Transcript
Paul Winkler: Welcome to The Investor Coaching Show. I’m Paul Winkler, along with Ira Work and Evan Barnard talking about the world of money and investing.
ETFs
The article in Morningstar “Farewell, Mutual Funds”. We were just getting kind of a kick out of this. Some 20 years after their 1993 debut exchange traded funds had become commonplace. However, several obstacles prevented them from supplanting mutual funds as the main street investment ETFs, Slack sales commissions, which limited their appeal to financial advisors.
And they were almost always passively managed stock portfolios. In addition, several ETFs had behaved erratically and it’s funny, they were passively meaning you don’t have stock picking going on inside of most ETFs still, but they’re used basically we have moved. We’ve transitioned in the world from,we’re going to try to pick which stock is going to be better than another, which area of the market or which sector is going to do better than another.
No. It’s funny. It’s like we have this gambling mentality as humans and it’s hard to break free of that. And hence the reason people are so challenged when it comes to investing so ETFs, they have become more popular. They said that now some of these roadblocks don’t exist. You know, ETFs behaved erratically during the 2010 flash crash, which raised concerns about the group’s structural stability. Roadblocks no longer exist as consequently ETFs are positioned to overtake mutual funds, but the event won’t happen anytime soon because mutual funds possess the power of history.
Currently, US financial mutual funds own $18.2 trillion in assets, as opposed to 5.5 trillion in ETFs. So, you know, they’re basically a quarter, you know, a little bit less than a quarter of the market, but the outcome appears inevitable. ETFs offer several advantages that mutual funds cannot match without counterbalancing drawbacks. Eventually assets will be on their side. I would disagree that there aren’t counterbalancing drawbacks. There are still some drawbacks in, in particularly the, the drawbacks is the lack of access to asset categories and management styles. That would be helpful, and I would love it. I mean, you know, from a tax standpoint, I love the idea of the ETF.
I really do. It’s great. You know, the idea that you can trade a stock during the course of a day is I could care less about that. That doesn’t matter, but just the basis and handling of taxes on them is very good. But you know, the counter balance to that in a big way is that the funds just the asset management style isn’t there and I hope it gets there. That’s one thing. The other thing is just sheer volume. You know, when you’re dealing with low volume asset categories, you know, there are a lot of asset categories that I want to own that quite frankly, there is no demand for the American investor for that asset category.
401(k)s and ETFs
You know, like if you look at a 401(k), I defy you to find hardly, I mean, I’ve, I’ve seen one maybe in 10 years, and it wasn’t even a good one where they had an international small value portfolio or they had emerging markets value or emerging markets, small companies. You just don’t ever see a lot of asset categories and a small value. For example, you don’t see really good funds in that, that space us and we’re talking US yeah. You know, and then you don’t see, and then you see a lot of the capitalization weighting on the ETFs and you just see the problems with the way portfolios managed or managed. And it’s just, it’s problematic to me.
I really would love to see a good fund company that doesn’t wait based on the size of the company that holds the bottom 20%, as far as price to book on the stocks or the bottom 20%, as far as size of the company in the market cap for the company, you know, just manages it in that way and does some of the academic things that I require that was in an ETF. That’d be great, but you know, they’re just not there yet is the issue that I find. And then, because the problem is if you’ve got a fund that’s not very big. The other issue is that they go and shut down the fund on you and they have to liquidate the fund because there’s enough assets in it, you know? So an ETF doesn’t gain critical mass as far as the amount of assets.
And it can be problematic because basically what happens is the arbitrage issue with the ETF. So you have a basket of stocks and then you have the ETF. If the basket of stocks is selling for above the ETF shares, then you have the ETF, the creation, you have the people that have the creation unit that came up with it, have to sell the stocks in order to drive the price of the stocks down and buy the ETF to drive the price of the ETF up. So it’s an arbitrage that’s constantly happening. And if you don’t have that critical mass, it can be a problem. So that’s, that’s one of the reasons that I don’t see it happening anytime, terribly soon, but I hope it does, you know, that’s my thinking.
All right. Did you have some thoughts on that?
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ETFs: Advantage or Disadvantage?
Evan Barnard: Yeah, yeah. I actually pulled that off the same article. I thought it was kind of interesting, a couple of things and one that either, I just had never given a lot of thought to, but one thing was, it showed outflows of mutual funds of about 280 million. Right. And inflows to ETFs of over 500 million or billion maybe. And yeah. And so I’m thinking, okay, well, it didn’t just all go from funds to ETF. So this was either people that were new money in the end coming into the industry. Right, right, right. Advisors or investors doing it on their own or picking ETFs typically for some of the reasons we don’t like them.
Oh, I can sell them at $10 and I can buy it again at $115 and sell it, you know? So that doesn’t bode. Well, yeah. One interesting thing that I just really hadn’t given much thought was it was talking about the fact that you can’t close an ETF. Like you can close a mutual fund. And so, you know, it’s just, it’s there until they’re just gone or whatever, but you can’t just say, okay, no new investors.
Paul Winkler: And, you know, I frankly don’t, I don’t know if I would even consider that an advantage or a disadvantage. It’s just not something that I’ve given a whole lot of thought to. It can be a disadvantage, you know, simply just because of the fact that when you have that level of assets and you’ve got to spread that amount of money over a limited number of stocks that are in the asset management style that you’re trying to go after. Yeah. Now all of a sudden you’re going, well, I got all this extra money coming in and I really don’t want to buy all of this, more of this particular company or these companies, you know, so I could see where that could become a problem because you can’t have, I don’t know.
I wonder if they would bump up against the ownership, you know, capacity issue cities. Yeah. You know, so there might be a problem there too. I didn’t really think about that, but it may be a problem that you can’t have a mutual fund and an ETF can’t own too much or too high of a percentage of any one company. And it’s a control issue, a capacity issue. And they would bump up against that. So that would force them to buy stocks that they didn’t want to buy. That wasn’t necessarily in the asset management style that they were going after. So for example, the example I gave earlier is let’s say that you have an ETF and it’s doing what I like is in the value space. It’s going, well, we want to own value stocks in this.
You know, cause we know that 96% of the time value stocks do better than growth over 20 year periods. And we want to own value. And we know that the area of the market that’s kind of the sweet spot is owning the 20% lowest price compared to book value. So, you know, that’s what you want to do. And all of a sudden, now we’ve got a problem where we got more money coming in. And it’s either changed the relative percentages that we have and maybe buy more of the companies that aren’t necessarily above capacity don’t really want.
And then it’s going well now. It’s going to be the 30% lowest price to book or the 40% lowest price to book or you know, or that. So you end up in a situation where now you have a problem on your hands. You’re buying companies that are not in necessary, Sarah Lee, the space you want, which does what hurts returns, you know? So that, and then the other thing is, is the capacity issue has always been this and Magellan ran up against this right fidelity Magellan, which is where, look at Peter Lynch. He rocks, wow. Look at the returns that he beat the market 11 out of 13 years.
Oh no, here’s the problem. All of a sudden, all this money’s flowing into the fund and they’re like, what do we do with all this money? And then all of a sudden, Peter Lynch couldn’t run his game anymore. He couldn’t manage the way he wanted to manage. And his, the person that took over the portfolio subsequent couldn’t do that either. And it became a glorified index fund is basically what ended up happening. And you’ve just gotten too big. And every time you sell a stock out of your portfolio, every time somebody pulls money out, every time you change a strategy, or maybe let’s say we’re talking about our value fund.
An Example
Let’s let me just use a real example from the philosophy that I always talk about here, owning that area of the market and hanging onto that area of the market.
So I got a company that’s a value company and let’s say that it does like what we were talking about with Ford and GM earlier. It rocks it, it does really well on return. And all of a sudden it becomes a blend company or a growth company even, well, I don’t want to own growth companies in my value portfolio. Now I must sell that particular company, but because my mutual fund is so stinking big and we are such a high percentage, our ownership has such a high percentage of the outstanding stock of that company. Now I have to drop the price to get rid of all the shares I’ve got of that company, which hurts the share price.
And I literally drive the share price down against myself. And that’s, that’s the problem you run into, it’s called the capacity problem. And then vice versa. If I’m going well, you know, we’re this unbelievably huge ETF and we’re wanting to buy the stock because now it’s a value company and it should be in our portfolio. And then we go and buy it and we drive up the price so much. So now it’s the gross company from a price standpoint. I mean, literally you caused these problems for yourself. So, I can see where those would be issues as well. It’s gotta be interesting in the boardrooms. If some of these fund companies are going, can we do this? Because it’s popular and the media is about and thinking, acting like it’s really good.
Evan Barnard: You know, my money is on. That’s what they do.
Paul Winkler: Yeah. You better believe it. You better believe it. It’s like, what will people buy? This is the mentality of the investment world. Anyway. That’s interesting stuff. So, yeah, thanks for sending that along ETFs mutual funds. Is it going to be something of the past? Well, there are a few hurdles. Let’s just put it that way. You’re listening to The Investor Coaching Show. Paul Winkler, along with Ira Work and Evan Barnard, we’ll be back right after this stay tuned.
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