Posted in Money on October 31st, 2016
Acknowledging the dilemma of uncertainty, I am not cynical when I say that most people are pretty clueless of where they are going, and the most clueless will most vehemently disagree with me.
~ Andreas Schneider, The New Man
The following post is intended as a thought experiment on financial instruments. I’ve listed reasons in the below post why I’m concerned about ETFs relative to mutual funds. I tend to prefer investing in stocks directly, but due to basket limitations, will use ETFs in some situations. If you fail to perform your own assessment of anything mentioned in this post, or intend to avoid performing any assessment on your own, you should not read this post and stay away from investing in companies in general. Investing requires many hours of work in due diligence, as well as carefully planning for the future of a business.
My generation tends to prefer ETFs over mutual funds, but when asked about these instruments, tend to describe them inaccurately. The main difference between the two is that ETFs supposedly offer liquidity similar to stocks, while mutual funds may come with restrictions. Both also carry other disadvantages from my own point of view only, making stock purchases a superior choice. In this post, I start with what concerns me about both, then move into why my thought experiment leans in favor of mutual funds, if I had to choose.
“SELL EVERYTHING, NOW!” Iceland’s stock market collapsed in a manner that is worse than most of us have ever seen in our lifetime – from around 8,000 to 600 (a 92+% collapse). Most people would panic, throw in the towel, and state that the world had just come to an end. Not me; if something falls 90%, I call it the buying opportunity of a lifetime. Yet, I’ve watched time and time again how a market will drop 80% or more and the mutual funds or ETFs tied to that market “give up” only to be wrong a decade later (Iceland’s stock index, for instance, at the time of this writing is around 1200). Most fund managers don’t have the balls to press on during difficult times, even though – in my opinion only – those are the best times to buy stocks. I like buying my goods 90% off and I love buying my stocks 90% off. This is a strong argument against both mutual funds and ETFs; they inherently provide offerings of markets that are “popular” which is dangerous.
A recent example of this from the last three years is Russia’s stock and currency collapse: ETFs and mutual funds with exposure to Russia took a beating and at one point, many of these were down over 80% in value. That’s when I began to make large purchases of Russian stocks and the Ruble – as Russia raised interest rates, few noticed that its government started rapidly paying off its debt and building a large gold reserve. In addition, Russian companies that didn’t solve real problems went bankrupt in the double digit interest rate environment, while strong companies performed even better than before and rose to the challenge. Multiple ETFs threw in the towel on Russia and if they were still present in the market right now, many of them would be up over 200% as the worst of Russia’s fall has finished. Many of these closed Russian funds will come back, but only after Russia has mostly recovered.
ETFs attract short term thinkers. In my opinion, ETF buyers tend to think very short term and are looking to make a quick profit, much like a stock investor with a short attention span. Compare for instance that I can buy an ETF, sell it tomorrow, then buy it again in a week. This may not be true with mutual funds – many of them place restrictions such as: (1) I must buy a certain amount, (2) if I sell shares, I am then prevented from buying more after a period of time, and – my favorite – (3) some mutual funds are closed, meaning you’re too stupid to be an owner in the first place, so they keep you out (some ETFs are closed ended, though I’ve observed that they have more frequent openings). In other words, a mutual fund is not liquid at all, forcing owners to stop and think about what they’re doing. A close friend of mine once told me that his favorite savings’ strategy was to dump a bunch of money into many different banks and disable all electronic transfers. If he needed the cash, he had to stop and think about whether he actually needed it or not because obtaining the cash required some effort. I don’t like to be part of brainless investors who want to get-rich-quick, or think that ETFs offer a good retirement plan (some people are seriously this stupid).
ETFs encourage short term thinking. The liquid nature of ETFs encourage people to react to events, not contemplate what they’re doing. I could list examples of this all day, and it would be a waste of everyone’s time, so I’ll highlight some examples. Currently, many stocks are significantly overpriced. The probability that they’ll ever be profitable enough to justify their price is laughable at best. Most investors don’t know this; simply ask them how much did the company earn in the last quarter relative to their price and watch them melt into a puddle of ignorance. Yet they’re buying these stocks like crazy. On the inverse of this, what happens when things go wrong and short term thinking rears its ugly head? For instance, I love the people who talk about the “disastrous” stock crash of 1987, when stocks fell 27%. Yet, the stock market ended in positive territory that year, so the crash was the buying opportunity of that year. Likewise, suppose stocks do end down for a year – is that really bad thing, if stocks have been overpriced for a while? No, and we’d recognize that if we reflected about how things are. Of all the critiques of ETFs, this bothers me the least because I can use this to my advantage, as an overpriced security will eventually meet its plummet to a more justifiable level.
Note: people tend to think that the stock market is how to create wealth, which it is not, as the market is for shareholders, or part owners of companies. Being an owner requires responsibility and owners should always be careful about their business being appraised at higher values than it is actually worth, as a “highly appraised” value might encourage an owner to spend recklessly, only to find out that his business is not worth as much as he thinks later, when a difficult season arises. Think of this business analogy like dating: you date a very attractive person, and you are also an attractive person. Because the person you are dating thinks that they are “hot stuff” and perceives that you couldn’t do better, this person treats you however they like. In the beginning you tolerate this (though you shouldn’t), but after a while, you pursue someone else. The “hot stuff” you were dating realizes that they don’t have quite as much value as they thought, and try to get you back, but it’s too late. In other words, their perception of “I can do anything I want in this relationship” actually set the stage for their eventual demise. This consistently happens in business; overvalued companies generally squander opportunity because prosperity destroys fools.
Where does the cash come from in a crisis? If everyone hits the sell button at the same time with an ETF, since it promises liquidity, how exactly does this work, considering that during a crisis there aren’t as many buyers as sellers – and in some cases, no buyers at all? People without brains will often state that the fund will just sell securities, but they’re forgetting that so is everyone else during this time. Remember that ETFs have two values: the value of the securities that it holds and the “appraised” value based on the investor demand (this is how one can arbitrage trade with ETFs). This means that investors might think that they’ll get one price when they hit sell, when the reality is that it could be completely different. Also, if the crisis is bad enough, an ETF may not have the funds that it promises – most of these ETFs do not have that much cash on hand for a crisis and thus I have to wonder how liquid they actually are. I think that we’ll see an ETF crisis in the future that will involve a liquidity problem, where investors don’t get the returns they think and the reason I think this is predicated on the fact that the market experiences many times where there aren’t buyers for a season. Most mutual funds, by contrast, don’t offer any promises or guarantees because they’re inherently illiquid. Returning the earlier point about short term thinking and ETFs, mutual funds during a crisis tend to attract long term thinkers, so those who buy during a crisis (yours truly) will usually look for mutual funds over ETFs, but still think quite a bit before buying. One benefit to investors like myself is that ETFs will probably exacerbate crises, meaning the discount that I’ll buy at will be even greater.
Because no one sees a possible crisis, in our later podcasts we’ll look at some possible scenarios of how this could play out and what investors can do to prepare for these events. Either way, most people don’t think about these things until they happen..
ETFs distract people from what co-ownership means. I received a notice once from an ETF and immediately called the 800 number because I disagreed with the decision that it was making. When I spoke with one of the people at the ETF, he said something which I find sad, but not surprising, “Wow, you actually care about what we do. Most people don’t.” I love it when investors say that “investing in stocks” carries great risks – which really means that if you don’t care about what you’re doing (brainless investing), don’t bother. Make no mistake: when I buy stocks, I vote shares and I pay careful attention to who cut costs, who incentivized workers (very good), and who’s making sure that they’re taking pay cuts when times get hard. Why? Because buying stocks directly carries huge risks and if I “don’t care” then I shouldn’t be buying them. Here’s the deal: when we buy stocks, we become part owners of the companies, so we should always care about what the companies are doing. Reckless companies don’t only hurt shareholders, they hurt their employees, and the attitude of “don’t care” costs everyone in the long run. The same holds true for ETFs: most voting takes less than a minute, though the research part on issues may take some time. Both are valuable and we should all do both, otherwise, we have nothing to complain about when companies engage in reckless behavior.