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Sunday Papers

The Sunday Paper – The Dark Side of ETFs

Feeling good about the market? Wanna get some money to work on Monday because the German data last week suggests the Eurozone might be in better shape than previously thought? Whatever you ‘feel’ about markets and, more importantly, the feeling you can somehow time your purchases and sales for optimum effect is almost certainly wrong.

For clarity’s sake let me remind; you can’t time markets, it can’t be done, by anyone, and has never been possible. It’s as mad a notion that somehow you can go into a casino and beat the house. However, just as millions of idiot punters go about with the idea that on certain days they ‘feel’ lucky so too do millions of investors regularly buy and sell stocks because ‘they’re about to break out!’ or ‘they’re finding a bottom here’, or some similar nonsense (BTW, the academic literature on this is very dense and yes, it applies to all of us).

You may by now have guessed where I’m going with this?

The paper I’m highlighting this week, the first of it’s kind from October 2013, looks at the ease with which ETFs allow investors to buy and sell which in turn leads to a loss of any benefit they may gain from diversifying their portfolios. In short, ETFs allow investors to play market timing games (which they will always lose!) in a way in which an investment in a traditional mutual find makes harder.

The paper’s authors, Mr. Utpal Bhattacharya et al, conducted a study of just under 7,000 clients of one of Germany’s largest brokerages between 2005 and 2010 and if you’ve dabbled in this asset class either professionally or personally I’d urge you to read the paper in full which you can access via the following link http://som.yale.edu/sites/default/files/files/20131115_The%20Dark%20Side%20of%20ETFs.pdf

An interesting follow on observation is that investors’ portfolios that included ETFs exhibited persistently higher returns on the non ETF portion i.e. the users are actually not bad stock pickers but would get better returns if they just concentrated on that strategy.

Teach the controversy? Vanguard conducted a study in 2012 (https://personal.vanguard.com/pdf/s318.pdf) that came to the conclusion ETFs didn’t induce punting; but as they’re a big supplier of these products I’m inclined to think, well, they would say that wouldn’t they?

The bottom line chimes, for me at least, with all the accepted literature on what makes for good investing. ETFs, if used wisely, have benefits but only in the context of some cardinal investment rules. Diversify, but not too much. Manage your portfolio, but doing nothing is usually a more profitable decision than doing something and above all, be reminded successful investing is a marathon not a sprint.

The main problem with ETFs is they encourage and facilitate sprinting; fun, but when it comes to successful investing, the tortoise really does have the more reliable track record.

Happy Sunday

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