In just the last year, the number of exchange-traded funds (ETFs) on the market has shot from 267 to well over 500, with a backlog of ETFs currently at various phases of development. Some have called it a bubble. Iconic figures like John Bogle, Warren Buffett and William Bernstein have expressed their cynicism about ETFs.
Have ETFs become a mania? Do ETFs induce investors to self-destruct? Is there an ETF bubble? Here’s a brief sample of the ETF fiction that’s floating around:
1. ETFs encourage investors to become hyperactive traders.Intraday liquidity is an important product feature of ETFs. It gives investors a flexible exit strategy by allowing them to buy and sell shares when the financial markets are open for business.
In recent years, trading in ETF shares has exploded and many funds, such as the SPDR Trust (which tracks the S&P 500 under ticker SPY) and PowerShares QQQ Trust (tracks the Nasdaq 100 as QQQQ) dominate the daily volume on major stock exchanges.
However, it’s a widely known fact that large institutions — not individual investors — account for the bulk of ETF trading volume. It’s true that some individuals have become compulsive traders, but the fact is that many were trading stocks in exactly the same way long before ETFs arrived on the investment scene.
After all, individual stocks also have intraday trading just like ETFs. Should we make the case that stocks should be completely avoided because they trade daily and might induce investors to needlessly trade? Making a similar claim against ETFs is irresponsible. Should we fault automobiles for car accidents? How about blaming fire for burning people? Knives for cutting people?
2. ETFs are a bad choice because of the growing number of poor ETF investment options.One gander at the mutual fund marketplace reveals a true lesson in financial clutter. Counting funds with multiple share classes, there are over 20,000 mutual funds to choose from. How about the 9,000 or so hedge funds? Even though the ETF market is headed for the same overcrowded destiny, the clutter is arguably worse elsewhere.
With ETFs, just like with mutual funds, investors need to choose wisely. Favoring funds based upon traditional indexes with rock-bottom costs and a long-term investment horizon never hurt anyone. This is exactly the sort of high value proposition many ETF families offer for anyone smart enough to notice.
3. ETFs are trading vehicles, not long-term investments.Many ETF shareholders own their funds for different reasons. This is considerably different from investing in mutual funds, where individual shareholders typically share the same investment objective. Some ETF investors may have a short-term time horizon whereas others have a longer-term view.
However, even if some investors choose to trade ETFs excessively, this doesn’t diminish their appeal for buy-and-hold investors. I believe ETFs best serve investors that are managing serious money, not gambling for short-term profits. Independent studies confirm that traditional index ETFs are just as low-cost and tax-efficient over the long haul as traditional index mutual funds.
4. The ETF industry markets and sells ETFs the wrong way, therefore ETFs are bad investments.It’s irrational to judge the investment merit of ETFs by the marketing behavior of fund companies. ETFs should be evaluated by the underlying securities they hold and the investment strategy they follow.
If the ETF industry wants to ape the mutual fund industry by mislabeling funds and launching new products with questionable investment merit, so be it. But broad generalizations and sweeping statements that characterize the entire ETF market as “good” or “bad” are counterproductive.