A run of the mill attitude is no way to invest

(Published in the South China Morning Post in July 2009)

I'll be upfront. I don't like exchange-traded funds (ETFs) or, more precisely, the way they are being used.

ETFs appeal particularly to those who do not have the time, inclination or tools to sniff out a good active manager. Granted, they have worked well. Over time, stock market indices, which ETFs were designed to track, have outperformed around two-thirds of active managers. Invest a little money in an ETF every month and over 20 years, say, you will almost certainly do better than the average fund.

Institutional investors have long grasped this. For some years a "core/satellite" approach to asset allocation has been de rigueur. The bulk of a given portfolio goes to a passive index tracker, while smaller, but potentially higher alpha-generating allocations go to specialist managers investing in less efficient areas such as global emerging markets.

Originally, index mutual funds performed the passive work. They have got better as computer power has improved. And they have always been cheap, though fees and tracking error can cause them to underperform the index they mimic. But while index mutual funds can only be traded once a day, ETFs are listed and thus provide continual liquidity. Moreover, they increasingly offer access to more esoteric opportunities.

A few years ago, ETFs were good for investing in commodities or single strategies like oil or gold. They had the great benefit of opening up these once-illiquid and seemingly non-correlated investment areas to mainstream investors. Today, such a focus seems run of the mill. There are ETFs that go short; there are leveraged funds; and there are many that don't invest in any physical asset but instead, invest via swaps and other derivatives. All this invention may be evidence of dynamism. But it may also have unintended consequences.

The majority of ETFs originate from big investment banks which alone have the capability to make these products work. Yet in focusing on narrow market opportunities, many of the newer ETFs are not that cheap (once you take into account trading costs and market spreads); and they often replicate customised indices, making them difficult to compare.

Far from being a tool to capture the beta of a well-traded strategy, ETFs are increasingly put forward as vehicles to generate alpha themselves. And because they are listed stocks, the temptation is to trade them.

As US firm Dalbar notes in its annual survey of investor behaviour, mutual fund investors have underperformed markets by several percentage points each year by getting their timing wrong. Time and again we see the biggest inflows at the top of the market and outflows at the trough. There is no reason to think investors timing their ETF trades in gold or oil have done any better.

To my mind, the corporate equivalent of an index fund would be a company that did everything, and in a mediocre, average way. I doubt such a company would last long. Success is about being different not average.

Consider what the bulk of passive strategies do. They track indices based on weights in securities with no distinction between good and bad. By that count, a Dow Tracker would have held General Motors and Citibank until this May (when they were ejected).