Monday, December 14, 2015

ETF Fear, Uncertainty, and Doubt

There have been a number of prominent articles about the dangers of trading Exchange-Traded Funds (ETFs) over the past year. The latest ETF story is from the Wall Street Journal. I read each of these articles looking for some new concern, but they tend to be the same recycled fears along with a scary title. Here I’ll list the categories of concerns and what I do to try to avoid trouble.

1. Some ETFs stink.

Yup, that’s right, not all ETFs are great. Some have high built-in fees and others are too narrowly-focused to be safely owned by the unwary. I stick to very low cost index ETFs.

2. Investors can lose money trying to actively trade ETFs.

True. That’s why I don’t trade them actively. Apart from a rare need to rebalance my portfolio to my target asset allocation, I don’t plan to sell any ETFs until I need the money in retirement. I buy more ETFs when I have more savings to invest.

3. Sometimes ETFs trade for prices far from their Net Asset Values (NAVs).

The NAV of an ETF is the price it should trade for based on the current price of the stocks or other investments it holds. ETFs are structured to keep their prices close to their NAVs, but it’s possible for ETF prices to differ significantly from their NAVs. This is rare, but it has happened. That’s why I always use a limit order.

If I’m going to buy an ETF, I first check that the bid-ask spread is small, and then I place a limit order for a few pennies more than the current ask price. Most of the time my order gets filled at the current ask price. But it’s possible for the price to run up on me. In this case, my order won’t be filled at a price higher than my limit. Similarly for sales, I place my trade a few pennies below the current bid price to limit the damage in case there is some sudden volatility.

Some people ask why I go a few pennies worse than the best currently available price. The answer is that I couldn’t be bothered to have to place my order again if the market happens to move a penny and my order never gets filled. By placing my order a few pennies away, this rarely happens to me. Because the market gives you the best available price even if you say you’ll accept a slightly worse price, my strategy rarely costs me extra.

4. Investing in ETFs cuts into the livelihoods of people peddling expensive mutual funds.

This is the unstated motivation behind some ETF fear mongering. I can’t tell for any particular article whether the writer has this motivation, but you can be sure that it is behind some stated ETF “fears.” Just to be clear, I have no reason to think this particular Wall Street Journal writer’s motivation is anything but concern for investors losing money trading ETFs using market orders.

I’d be pleased to hear if there is something else I should be doing to protect my portfolio, but I’m not going to lose sleep over yet another article about ETF dangers.


  1. Good article MJ. There is a never ending need for content on the 3 trillion web sites in existence so just about anything can get published.

    1. @Marko: True. But I was hoping for more from the Wall Street Journal.

  2. This is a question and a comment. Why don't you just buy the securities held by the ETF? An index fund must hold all the stocks in the index including the "good" the "bad" and the "ugly". I tried to avoid the "ugly". The fees for an ETF are low but ongoing. I pay a one time fee of between 0.05% and 0.1%.

    1. @John: To avoid the "ugly," you have to be able to identify ugly stocks. I can't. Out of 1000 people who say they can, I doubt that more than 1 actually can. What most people do is identify stocks that have gone down in the recent past (which says little about the future). So, if my stock picks are essentially random, I would either hold a modest number of stocks and suffer the drag from increased volatility, or I would hold a lot of stocks and pay extra for commissions. Either way, I'm better off with the index ETFs.

  3. People actively trade ETFs? #WTF? I suppose you can try to use a chainsaw to cut your hair too, but I wouldn't recommend it

    1. @Big Cajun Man: The trading volume on the most popular ETFs is insanely high. Hair-cutting with a chainsaw is probably less popular.

  4. WSJ is trying to sell papers or pageviews just as much as any other site :)

    A good reminder that no investing approach or product is perfect - far from it.