Why I’m cautious about using ETFs these days…

ETFs (Exchange Traded Funds) are the hottest segment of the investment market lately. For years, more money has been flowing into ETFs than actively managed mutual funds. They are being used by pension funds, robo-advisors, brokers, asset allocation programs and millions of individual investors, who like their low fees, their flexibility for moving in and out of markets quickly and their ability to give performance that is very close to market returns by replicating various indexes.

I am largely an optimist about equity investing, and rarely buy into doom-and-gloom scenarios. However, I have two major concerns about ETFs in the present environment.

  1. The first concern is structural, and has to do with crowd behaviour in a crisis. In a major market sell-off, ETFs could face significant redemptions. Many investors use ETFs as short-term holdings, and ‘hot money’ tends to flow in and out. In a crisis, cascading sales could add selling pressure to all stocks but especially the weaker and pricier stocks in the index. It is possible we could see something new: dozens of stocks going ‘no bid’, where there are literally no buyers for large volumes of many stocks. Market regulators will most likely suspend trading in these securities, and when trading resumes, the crash in those overpriced stocks could drag down the value of the indexes and their corresponding ETFs by a surprising amount. Investors who thought their ETFs were ‘safe’ could be shocked and financially damaged, especially if they panic and sell during the crisis.
  2. My second concern is more long-term. ETFs allow people to buy indiscriminately, buying good stocks and bad stocks without really looking at their price or their true value. This is probably contributing to the current high valuations in many indexes. I am reminded of the ‘Nifty Fifty’ stocks on the U.S. stock exchanges in the ‘60s and ‘70s. These stocks were considered solid, Blue Chip investments and it was widely believed that you couldn’t go wrong owning these stocks. They were bought by so many investors without much regard to price that valuations reached unsustainable levels. When the bubble burst for the Nifty Fifty, it took fifteen years for them to get back to their previous peak. I am afraid that something like this will happen to the more popular indexes, and the ETFs that replicate them.

In investing, following the herd can be one of the costliest mistakes an investor can make. I am still comfortable using short-term bond ETFs, and may look at equity ETFs again in the future. If they disappoint millions of investors and fall out of favour, I will likely be happy to buy them. Until then, I prefer to invest my own money, and that of my clients, with the very best active managers I can find and a select few stocks that are not widely followed by analysts and brokers. I like low fees as much as the next person, but in this case, I think paying a little more for fundamental analysis and active management will save a lot of heartache.

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