Journal Focuses on the Negatives of ETFs

Just when you think they get it… the media point to the exceptions, not the rule. The Wall Street Journal reported today that ETFs are meant to track established benchmarks and that many of them are failing to accurately track those benchmarks. The commentary went on to discuss how many funds are not living up to hypothetical rates of return.

I hate to make a comparison to the tragedy in Virginia this past week, but the Journal writer’s commentary holds as much water as the following: "The role of the police is to protect us and many of them are failing to do so."

The vast majority of police throughout Virginia and throughout the country do an exceptional job at protecting and serving their communities. Are there a few bad eggs? Yep… in every basket. (And that includes the 600 or more ETFs… some of them aren’t the best choices!)

While it’s one thing to point out the few ETFs that may or may not have failed us, it’s quite another to shine a microscope without considering the laboratory. For instance, we "hire" ETFs to provide diversification at a lower costs than mutual funds. The overwhelming majority of ETFs provide diversification at a significantly lower expense than traditional mutual funds.

Similarly, we "choose" ETFs that track established indexes because those ETFs (a.k.a. exchange-traded index funds) outperform actively managed mutual funds. The overwhelming majority of ETFs reasonably approximate the desired index and… more often than not… outhustle actively managed mutual fund performance.

We "invest" in ETFs because of their transparency (i.e., we know what’s in the index), flexibility (e.g., we can buy and sell them at a desired price point) and tax efficiency. The Journal’s commentator described the fact that 3% of ETFs had some form of capital gains distributions in 2005, while 6% of the expanding ETF population served distrbiutions in 2006. This completely ignores the fact that 94% of ETFs DID NOT have capital gains distributions at all, whereas 94% of mutual funds DID.

Moreover, the size of those capital gains distributions are ignored. While a few ETFs (6%) had small capital gains distributions, mutual funds turned out one of the largest distribution years on record. Whereas many investors were paying taxes on a signficant portion of their mutual fund gains, few ETF investors were paying much of anything, if at all. Credit needs to be given to the lack of turnover in the structure of most indexes tracked by the ETF industry.

Perhaps one of the most egregious statements in the Journal’s commentary was the following: "Back-tested data for the WisdomTree High-Yielding Equity Index (DHS) shows average annual returns outperforming the Russell 1000 Value Index (IWD) for several time periods, including by more than three percentage points for the 10-year period ending in March. However, from June 2006 through the end of March, the ETF based on the WisdomTree Index trailed the Russell 1000 Value Index by more than 0.50 percentage point."

Is a 10-month return the same as a 10-year return? With 9 years and 2 months to go, is it inconceivable that DHS may average 3% more than IWD? Since when is past performance a guarantee of future performance? (I seem to recall this being drilled in ad nauseum for the last 2 decades.)

Will every ETF perfectly track an index that it seeks to track? No. Do most ETFs offer index fund performance at a fraction of the cost of mutual funds? Yes. Will every ETF be equally tax-efficient? No. Do most ETFs offer zero or miniscule capital gains disstribution concerns? Yes.

When the media focus on the negatives, try to maintain a genuine affection for the positives. If this is challenging, simply open up your account statements with ETFs and see how much better you have done as an investor since you made the switch!

Disclosure statement: Some of Pacific Park’s investment clients may hold positions in any of the investments mentioned above.

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