Why ETFs Aren’t Risk Free the Way Most Investors Think

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If you’re an investor, you’re probably aware of exchange traded funds, better known as ETFs. Every bull market in stocks creates new wonder sectors. In the 1990s, it was tech stocks, and the mutual funds that invested in them. Back then, it was an article of faith that you couldn’t go wrong with tech stocks, all the way until the Dot-com bust took them down in spectacular fashion. Is the current bull market repeating the same pattern, but with a different sector? If so, ETF’s could be a parallel false security. As it turns out, ETFs aren’t risk free.

I know I sometimes write like a doom and gloomer when it comes to investing. A few weeks ago I wrote Why the Safe Withdrawal Rate Won’t Work for Most Retirees, challenging another Wall Street article of faith. But the way I see it, Wall Street is increasingly resembling a popular bar on a Saturday night. Investors are drunk on perpetually rising prices. And just as popular bars need designated drivers, I proudly assume that role with investing and retirement.

Why ETFs Aren’t Risk Free the Way Most Investors Think
Why ETFs Aren’t Risk Free the Way Most Investors Think

But it turns out my concerns about ETFs aren’t unique. A couple of weeks ago The Motley Fool ran an article on what I think is an increasingly worrisome trend. In The Hidden Index Bubble they warned that the ETF phenomenon may not end well for investors.

That’s a topic we need to discuss in some detail. Millions of investors have their money primarily invested in ETFs. Like tech stock mutual funds in the 1990s, it’s certain they don’t understand the risks they’re taking on.

Why People Invest in ETFs

Let’s start with the definition. Investopedia defines an ETF as follows:

“…a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.”

While ETF’s are often confused with mutual funds (in a prime example of how investors don’t always know what they’re investing in), they’re actually completely different animals.

Mutual funds are generally what’s known as actively managed. That is, they’re run by a fund manager who actively seeks out stocks that are likely to outperform the market.

ETFs are based on market indexes. For example, a popular index is the S&P 500 index. Rather than selecting individual stocks to invest in, the ETF buys the entire index. That is, the fund will contain a proportionate share of each company in the S&P 500 index.

ETFs have become popular because they take the guesswork out of stock selection. It avoids the need to pick stocks at all, and enables you to invest in an entire market.

It’s easy to see why ETFs have grown so popular:

  • They’re a perfectly passive investment, you’re simply invested in the market.
  • Because they’re passive, they generate little in the way of taxable capital gains income.
  • Based on the underlying index, they rarely trade stocks, which causes ETF fees to be much lower than those of mutual funds.
  • You can invest in a market sector, like high-tech or healthcare, without having to choose individual stocks.

So what’s not to love about ETF’s?

The Professionals Are in on the Act Too

It’s not just individual investors who have fallen for ETFs. Many investment professionals and advisors recommend them strongly. It makes the professional investment manager’s job easier. They can concern themselves strictly with portfolio allocation, and completely ignore the tedious work of selecting individual stocks.

An outgrowth of the ETF phenomenon has been robo-advisors. This development started with popular independent robos, like Betterment and Wealthfront. Today virtually every major investment brokerage firm has their own robo-advisor edition. And as is the case with ETFs, investors are also flocking to robo-advisors.

ETFs work perfectly with robo-advisors too. Robos are based on Modern Portfolio Theory, or MPT. That’s a theory that stresses asset allocation over individual security selection. (I also suspect it adds a touch of white coat scientific research to investing, which has always been far more art than science.)

ETFs fit perfectly within the passive, automated asset allocation-only format of robo-advisors. The robo determines your risk tolerance, then builds a custom portfolio usually comprised entirely of between six and 20 different ETFs. Each ETF represents an asset class. One could be the general US stock market, another can be large-cap stocks, while others hold mid-cap stocks, small-cap stocks, foreign developed nation stocks, emerging nation stocks, US government securities, US corporate bonds, municipal bonds, and foreign bonds.

By investing in a single ETF for each asset class, the robo-advisor can provide a completely diversified portfolio by investing in just a handful funds.

Absent the need to select individual securities, and trade them when necessary, the robo-advisor is able to deliver a professionally managed, fully diversified, low-cost investment portfolio to investors of all sizes.

So far, so good. And that’s the problem.

The ETF Risk No One Talks About

In a comment on the safe withdrawal article linked at the beginning of this post, reader/investor/fellow blogger Ian Bond quoted Mike Tyson’s brilliant saying, “Everyone has a plan until they’re punched in the nose.”

That perfectly sums up my suspicions about why ETFs aren’t risk free. ETFs are a fairly recent phenomenon. The first one rolled out in 1993 – just 25 years ago. But there’s another interesting parallel. A super bull market in stocks ignited in 1982, and but for three brief stock market crashes along the way, it’s been an elevator ride straight up for 36 years.

Question: Would ETFs be so popular in a much less predictable market?

In the steady kind of market increases we’ve seen since 1982, ETF’s are the perfect investment vehicle. You invest your money, and “ride it out” through thick and thin. But thin has been in short supply. That’s been especially true since 2009, when the market has not sustained more than a 10% reversal in nine years.

The kind of market that we’ve been in for 36 years – which most investment experts assume to be permanent – is perfectly suited to ETFs. No stock selection is necessary. Just invest in markets, push the UP button, and ride the elevator to higher stock prices.

But if prices begin to fall in a sustained pattern – which we’re overdue for – or merely move sideways for a decade or more, stock picking is likely to come back into vogue.

It’s easy to invest in markets when those markets rise predictably. But when they start misbehaving, the elevator will start to go down for everyone on it. When that happens, picking strong stocks will be the only strategy left.

WARNING: ETFs reek of the kind of complacency that doesn’t work in unstable markets.

How Hidden ETF Risks Could Hurt Small Investors

If the ETF phenomenon reverses course, the obvious outcome is that small investors will get clobbered. If the decline is particularly severe, or lasts for many years, small investors will be driven from the market. In doing so, they will have locked in permanent losses. The sheer number of small investors invested in ETFs means millions could exit the market, never to return.

Here’s the point: ETFs are only effective in predictably rising markets. My guess is most people who are invested in ETFs believe they’re safe. And why shouldn’t they think that? The investment community has clearly implied as much. They’re safer than individual stocks, safer than mutual funds – heck, they’re practically government bonds.

Except that they’re not.

Here are the basic flaws of ETF’s that small investors are hardly aware of:

  • Even though they’re ultimately comprised of stocks, ETFs are actually investments in markets, not individual stocks.
  • Stock valuation doesn’t matter, since individual stocks don’t matter.
  • Stocks rise in price not because of fundamental strength, but because ETF money flows indiscriminately into the market.
  • The above situation inevitably results in stocks having unsustainable valuations.
  • The typical small investor has no idea what he or she is investing in with ETFs.

I’m not predicting a market crash anytime soon. In fact I’m on record in predicting the Dow will break 30,000 before this run is over. But watch out when it ends.

Index Funds Aren’t as Diversified as We Commonly Think

The S&P 500 – that means you’re invested in 500 different companies. That sounds pretty safe, doesn’t it?

But maybe it really isn’t.

The Motley Fool article points out another important development. The index funds ETFs are based on are weighted by market capitalization. That is, the actual investment mix in the S&P 500 favors the largest companies in the index based on the total market value of their stock.

They break down S&P 500 allocations this way:

  • 13.3% of the index is comprised of just the five largest stocks by market capitalization.
  • The 10 largest stocks make up 21%.
  • The 25 largest stocks make up 31.1%.

In other words, index-based ETF investing means the rich get richer.

An ETF based on the S&P 500 then is not as diversified as we like to think. But even more significant is that index-based investing can drive the valuations of the largest stocks to absurd levels.

I’d also add a fundamental psychological component to the ETF phenomenon. When confidence in an investment strategy grows to the point where no one questions it, disaster isn’t far away.

What Could Tip the ETF Apple Cart

At the risk of sounding overly simplistic, the ETF phenomenon will continue until it doesn’t.

But what can prick the bubble of this seemingly perfect investment universe? Answer: anything that will derail the stock market in general.

The thing is, ETF’s are just another way to invest in the stock market. They don’t represent some sort of investment brave new world. They have their nuances, certainly when compared to mutual funds. But they don’t alter the overall risk involved in stock market investing.

That’s also part of the problem by itself. Investment trends like ETFs cause small investors to believe the stock market is less risky than it really is. And when too many people believe that, trouble starts.

The ETF phenomenon is not some sort of specific bubble that will burst on its own. It’s merely a subset of the general stock market. And when that goes down, it will take ETFs with it – the confident assurances of the investment community notwithstanding.

Anything that can bring the stock market down will also torpedo ETFs. It’s anyone’s guess how that will play out specifically.

My best guess is that will have something to do with a dramatic rise in interest rates. It’s no coincidence that the super bull market in stocks began in 1982. That’s the same year that a long-term trend in declining interest rates began.

Interest Rates are Pivotal

Look at the following chart (courtesy of the St. Louis Fed). It shows the history of the yield on the US 5-year Treasury Note, going back to 1962.

The rate topped out at over 16% in 1981. At that time stocks were in a prolonged 15-year bear market that began in 1966. By the end of 1982, the rate drifted down to just over 10%, a decline from the peak of more than six percentage points. It was during that rate decline in the second half of 1982 that the stock market began its 36-year super bull run.

By early 2009, at the end of the Financial Meltdown, the 5-year note yield had fallen below 2%. It continued to drift lower until it fell well below 1% in 2013. It has since increased to 2.75% as of July of this year. That’s considerably higher than the bottom in 2013, but still at Great Depression-era levels or even below.

It’s clear the bull market in stocks has paralleled the steady decline and prolonged flattening out of interest rates.

But what happens when the interest rate trend reverses?

Stock market “experts” like to downplay the centrality of interest rates in the investment picture. But interest-bearing investments compete with stocks for investor’s money.

If you can get 10% on a CD, you probably won’t to invest in stocks. After all, CD interest is guaranteed, stock gains are not.

But when interest rates on those same CDs is 2%, investors are pouring into stocks. I think that explains the latest iteration of the super bull market, certainly since 2009.

What would cause interest rates to rise dramatically? Certainly not these occasional but much heralded quarter-point hikes in the Fed funds rate by the Federal Reserve. Those are mostly for window dressing, and they don’t have the effect on interest rates we tend to think. And closer to the truth, the Fed isn’t going to raise rates to any level that causes problems in the stock market.

That also helps to explain why interest rates continue to be near historic lows, despite a supposedly booming economy. In a truly market-driven economy, current debt levels would drive interest rates much higher than they are right now. Instead, they remain at artificial lows.

What would cause a legitimate and prolonged spike in interest rates?

The most obvious reason is loan defaults. At very low rates of interest, debt of all kinds has been increasing dramatically in recent years. Defaults could be the result of a weakening economy, or simply too much debt, or combination of both.

And when that happens, and interest rates rise legitimately, the stock market will look like the high risk venture it’s always been.

Until that happens, we’ll continue to play let’s pretend everything is really that great. But once the interest rate dam breaks, the cold reality will be what were we thinking?

When ETFs Aren’t Risk Free Plays Out – Protecting Yourself from the Fallout

The obvious answer is the lower your faith level in ETFs. And it should follow that you should also lower your exposure to them. That doesn’t mean you should dump all your ETFs. But ending further investment is certainly a reasonable strategy.

Don’t assume the ETF success of the past nine years will continue into the future. A declining or unstable market will be unkind to ETFs and to those who invest in them. Stock valuations and picking fundamentally strong companies will come back into favor.

It might help to pay close attention to the actively managed mutual funds that have been performing best since 2009. That’s not a guarantee of future success, but it is a strong indication.

In the meantime, it will help to gradually shift your portfolio from all ETFs into safer assets, like money markets, CDs, and very short-term bonds (less than five years). Exactly when this bubble will burst is anyone’s guess. In the meantime, the best strategy may be to “keep your powder dry”. That means loading up on cash and cash equivalents, and sitting tight until a new trend emerges.

The bottom line is this: ETFs don’t remove the fundamental risk involved in stocks – they only mask it. The stock market has gone straight up in the past nine years, and since ETF investing has grown during that time, the natural assumption is that ETFs are less risky investments.

That theory is unlikely to survive the test of time, and it’s best to be prepared when it happens.

Are you heavily invested in ETFs? Do you assume they’re less risky than stocks or mutual funds? If so, why?

( Photo by francisco.j.gonzalez )

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16 Responses to Why ETFs Aren’t Risk Free the Way Most Investors Think

  1. I wish I could comment on the market’s but I really can’t. I have never owned a stock. I have a deep mistrust for anything wall street.
    I have a self directed IRA that I invest in precious metals, real estate, art, etc, etc.
    Especially growing up around two guys who were very involved in wall street in their adult years.
    They were two of the shadiest people I ever met. They were small timers. They cared nothing for the clients. I always figured their were plenty more where those two came from.
    I’m aware of ETF’s but care nothing about them.

  2. You’re doing just fine without ETFs Tim, so they’re irrelevant to you. Keep on the path you’re on. As for those two guys, don’t assume they’re indicative of everyone in the investment industry. There are those types, but I suspect most are generally honest, but they “drink the Kool Aid” of the industry, which isn’t always in the best interests of their customers. It’s that perpetual push-pull between making money and moral fiber.

  3. Kevin’s piece on ETF’s is a timely caution on the hazards of investing. Risk is inherent in any investment and the only safeguard, other than not investing at all, is to diversify. That said, ETF’s have provided an opportunity for the small investor to get into the stock market, given the high cost per share of the largest and most successful companies. As Kevin pointed out, interest rates have been at an unprecedented low rate and for a very long time so it is no surprise that the stock market seemed to be the only opportunity in town. Kudos to Canada for creating the ETF, I’d say!

  4. Hi Austin – ETFs definitely have their place with investing, and yes, for the small investor too. But confidence in them – particularly their implied safety – is way over done. People are going to get burned in ways they never thought possible. So caveat emptor should never go out of style.

  5. I know. These guys only made there clients half of what they could have made. They would only put them in things that made them the most money. Regardless if there were better things for them but maybe didn’t pay them as much. The person figures he is making money so he doesn’t ask. They used to laugh and tell me this stuff

  6. I used to see these broker statements from client’s investment managers. Many in fact. The client got a 6% return (market was 10%), and the manager took 1.5%. The client made 4.5% and was happy. Worse, the managers made their fee even if the account lost money. But it’s just as much the client’s fault. They want nothing more than to turn their money over to someone else to manage, and go about their lives in happy ignorance.

    Something I also learned back then…there are a lot of people who have a lot of money who are pretty unsophisticated. You wonder how they came into it in the first place. I learned a lot of people are good at making money, but clueless about what to do with it. Then of course there’s more inherited money than most of us realize. For better or worse, those are pockets waiting to be picked, and that’s where you see the financial guys you’re talking about.

    There’s incredible virtue in making and managing your own money from the ground up. You don’t get fancy, but you don’t get fleeced either. And you fully appreciate the value of what you have. It’s refreshing.

  7. I like ETFs for the very low management fees, and the breadth to own entire markets (indices) with little capital. They are particularly useful in Canada where mutual funds are an absolute rip-off.

    Owning an ETF instead of individual stocks allows you spread your risk across many companies. The failure of one company doesn’t sink your portfolio. You are right though, an ETF does NOT reduce overall market risk.

    I found your comment on rising prices very insightful. If people are just buying ETFs (or mutual funds for that matter) indiscriminately, then they are just pushing up prices without regard to fundamentals. Actually this may be more of a mutual fund issue, as mutual funds do not have cap on units issued, whereas (I think) ETFs are typically not a growing block.

    Finally, interest rates. If they rose sharply, the effect would be significant. But they won’t. Governments are simply not willing to raise rates, for two reasons: ( 1 ) governments themselves cannot afford their own debt if rates increase, and ( 2 ) the impact on the economy would be politically unpalatable. Neither the general populace nor policy-makers are willing to face economic responsibility.

    In summary, I think ETFs are an incredibly useful investment tool. But they are not federally insured GICs by any stretch. Like any investment, if you don’t understand it, don’t buy it.

    I am currently invested primarily in individual stocks, but hold some ETFs. I hold some individual corporate bonds, but am not buying any more. I do not buy mutual funds and will never do so again.

  8. I love your comment. I you don’t understand it don’t buy it. I was taught that early on in life and it has served me well. Too many people I know just buy stuff, move stuff around all the time but have no clue what they are doing or what they are trying to accomplish

  9. Neil – I agree that ETFs have their place. I think using them to buy into an under-priced sector makes a lot of sense – as long as you know what you’re getting into. So does using them to take a position in an asset class, the way robo-advisors do. Bond index funds come to mind since it’s hard for smaller investors to diversify into individual issues (but I’d also argue most investors don’t know what they’re getting into with bond funds, and would be better served by Treasury securities or CDs).

    But the basic concept of investing your money in an S&P 500 index fund is often a mask for ignorance. It’s like “I don’t really understand stocks so I’ll invest in the general market”. In that case, you really don’t know what you’re investing in, so you’re really just speculating, thinking you’re investing. That will only become apparent in the next bear market, when investors will be crying that they never knew they could lose money.

    I have to go with what Tim alluded to earlier, that the average investor doesn’t really know what’s going on, and invests in what they don’t really understand. But in rising markets, everyone’s an investment wizard. As the saying goes, “Victory has a thousand fathers, but defeat is an orphan.” I suspect that’s what the ETF phenomenon will turn into in a prolonged bear market. There’ll be a new class of self-proclaimed victims, none of whom were crying on the way up.

  10. Yes, how right you are Kevin. I lived in a very wealthy neighborhood for ten years until I sold. Anyway they used to have block parties and I would go. Everytime I went I would leave wondering how the hell these people got so weathly. They were some of the dumbest people I ever met. I’m not saying all but it seemed the majority I knew we’re.
    What you wrote is exactly why I don’t trust money manangers. You have to be an active participant in your money and where it is and why. What are you trying to accomplish? If you don’t know or ask you deserve to loose it

  11. I have a controversial opinion on this Tim (wealthy people who don’t seem particularly bright). In the past I’ve written that some careers are better and easier than others. But that’s also true from a financial standpoint. For some people, making money comes easy. And when it does, you don’t need to be on top of things. For example, if you make $250,000 per year and aren’t killing yourself, you may have a more casual attitude about money. If you lose it investing or overspending, there’s always more where that came from (this explains why the wealthy are often indiscriminate about spending money). But if you make $50,000 in a tough occupation, you’re more aware of both your spending and investing, because your money isn’t as abundant or as easily earned.

    I’ve learned that the people who make/have the most money aren’t always the smartest, the most talented or the hardest working. A lot of them are just climbing the right ladder, or they work in a field or business that’s hot. You learn these things when you work with people and their money, as I did when I was in mortgages and accounting. People who have/earn more money think differently about financial and spending decisions than people of limited means, because they can.

    That said, I’ve also known a lot of brilliant, hard working people who earn or accumulate a lot of money. But I think there are more of the other type, unfortunately. It’s part of that “life’s not fair” thing. I know we cling to the idea of merit, but that’s not always the case.

  12. You might get a kick out of this story. I have a close friend in Charleston SC. Every year I visit him in spring and fall. We play some golf and enjoy the weekend. This past spring I was at Kiawah Island. It’s a very expensive golf destination. In one of the clubhouses there were cigars that sold for 100 a piece. Of course I’m not buying one. I can but to me it’s a waste. A guy asks me in the parking lot if the clubhouse has any cigars. I tell him but warn him the price. Ten minutes later he walks out with six. 600 dollars for six cigars. So your right about that on many levels.

  13. I’m the same way Tim. Two days I ago I bought tickets for a Daughtry concert for me and my wife. It was $54 per ticket, $108 total. Not bad as concert tickets go. But the ticket broker added on $34 for their cut. I announced to my family that I’m done going to concerts. They’re a big rip off. I can buy a Daughtry CD for less than $10 on Amazon, or I can listen for free on YouTube (and I’m a YouTube junkie to start with).

    It’s not that I don’t like going to concerts, but I don’t like that feeling that I’m being ripped off. And $34 for a broke fee is a rip off. I despise paying inflated prices to line someone else’s pocket, and can’t enjoy participating when it happens. Same with an overpriced meal.

    Back in the 70s and 80s we went to concerts regularly. The tickets were $10 to $20, maybe $30 for the very top bands. They’d play at packed stadiums and arenas. Now they play at small venues because at the prices they’re charging they can’t fill an arena or stadium. The place we’re going holds less than 1,000. I guess they figure they’d rather play smaller venues at higher fees. So be it, they can do it without me.

    My daughter is a concert junkie. I joke that if she and her friends ever stopped going to concerts the whole industry would shut down (no joke, she’s been to two this week, including a Warped Tour). But I’m hearing stories of bands canceling concerts because they can’t sell out, even in small venues.

    What sucks is that everything is like that. When we lived in Atlanta we got free tickets to see the Braves. The tickets themselves were $57 each (OK, they were good seats), which meant $228 for four people. I calculated that if we’d paid for the tickets, plus parking and a meal, it would have come to about $350. When I was a kid, me and my friends used to hop the train to Shea Stadium and watch the Mets. I’d bring $20 and come back with change. And that was after stopping in Manhattan to hang out. I think the general admission seats were $4. You could get a lunch and snacks at the stadium for $5-$6.

    When the hell did everything become so expensive?????? So now we spend our time going to the beach, taking drives in the mountains, going to bars with no cover charge, looking for free concerts around the state (the local talent is surprisingly good!), and taking in an occasional minor league hockey or baseball game.

    And you know what? We enjoy those free and near free activities as much as the gold plated stuff. Maybe more since we don’t usually have to fight crowds to get there and back.

    I must be getting old – I just don’t want to play games anymore…OK, I’m done complaining, and I’m going to get off my soapbox and stop complaining.

    For now.

  14. That’s my strategy Neil, but my family think I’m over-reacting. But to me, when prices get out of hand you simply stop paying them and make other arrangements. If they’re OK paying those prices they can go to concerts without me. I’m not into giving money away to people who don’t need it.

  15. I’m with you. You sound just like me. I stopped doing that stuff a long time ago. I can afford it but it’s just so stupid to me. I kinda of do alot of the same stuff as you. My only real indulgence is golf.

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