DO YOU BUY INVESTMENTS LIKE YOU BUY FOOD? The last time you went to the grocery store and bought a new brand of yogourt, cereal, tomato sauce, or any new snack food item; I bet you turned over the packaging and looked at the ingredients and nutritional breakdown. You are very conscientious of what the product may represent in terms of adding to your nutritional balance for yourself and your family members. Did you do the same thing the last time you bought an ETF or an index fund? I doubt it. Why? Probably because a generic ETF based on a familiar index can be seen in the same light as a reputable brand of packaged food (S&P, Dow Jones, TSX, Russell equates to Heinz, Coca Cola, Kraft, Nestle, Danone etc). You are less likely to refer to the back of the package and its contents.
WHAT's THE CATCH ABOUT ETFs? The whole basic premise around building an ETF driven strategy is twofold: To have a basic lowcost packaged method of following the main market indexes, and to sit back with a passive convenient investing strategy that is low maintenance. What's in the packaging? Who cares, right? It's tracking a blue chip index so how can that be a bad thing? This is where the passive part can slowly creep in and compromise your returns and damage your investing confidence. It's always good to watch your diet.
PASSIVE CAN MORPH INTO COMPLACENT. What's wrong with being passive as an investor? Nothing really except that it very often invites a sense of complacency for you as an investor and the person that's running your portfolio. Complacency is a dangerous affliction for anyone entering the investment fray - especially stockmarket participants. Because when you wake up and take notice that the porftolio is offside - that the returns are dramatically lagging the plan or the benchmarks - it can be a very upsetting experience. And an upsetting experience can turn one into an overly risk averse creature, someone who simply disengages from the process - not a winning investing formula. That's where ETFs present a major danger and traditional stockpicking, portfolio rebalancing, and trading literally keeps you engaged and on your toes. Sometimes we want a home cooked meal.
LOW COST. NOT EXACTLY. MORE LIKE CCCM! Finally, what's wrong with the obsession for low cost financial products? Lots. Once again, it takes away from the true driver of long term results by invoking a cost savings mindset that now is so ridiculously marginal and commoditized, that the special opportunities presented by market volatility, newly discovered investment ideas, and agile portfolio management are completely lost as the true value creators in the portfolio management process. It defers to what I call CCCM: convenience, commoditization, complacency, and mediocrity. Sounds like fast food!
THE TALE OF A NEWLY INDEXED STOCK.
In order to give you a specific picture of how passive ETF investing and index investing can be contaminated with some hidden costs, take note of the following anecdote. Just last week a company I follow (that will not be named here) was added as a stock component into one of the TSX/S&P indexes. Based on that announcement and a necessary follow up by all types of index tracking investment portfolios that emulate this index, there is a necessity within a short period of time to run out and buy that stock in these indexed portfolios in order to properly comply with the investment strategy. But here is the problem. Sometimes these indexed companies' stocks do not have many shares available on the market to accomodate the necessary buying that is required to fulfill the index requirements. So what happens? The price gets bid up, sometimes quite dramatically. In this particular case I can tell you that by astonishing coincidence that the shares have risen close to 20% since the announced news about its addition to the index. Nobody knows for sure whether the price rise is solely a technical event driven by index fund intervention, or that other forces are at play. Regardless, that seems like a rather DRAMATIC price to pay .....all in the name of passive investing. That could give you ETF heartburn.