The HS Dent Financial Blog

RSS      

The ETF Bubble

We’ve been a big fan of the exchange-traded fund as an investment vehicle for quite some time.  The instant diversification, tax efficiency, liquidity, and low transactions costs make them ideal for many investors and traders alike.  Mutual funds are still better in certain situations, such as when you have frequent, small contributions–as in the cases of 401k accounts and some variable annuity sub-accounts, for example.  In most such cases, investors are not charged brokerage commissions on new additions, whereas they would with ETFs.  Along the same lines, reinvestment of dividends and capital gains are generally done automatically and at no cost with mutual funds.  With ETFs, it is entirely up to the broker, and many do not offer “DRIP” programs.  

Still, on balance, we lean toward ETFs as the preferred vehicle on most occasions. That said, there  can be too much of a good thing.  And the flood of new ETFs that have hit the market in recent years would seem to fall into that category. 

We periodically get marketing materials from Barclays announcing new additions to their iShares ETF product offerings.   Over the years, we’ve watched their product sheet grow from half of one page, to one page, to one page front and back.  The most recent sheet we received was actually a two page, front-and-back booklet with an extra one-page insert listing their spin-off product, the iPath Exchange Traded Note.  (We should hasten to add here that we like Barclays products.  This is not intended as a criticism of the bank.  We simply use them as a high-profile example).   

In total, we counted 180 iShares ETFs and an additional 30 iPath ETNs, mostly relating to commodities.  That’s over 210 tradable index funds, and this is just one fund company.  Powershares, Wisdom Tree, State Street Advisors, and other, newer fund companies no doubt add several hundred more to the mix.Needless to say, there is a fair bit of redundancy.  The three ETFs used to track the Russell 2000 and its companion Growth and Value indices have rather tight correlations to the three corresponding S&P 600 Small Cap ETFs and to the three that track Morningstar small cap indices.  Do we really need nine ETFs that essentially track the same thing? We are a little more understanding of the industrial sector funds, which break down the market into technology, healthcare, financials, etc.  and to the single-country and international funds.  But even here, there is a fair amount of overlap that can get confusing.

It is the commodity ETNs where we are the most skeptical.  Recent product additions have included lead, nickle, tin, cocoa, coffee, and cotton.  Cotton?  How much retail demand can we possibly expect for a cotton ETN?  And given some of the unintended consequences of legions of naive retail investors jumping into a relatively thinly-traded commodity futures contract–such as the now infamous contango issue that decimated USO in early 2009–is it a good idea at all? Likewise, the emergence of double- and triple- leveraged ETFs does nothing to achieve the original intent of sector ETFs–instant targeted exposure to unique risk and return factors–and instead do nothing more than encourage greater speculation and portfolio churn.  Though some traders may benefit from them, we view these funds as a net loss to the investing public and as an unnecessary addition of volatility to a market that scarcely needs it. 

Like all other areas of the economy, high returns attract new competitors.  The supply/demand conditions that made the high returns possible eventually get turned around when a flood of new supply overwhelms existing demand.  The high returns that attracted the competitors eventually get whittled down, and weaker competitors and products leave the market.  We would expect their to be some kind of shakeout in the ETF sector in the months or years ahead.  Because it’s hard to imagine demand ever rising to absorb this level of supply, at least for some of these.  Again…cotton?  Seriously?