ETFs Are The Worst Idea Ever Or They Are Mankind's saviour

That title sort of sums up some of the current reading about how ETFs are bad versus the only things we should be using and of course both extremes are wrong. I have to say I am astounded that such bi-polarism still exists 17 years after the first US ETF started trading.

From worst idea ever camp is this article from Chuck Jaffe and what I believe was the tipping point for the collapsing ETF theme that a reader was kind enough to link to. Jaffe’s article seemed to support both Bogle’s idea that they are bad because of the trading they allow (so not the actual product but human behaviour) while conceding ETFs might be the better wrapper than traditional funds but he concluded with the suggestion to wait for five or 10 years for the “revolution” to actually prove out.

My first response to the collapsing ETF idea was no because in the now famous XRT example it would, IMO, be worthwhile for the fund provider to keep a popular and actively traded ETF seeded with capital if somehow there were to be a run. While I believe it would be worthwhile, folks like IndexUniverse did some sleuthing on the matter and the short answer is that creation/redemption process does not allow for the scenario that Bogan laid out in the original paper.

Just because a collapse as described by Bogan appears to not be plausible some other sort of serious malfunction could be. Part of the case against ETFs stems from how they reacted during the flash crash. I think the narrowness of the argument is a miss because of how short lived the event was and someone who actually thought a fund with an NAV of $50 at noon could all of a sudden be worthless at 2:30 probably needs help with their investing. But looked at from a broader perspective the funds malfunctioned for a short while after many, mostly bond funds, had previously malfunctioned during the Lehman panic days drifting very far from their NAVs.

It would be easy to envision some sort of event where an ETF does not recover from some sort of distortion so quickly. I don’t know what this might be but ETFs are investment products that rely on certain things working properly. There can be no assurances that all the things that need to work properly can do so 100% of the time.

From the Mankind’s saviour camp is an article from Seeking Alpha that seemed like nothing but a commercial for a website so I’m not going to link to it but it laid out a bunch of different portfolios using broad ETFs from different asset classes (there were no benchmark comparisons). So the entire business is built on broad ETFs and there are plenty of advisory shops who run their practices this way–that is relying solely on the ETF wrapper.

The best use for ETFs is of course in the middle of the two extremes. A point I have been making from the start has been that ETFs are just one of several tools available to all types of market participants. For some they are vehicles to be traded frequently, for some they are core investments and others still (this is where I fit in) they are part of the solution for portfolio construction and cycle navigation.

Yesterday I read an article making the case for uranium as an important investment for quite a few years to come. For anyone for whom this thesis resonates they would probably want to find a way to add uranium to their portfolio. Once that decision has been made the next step should be figuring the best way in and being open to buying whatever this step yields.

Uranium is obviously a play on the nuclear energy theme. GlobalX has filed for a uranium fund but it is not trading now and there can be no guarantee it will ever trade. There are three nuclear energy ETFs that I am aware of each with varying amounts of uranium exposure. The iShares Global Nuclear Energy Index Fund (NUCL) appears to have 18.1% in uranium miners, the PowerShares Global Nuclear Energy Portfolio (PKN) appears to have 13.6% and the Market Vectors Nuclear Energy ETF (NLR) appears to have 39.5%.

If you are convinced uranium is the single most important theme of the decade are the weightings in any of the ETFs enough? If the 39.5% in NLR might be enough, is the 18% in Japan then a problem? If I loved uranium the 39.5% would not be enough but the Japan weighting would not be too big of an issue as the correlation of the fund to Japan looks low enough to me. FWIW the PowerShares Coal ETF (PKOL) has about 11% in uranium and while the fund itself is interesting it is clearly not a pure play for uranium.

So until GlobalX Uranium comes, if it ever does, and an investor thinks uranium is the most important theme what are they going to do? Obviously right here right now they must consider a stock. There are a few stocks out their to choose from mostly from Canada and Australia. It doesn’t make sense for an investor to deprive them self of “the most important investment theme” waiting for an ETF that could be several years away or might never come.

Contrast that with something like copper miners where there are at least two ETFs or water where there are I think four ETFs and of course there are others. Here there is more choice for anything else that might be “the most important investment theme” which in a way creates more work; the decision of whether one of the ETFs is better or one of the stocks.

A building block for this post is my belief, that IMO has been playing out, that investors above a certain account size need to learn about and implement narrow investments in their portfolios instead of some combo of SPY/EFA/IWM. My preference is to go sector by sector and a perfectly valid way to do this is with a mix of products (for most people this means individual stocks combined with ETFs). Sticking with the materials sector example a blend of something broad based like the Materials Sector SPDR (XLB) or one of the foreign sector funds that will be heaviest in BHP Billiton (BHP) along with a miner of some specific resource or a fertiliser company can work without taking obscene risk.

This can be applied in all of the sectors and ETFs can be a big part of the solution. For people not wanting too much reliance on ETFs functioning normally I would suggest that a basket of staples stocks with products you have used your entire life that have paid decent dividends for decades would not likely all go to zero at the same time.

The all or none idea with ETFs above a certain account size seems woefully misguided.

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