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Eric Nelson: Why ETFs Are Inferior

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Advisor and investment writer Eric Nelson joins Jack Bogle in the lonely corner of market observers who don’t share the general public affection for ETFs.

In his two most recent posts, the feisty investment pundit whose pen (or keyboard) has not spared even St. Jack, this time forms common cause with the Vanguard founder who counsels investment in index-based mutual funds but not ETFs.

In a broader examination of the topic, Nelson, a registered investment advisor who is principal of Oklahoma City-based Servo Wealth Management, decries the ease with which ETFs can be abused. That is, their stock-like tradability invites frequent portfolio adjustments that end up hurting long-term investors.

Nelson also approvingly cites Bogle’s criticisms that many ETF products — such as sector and country funds — are too narrow for most investors, and he quotes Bogle’s description of leveraged and inverse ETFs as the province of “fruitcakes, nut cases and [the] lunatic fringe.”

But more generally, from the standpoint of a financial advisor’s toolkit, Nelson regards ETFs as inferior products. Because they are meant to track an index, they carry all the shortcomings of that index.

These include structural problems such as reconstituting only once or twice annually, which allows traders to front-run index changes, thus distorting prices, and means holdings get stale and off-target. Indexes with small and illiquid holdings face the additional difficulty of buying and selling on a set schedule when prices may be unfavorable.

While Nelson acknowledges the industry is seeking to address these problems, he draws an unflattering comparison between the results of his own preferred Dimensional Fund Advisors mutual funds and comparable indexes.

Over extensive periods and in categories from U.S. to international to emerging-market large, small and value stocks, the DFA funds’ edge over the indexes was minimally 0.6% in the broadest large-value area all the way to a whopping 3.6% annual improvement in emerging market small-cap area, the most illiquid and costly investment category.

Nelson points out a few of his comparison’s ironic results:

“DFA’s US Large Value fund has outperformed the Russell 2000 Value (small cap) index despite a sizable historical small cap return premium. The DFA International Small Cap fund, with no value orientation, has matched the MSCI EAFE Small Cap Value Index. And the DFA Emerging Markets fund (DFEMX, +10.4%) almost matched the MSCI Emerging Markets Value Index and beat the MSCI Emerging Markets Small Cap Index despite robust small cap and value return premiums over this period,” he writes, adding that the indexes used in his table carry no expenses, unlike the DFA funds, and thus understate the funds’ superiority.

In a second, more narrowly focused post, the Servo Wealth advisor takes on the sacred-cow subject of ETFs’ vaunted tax efficiency.

Comparing a broad market ETF portfolio (a typical choice of do-it-yourself investors) with a DFA Funds “asset class mix” (30% large-cap, 30% large-value and 40% small-value) and a third tax-managed version of the DFA asset-class mix, Nelson finds that the two DFA alternatives trounce the ETF total market portfolio.

Both DFA funds lead by 1.5% annually over the 12 years from 2003 to 2015 before taxes.

(Note that the indentical performance of the DFA tax-managed and non-tax-managed asset class portfolios is a tribute to DFA’s ability to not impair investment results even while excluding tax-inefficient investments such as REITs from the portfolio.)

But the real issue is how do the funds stack up after taxes.

Nelson finds that ETFs do, to some extent, prove their worth by losing less to taxes than the mutual funds, with 0.4% lost to taxes versus 0.7% for the regular DFA asset class fund and 0.5% for the tax managed version.

But given their significant return advantage, the regular DFA fund still beat the ETF basket by 1.2% whereas the tax-advantaged version — by losing just 0.1% to taxes over the ETF — maintained a 1.4% annual lead.

“By using tax-managed mutual funds, investors are able to closely mimic the returns of traditional small/value-tilted portfolios with overall tax efficiency as high as the most tax-efficient ETFs available,” Nelson writes.

While not a fan of ETFs, the pundit does acknowledge that ETFs can be a reasonable option for do-it-yourself investors. “Good, not great,” is his faint praise in an interview with ThinkAdvisor.

“They’re much better than actively-managed funds: lower cost, more tax efficient, etc.,” he adds.

But the advisor and investment optimizer says they trail the funds he uses by 1% to 2% per year.

As he concludes his first post:

“As advisors with a fiduciary responsibility to clients…we…attempt to use only those [products] that deliver the highest return in the asset classes we want to own. Squeezing a bit more out of your portfolio can help [clients] retire sooner, generate a larger stream of cash flow in retirement, and leave a larger legacy to those you will one day leave behind.”

– To hear Nelson debate Meb Faber on investing strategies, check out ThinkAdvisor’s May 7 webinar, The Great Asset Allocation Debate.

— Check out Faber’s No-Fee ETF — and Why Asset Allocation Doesn’t Matter on ThinkAdvisor.

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