Making Sense of the ETF Universe

Thursday, April 23rd, 2015


Following on the heels of another strong year, the S&P 500 ended the first quarter of 2015 essentially where it began, posting a gain of 0.40%. What seemed to characterize the first quarter more than anything else was turbulence. Stocks fell 3.7% in January but gained over 5.5% in February then fell 2% in March. It is worth noting that in this environment equal weighted and balanced Index ETF’s outperformed their traditional benchmarks. For example an ETF which weights the S&P index components equally rather than by market capitalization, was up 1.2% in the first quarter more than doubling the performance of the S&P itself. Expectations are for the turbulence that characterized the first quarter to continue so the relative performance of equal weighted funds vs. their benchmarks will be an important trend to watch. Equal weighted ETF’s were not around in 2008, but the research shows that they would have held up better than their market cap weighted counterparts. With this in mind a short essay follows placing the origin and growth of Exchange Traded Funds within the investment landscape of the past 30 years.


As democratic nationalism swept across Europe in 19th century, the French author and humanitarian Victor Hugo proclaimed: “Nothing is more powerful than an idea whose time has come–one can resist the invasion of armies; one cannot resist the invasion of ideas.” Fast-forward to the 21st century and we see a very similar democratizing phenomenon in the world of investing. For decades individual investors had a built-in structural disadvantage to the institutions that dominated the US and international equity and fixed income markets. For the individual investor, research was often second-rate, transaction costs were higher and executions poorer. Since you couldn’t beat them, then why not join them by buying mutual funds and unit trusts. Mutual funds, however, fostered an “in loco parentis,” relationship between the fund and its shareholders by virtue of the regulations established in 1940, which are still in place and govern mutual fund reporting. Funds had no need or desire to be transparent since they only had to report their holdings twice a year and did not need to be particularly timely in doing so.

In the 1980’s mutual fund managers such as Peter Lynch at the Fidelity Magellan Fund became the rock stars of investing and preached a populist message.  Mr. Lynch told Main Street investors that Wall Street had nothing over them. After all, he stated that one of his best investing ideas came about because he had tagged along with his wife on a trip to the supermarket where she bought a pair of Hanes L’Eggs Pantyhose. Mr. Lynch noticed that practically every woman in the market had an egg shaped container in her shopping cart–a phenomenon discussed with trepidation by Don Draper and his team in a recent Mad Men episode since they represented a competitor. After the L’Eggs light bulb went off, Mr. Lynch made a lot of money for himself and the Magellan Fund being an early investor in the company. We all can do this, Lynch proclaimed in his best sellers and on NPR’s Wall Street Week: just look around, keep your eyes and ears open and trust your gut. He made it all sound so simple and the populist-investing theme caught fire. The main beneficiaries were mutual funds such as Fidelity Magellan, whose assets increased astronomically and same day trading brokerages (many now defunct) catering to folks who thought they could be like Pete. The only problem, as investors found out, was that as mutual funds assets grew exponentially at the Magellan’s of the world their performance suffered. If Mr. Lynch had gone to the supermarket with his wife after the large infusion of assets into the Magellan Fund, he could not have bought the stock of a new small company with a bright idea because he would have needed to buy most of the company and the regulations governing mutual funds prohibited that.

Then in the 1990’s, exclusive investment partnerships such as hedge funds restricted to wealthy and institutional investors took over the rock star space from Lynch and other mutual fund managers. Iconic and controversial hedge fund managers such as George Soros, John Paulson and Julian Robertson were now the featured guests on CNBC, Bloomberg TV and other financial networks. Unrestricted by mutual fund regulations, they could use leverage, trade complex derivatives, sell stocks and bonds short (to profit from downturns), and buy all of a company in a hostile takeover. But unlike Lynch, they said to the individual investor, “You’re not anything like us: we’re the rock stars with a complicated secret investing sauce. We are not going to tell you about it, (you probably would not understand it anyway) and don’t think you can replicate what we do”. Individual investors could watch and listen to the rock stars and endowment managers such as David Swenson of Yale University who successfully invested with them, but as the saying goes, that and two bucks got you on the subway. However, a perfect storm was on the way as investors benefited from the information explosion on the Internet and SEC full disclosure regulations created in 2000, which mandated equal access to what had been privileged information. Democracy in the investment world had taken a significant step because in Victor Hugo’s words, “its time had come”. This confluence of events and ideas spurred the exponential growth of a new type of investment vehicle known as the ETF, or Exchange Traded Fund.

An ETF is similar to a mutual fund in that it consists of a portfolio of individual stocks and/or bonds. However, like an individual stock and unlike a mutual fund, an ETF trades on an exchange, its price fluctuates during the trading day, and it can be bought, sold and sold short at will. The first ETF, which replicated the S&P 500 Index, began trading January 2, 1993. Since then the growth of exchange traded funds has dwarfed any other asset class and are owned and traded by individual investors, mutual funds and in large quantities by hedge funds. There is some irony in the most exclusive investment partnerships being the largest holders of the vehicle that levels the playing field for the little guy. Besides funds that replicate broad stock and bond market indices, especially fast growing areas for ETF’s have been funds that own hard assets such as gold, oil and silver. Owning commodities such as gold or oil had always been cumbersome and costly, but buying the ETF that owns the asset and is a pure play on its price movement removes this obstacle. It is safe to say that the explosive rise in the price of gold after 2004 was due in part to the creation of the SPDR Gold ETF.

Since ETF’s are relatively easy to launch , purveyors can take a “build it and see if they will come” approach. Consequently, the ever-expanding universe of exchange-traded funds has spawned some strange birds. There are or were funds that track trends in industries like fishing, livestock and gambling, and some esoteric index funds that claim to replicate a sector, strategy or index that does not seem to exist: try to find the Market Neutral Anti-Momentum Index for example. However, in the past few years there has been an important development in ETF’s that are actively managed and go beyond trying to replicate a passive capitalization weighted stock or bond market index. Large growth areas for ETF’s, for example, have been in quantitatively driven investment strategies, equal weighted index and sector funds and tactical ETF’s that create their own portfolio of ETF’s. Before equal access to company information was mandated in 2000, investing in companies that buy back their own stock or have growing insider ownership used to be the domain of restricted investment funds and research firms that charged heavily for their proprietary information. Now investing in those areas can be done in one click through an ETF.   What had been a richly priced and exclusive investment cake is now more readily available for all to eat thanks to the growth of ETF’s.

It would be a massive understatement to say this has been a game changer in the investment landscape. The hedge fund universe is shrinking as pension funds and endowments shift their allocations away from high-cost and underperforming partnerships. For example, according to the Wall Street Journal, CALPERS, the largest US Pension Fund decided at the end of 2014 to exit entirely from all their hedge fund holdings. Appropriately there is now a user-friendlier, less arrogant guest lineup on CNBC and Bloomberg consisting of affable and approachable managers who say we have created our investing recipes that we’ll tell you about and want you to go out and use. This democratization, still in its early stages might help to restore a more positive perception of the investment management industry that had suffered from a surfeit of arrogance and lack of connection with the public. JP Morgan’s well known comment, “I owe the public nothing” was reiterated in different forms by some of the larger players on Wall Street. Goldman Sachs CEO Lloyd Blankfein had defended his firm in a Senate hearing in 2010 from accusations about their profitable trades betting against sub-prime mortgages they had previously underwritten. Longtime client and America’s favorite capitalist Warren Buffet praised his defense, and rightfully questioned the premise of the hearing. But Mr. Blankfein then said to the Financial Times that his firm, “had only been doing God’s work.” Needless to say Stephen Colbert and Jon Stewart got a lot of mileage from that comment.

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