the list goes on. They’re the perfect investment for this generation. I’ll admit, they appeal to my millennial preferences too. But, there are a few important things to understand about ETFs before making any investment decisions, and there’s a reason we don’t recommend them.

Now let’s define ETF a little more specifically. The easiest way to explain them is by a comparison with mutual funds. Mutual funds have been around for much longer, they’re a little simpler, and probably a little more familiar. We’ll look at two distinguishing characteristics between mutual funds and ETFs:

1) Ownership.

A mutual fund owns shares of different companies. So if you buy one share of a mutual fund, you’re actually investing in each of the different companies that the mutual fund owns. Different mutual funds make different decisions on which companies they own. Some are actively managed, meaning there’s a manager buying and selling different shares within the mutual fund; some are passively managed, meaning they own a group of companies that are chosen based on a set of rules and the companies don’t change too much; some are index funds (which is a type of passive fund), which means they own the same companies that an index tracks (like the S&P 500); there’s no shortage to the type of mutual fund you can own, there are lots of them, and they’ve been a very popular investment vehicle for a long time. The thing to remember is that the value of a mutual fund is the value of the stocks it owns. Mutual funds actually own stock shares.

ETFs also invests in different companies, and different ETFs have different criteria for the companies or sectors they invest in (the most popular ETFs track with the S&P 500). However, ETFs don’t actually own stock shares in those companies. Instead, they own pledged assets, which are contracts to provide shares. Essentially, ETFs own rights to shares. This brings benefits like low expense ratios within ETFs (no fees for buying and selling stocks since the only things that trade within an ETF are contracts) and occasional tax savings (if you have a taxable account).

2) Fund type.

Mutual funds are their own separate type of investment, they’re not like stocks. Mutual funds are only valued once per day, after the close of market. Then all the stocks and investments within the fund are added up and the value of the mutual fund is determined anew. Because of this, you can only buy and sell mutual funds once per day, when the value has been calculated. Mutual funds are a longer type of investment by design. That doesn’t mean the holdings within the mutual fund are long term, a mutual fund manager could be making trades inside the mutual fund at any time, but the mutual fund itself can’t be day-traded or hedged or anything you might do with stock holdings.

ETFs however, are traded on an exchange, which means they act like a stock. You can make inter-day trades, the value is moving whenever the market is open, you can hedge and short and order stops, and engage in all sorts of risky stock market things. It also means there’s a fee for each trade, which isn’t necessarily a problem, but you wouldn’t want to be executing lots of ETF trades. This extra trad-ability makes mutual funds appealing for many. The trade costs are a bit of a deterrent, but you can actually day-trade with ETFs.

So that’s what ETFs are. The rise of ETFs in one of the most significant changes in the world of investing over the last 20 years and many people are excited about the opportunity. Here are a few reasons why I’m less excited, and why we don’t recommend ETFs for our investors.

Regulation surrounding ETFs has proven insufficient. I’m usually not a big proponent for the increase of regulation, but when it comes to ETFs, the lack of regulation is a real problem. There currently isn’t even an official legal definition for ETFs so they’re regulated individually, fund by fund, under mutual fund rules. As you’ve seen above, ETFs differ from mutual funds in significant ways, and mutual fund regulations simply can’t account for the discrepancies.

Since ETFs own contracts for shares instead of actual shares, the value of an ETF is tied to the viability of its contracts to perform, its arbitrage mechanism. Theoretically, the value of an ETF should be the value of the promised shares (like mutual funds are valued based on the shares they own), and usually, it is, but not always. When the price diverges, the arbitrage mechanism has to kick in to bring it back. So there’s a whole new type of risk involved, the reliability of the arbitrage mechanism, which can also dramatically affect the price. The fact is, when the market is stressed, the arbitrage mechanism can fail, causing massive swings in the pricing of ETFs, unrelated to the underlying stock assignments. That’s not just a hypothetical, it has happened, and continues to happen. August 24, 2015, is one specifically egregious example. It’s not entirely clear how or why these things happen from a market perspective, and the differing regulations (even between funds with the same pledged assets) only cause more uncertainty. The whole system is shrouded. What we know is that the inconsistent regulation, the cloudy definitions, and the unreliable arbitrage mechanisms have created more risk for ETFs. Unfortunately, it’s impossible to quantify the additional risk in any meaningful way because there are still too many unknowns. Investopedia even admits in reference to ETFs, ‘the perceived increase in volatility needs further research.’ In its current state of affairs, the ETF market is simply not reliable enough to recommend as a vehicle for a person’s life savings. There seems to be increasing support for research and regulation surrounding ETFs so the issue is certainly not over-with, perhaps we could even end up recommending ETFs to all of our investors in the future, but for now, stick with some good old mutual funds.

 

Sources:

Financial Times: The $5tn ETF market balances precariously on outdated rules

Financial Times: Market turbulence revives fears over ETF structural issues

Evanson Asset Management® – Are DFA Strategies Superior?