It is no secret that Exchange Traded Funds (ETFs) have been one of the most successful financial innovations of the last 30 years, and it is little wonder as to why—in a world where active money managers have struggled to generate benchmark-beating returns, yet still charge hefty fees, ETFs offer low cost, broad diversification and easy tradability. Unsurprisingly, investors have flocked to ETFs and many Financial Advisors (FAs) have been recommending them to clients en masse, especially following the Department of Labor’s examination of a fiduciary standard a few years ago, as well as the SEC’s Suitability rules.
But are investors really better off with ETFs?
Unfortunately, the answer from several studies seems to be a resounding no. Investors have a very poor ability to select ETFs and they tend to trade in and out of them too often, just like the herding behavior observed in individual stocks.
- In isolation, investors are much worse off as a result of the proliferation of available ETFs versus a market where the only choice they had was to simply buy a broad-market low-cost ETF.
- Investors’ actual returns when using ETFs underperform the relevant benchmark index by 169 basis points per year. Of those basis points, 77 come from poor market timing ability, with the remainder coming from poor ETF selection and the higher cost of ETFs selected by investors compared to low-cost benchmark opportunities.
All of this implies that even if an investor is intent on using ETFs for their investing decisions, the typical investor still benefits from having an FA—someone to help with ETF selection and with restraining the investor’s market timing impulses. Investors generally tend to have one very specific judgment error—they hold losers too long and sell winners too early. In particular, investors tend to sell stocks or ETFs in the month after large price increases and buy stocks or ETFs in the month following large price declines. As a result, they tend to capture negative momentum—one of the key factors that drive long-term portfolio returns, while not gaining positive exposure to any of the other factors such as value, size or beta.
For FAs that want to go beyond just adding value via keeping investors in their seats throughout an investment market cycle, there is a real opportunity to help clients understand what factor modeling is and the results it can have on a portfolio over the long run. The topic of factor modeling, sometimes called Smart Beta, is not well understood by most investors or even some FAs and investment managers, but it is a quantitative investing approach that offers clear performance opportunities for most portfolio managers. As a result, it’s a topic that should be top of mind for FAs, especially in 2023 with the market turbulence we have seen over the last year, and the likelihood of more volatility ahead as interest rates normalize.
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 See for instance Bhattacharya, U., Loos, B., Meyer, S., & Hackethal, A. (2017). Abusing ETFs. Review of Finance, 21(3), 1217-1250.