Friday, May 23, 2014

Fallacies of ETFs

This post is updated in 2016.

I have posted a long time ago that investing in ETFs could be one of the easy ways to make money. The theory was simple. Since 80-90% of all investors never beat the index, then why should we even try? We should just buy the index. That was simply buying ETFs. Since ETFs replicate the indices and are traded just like any stocks. We can easily buy them using one of the brokers like Poems or Kim Eng or whatever.

We stand to enjoy market growth (8-10% per year) and we need not worry too much about losing our shirts.

Well, the story didn't turn out that way. As I have mentioned before, every investing decision only has a 60% chance of getting it right. At best. There is no such thing as a sure win... far from it. Investing is just a bit better than playing roulette, betting red or black whatever. Of course, roulette is actually only about 40+% of winning since the zeros and double zeros somehow appear more often than they should. So 60% is as good as it gets.

Back to ETFs, what looked like a good way to invest turned out to be wrong. Even Buffett got that wrong. He did advise laypeople to just buy ETFs if value investing is just way too tough.

Why did ETFs fail?

Well, the following would be my own reasons:

1. There are only one or two ETFs that generated good returns over time.

The famous ETF that we should buy is the one that replicates the S&P500. All the other thousands of ETFs out there just don't generate good return over time. Why? Because ultimately ETFs are just putting different stocks together. If you put enough crap together, you will still just get crap. Worse still, the crap overwhelms the true good gems or firms and you do not benefit by investing in such ETFs.

Even for ETFs that replicate market indices like those of the Hang Seng, or Nikkei, or China's A share or India's Sensex. The construct of most indices by definition includes a lot of crap such as financial entities, domestic firms and moatless businesses. Hence by investing in them, we might be able to generate a positive return over a very long time frame (like 20-30 years) but the return would just be mediocre (like low single digit). 

The reason why the S&P500 have historically been a good performer is probably because it represents the success of capitalism hitherto and the dominance of the US economy across the hundreds of stocks. Also, the index itself is actively managed by a committee. There are professionals debating which stock should be taken out and which stock should be added in. The careful selection ensures that the 500 companies are the real global dominant leaders with superb businesses like Colgate, 3M and Johnson & Johnson etc. By investing in this special ETF, you are buying pieces of great businesses. 

Over a good long term investment horizon, the indices of other key economies such as DAX of Germany, FTSE of UK and Hang Seng of HK/China had also performed well, representing the success of these regions/countries. Alas, for most of the other ETFs, especially those that were cut to finely like tech ETF or oil and gas ETF or renewables ETF etc, the returns are just too crappy. Even our own STI index. The longest dated chart from 1999 showed it started at 2000 and after 15 long years it's now at 3000. Yes 50% return but over 15 years just means that it's a paltry 3% return per year.

FSSTI over 15 years

2. ETF came with too much hidden costs.

After investing in ETFs over a few years, I have come to fully appreciate some of these hidden costs associated with ETFs. I must admit I have not understood these fallacies holistically and some of my claims here have to be further verified. They are just hunches that I believe could be true. 

Now the few problems with ETFs are: forex, dividends and liquidity. How forex is being mitigated in ETFs is not completely clear to me but my experience with the banks tells me that forex is a big way that banks can cream off the customers ie us. Ultimately ETFs are products pushed by the banks and I would think that ETF investors are also taken for a ride.

A few ETFs pay dividends which is all good and proper. But sadly, the majority of ETFs don't pay a single penny even when the underlying indices have good dividend yields. For instance, the Brazilian stocks that make up most Brazilian indices now pays 3-4% dividend but most Brazil ETFs do not pay anything to retail investors! Again, I see this as another way of ripping off investors.

And finally the last problem with liquidity is real and visible. ETFs traded on SGX are very thinly traded and the spreads could be very wide like 2-4% or more. Some are not even tradable since there are no market makers ie if there is no one on the other side of the trade, you cannot buy or sell the ETF.

So in short, while ETFs work on theory it just doesn't work in reality. That reminds me of Yogi!

"In theory, there is no difference between theory and practice. In practice, there is." - Yogi Berra

My experience with ETFs tells us that we make single digit return at best and probably barely breakeven if we enter at the wrong times. We stand to have a good chance of generating good return only when we buy the S&P500, which is the exception rather than the rule.

In the end, the best way to invest is to find great companies with great businesses and buy them at reasonable prices.