Fact or Fiction? 4 ETF Myths
February 10, 2009
By Ron DeLegge, Editor

SAN DIEGO (ETFguide.com) - It’s hard not to be confused by the rapid ascent of exchange-traded funds or ETFs. In just a few short years, the number of new ETFs has climbed from a few hundred to around 700 today.

All of this has sparked a wave of controversy, debate, and criticism about the state of the ETF marketplace. Iconic figures such as Vanguard’s founder John C. Bogle have expressed their cynicism about ETFs. Less iconic figures like CNBC’s Jim Cramer have called on the Securities and Exchange Commission (SEC) to ban certain ETFs.

Sadly, many of these outspoken voices mischaracterize ETFs by making broad assumptions or irrational generalizations. In the end, it does little other than to help the investing public to draw incorrect conclusions.

Here’s a brief sample of the ETF fiction that’s floating around:

FICTION #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 S&P 500 ETF (AMEX: SPY) and PowerShares QQQ Trust (tracks the NASDAQ 100) (Nasdaq: QQQQ) dominate the daily volume on major stock exchanges.

It’s a widely known fact that large institutions account for the bulk of ETF trading volume. Before you believe the false argument that ETFs have transformed an entire generation of investors into hyperactive traders, it’s important to have some context. The vast majority of ETF trading volume comes from institutional investors trading large share blocks, not mom and pop investors trading 400 or 500 shares.

Interestingly, individual stocks also have intraday trading just like ETFs. Should we make the case that stocks should be completely avoided because they have daily volume and might induce investors to needlessly trade? Making a similar claim against ETFs is irresponsible. 

The fact is many investors with chronic behavioral problems were that way long before ETFs arrived on the investment scene. Demonizing ETFs is misplacing the blame. Should we fault automobiles for car accidents? How about we blame fire for burning people? And while we’re at it, shall we fault knives for cutting people? Do you not see the foolishness of such arguments? Likewise, saying that ETFs induce investors to self-destruct is absurd. Investors are the ones responsible for their own financial fate, not ETFs.

FICTION #2 – Bid/ask spreads destroy the low cost nature of ETFs.
Morningstar recently launched a helpful ETF database that reveals the real trading cost of bid/ask spreads. The costs are expressed in percentage terms. Generally speaking, ETFs with lower trading volume tend to have larger bid/ask spreads and consequently higher trading costs, whereas ETFs with higher trading volume have lower bid/ask spreads and cost.

It’s important for all investors to understand that the cost impact of bid/ask spreads is not exclusive to ETFs and that all exchange listed securities (stocks, closed-end funds, ETNs, etc.) have this overlooked cost attached to them. It’s just as vital to recognize that mutual fund investors are also impacted by the trading cost of bid/ask spreads too. That’s because fund managers are buying and selling stocks and other exchange listed securities within their portfolios. In the case of mutual funds, bid/ask spreads are an embedded cost that’s not reflected in the fund’s expense ratio.

It’s interesting that Morningstar was motivated to develop a bid/ask cost database for ETFs, but not for other investment products. Why? Think about it. If the cost of bid/ask spreads is relevant data for ETFs, why wouldn’t it be equally relevant for stocks, other exchange listed products, and even mutual funds?

Yes bid/ask spreads matter, but not any more so than other significant financial costs. Is there any doubt that mutual fund loads, internal portfolio turnover, mutual fund taxes, ongoing 12b-1 fees, and elevated expense ratios are creating more financial damage than ETF bid/ask spreads?   

FICTION #3 – Short ETFs replicate the inverse long-term performance of their benchmarks. 
Short ETFs are designed to provide 100%, 200% or 300% the inverse (opposite) DAILY performance of their underlying index. It is a common misconception that inverse ETFs are constructed to attain the exact inverse performance of their benchmarks over longer periods, such as weeks, months or years.

One example of the failings of short ETFs is the performance of the ProShares UltraShort Real Estate ETF (NYSEArca: SRS).The fund is designed to increase in value by 200% when real estate stocks fall. In 2008, long real estate funds like RWR and VNQ decline by around 37%, Meanwhile, SRS performed even worse, by falling 50.24%! Even though SRS may have been executing its magnified returns on a daily basis, it’s compounded annual returns were highly distorted.

The problem with SRS is the same problem facing all leveraged and short ETFs, namely big time tracking error along with huge year-end tax distributions. And the lesson for ETF investors couldn’t be clearer; Long-term investors using short term ETFs usually get the short end of the straw!

FICTION #4 – The best ETFs to own are the popular ones with significant trading volume.
Just because an ETF is heavily traded, touted by the financial media or follows a well-known index doesn’t necessarily make it the best choice.

For example, the Dow DIAMONDS (NYSEArca: DIA), which follows the popular Dow Jones Industrial Average contains market exposure to just 30 stocks. How can such a tiny basket of stocks provide an accurate representation of the total U.S. stock market? It can’t.

That’s why ETFs following broader but lesser known benchmarks like the DJ Wilshire 5000 (NYSEArca: TMW), the MSCI US Broad Market Index (NYSEArca: VTI), or the Russell 3000 (NYSEArca: IWV) are better choices for investors desirous of complete U.S. equity exposure. 

Conclusion
In summary, arm and defend yourself against the financial fiction that permeates. Your livelihood and financial well-being depend on it. Also, use financial tools like Yahoo Finance’s ETF Center to keep you educated.

The growing number of ETF choices calls for diligent evaluation and discriminating selectivity. It’s up to investors and trained financial professionals to separate the facts from the fiction. You can do it!

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