One of the greatest risks facing investors is the person staring back at them in the mirror. Flush with biases, that reflection often tells a tale of investor mistakes rather than investor success. And following the herd is one of the most talked about impulses an investor can possess. It is understood how herd mentality developed as a survival technique – when the herd runs, few of us want to be skeptical of the group’s decision. What is less understood is why we still do it?
Herd mentality relies on the assumption that everyone knows something that you don’t. Our ancestors wouldn’t wait around to see why everyone was running. Motivated by the possibility of danger, you ran with them. For investors however, the thinking has evolved to a “if you don’t follow the herd, you will miss out on what these investors know that you don’t”. So you buy on the upswing; sell into a dip.
What if, that form of herd mentality aside, carried over into a novel investment idea? I use the word novel to suggest recent popularity and it can aptly be applied to exchange traded funds or ETFs. ETFs, have been around for over a decade. Morphing from the world of closed-end funds, they are structured differently than mutual funds and were originally designed for the institutional investor, an entity who purchases such large quantities of securities because a purchase that large might alter the preferred target price.
So huge baskets of stocks were assembled by the ETF creator, often indexed with a specific weighting, for these large investors. Weighting refers to the way an index is created. In many index funds, the goal is to mimic the published benchmark basket of securities. To do this, how much of which stocks to purchase, as long as the index was followed, can result in better returns. For instance, a small-cap index seeking to mimic the Russell 2000 does not hold 2000 stocks. In most cases, the bottom third are too thinly traded and buying them would alter their underlying worth so the “index” at this level is incomplete. For the S&P500 index, the percentage of top companies in the index fund will lead the performance the markets do well and vice versa. The structure in this case is nuanced.
Exchange traded funds are not that dissimilar. They too buy to mimic an index. But they do so with a slightly different make-up of underlying securities. And this is where investors need to pay attention. Institutional investors know exactly what they are buying, why they are doing so and understand the risks and the costs. Smaller investors are less research oriented. So they are highly susceptible to the herd assuming that the herd knows what’s best.
Making ETFs available to everyone via exchanges, allowing them to be traded throughout the day (something touted as a pricing plus) and introducing ever newer index opportunities and more recently, actively traded ETFs, our primal instincts have been stoked. What, we ask our reflection might we be missing?
The simple answer is something and not-much-of-anything. Exchange traded funds are less expensive than plain old vanilla index funds. But by only a fraction of a percentage point. As I mentioned, they are structured somewhat differently which does protect an investor from redemptions in large part because the way you buy an ETF (or sell one) does not impact the remaining investors.
But in an index mutual fund, a sell-off is a reflection of the market; as it is in an ETF. Only in actively managed mutual funds does this have a negative impact. And ETFs are making surefooted steps into this arena as well and admittedly, this is where they could trump actively managed mutual funds. But those types of funds, transparency aside, are still a riskier investment than an index.
In 2012 you can expect the creation of ETFs to increase to meet investor demand. Mutual funds have seen nothing but outflows of late and not for any other reason than the educational program ETFs have offered about what they are. Mutual funds, to survive this sort of momentum and to keep their shareholders invested should embark on a similar effort. This would be a cultural change that is unfortunately embedded into the mutual fund industry, an air of mystery that surrounds how a fund invests, what the manager is thinking and how much it will cost. It’s changing but slowly.
Is the herd right about ETFs? Not really and they aren’t necessarily wrong either. We have given a great deal of effort trying to figure out who makes money in mutual funds but not so much in ETFs. These funds need volume. They need new investors to not just invest; they need them to flock to their investments. To do this, they market.
This is not a criticism of the worth of these investments. You will begin to see them crop up in 401(k) plans. You will see some plan administrators adopt an all-ETF platform to keep costs down and take you the investor (and all of your biases) out of the picture. But to be successful, they will need you for one bias: following the herd.
The ETF world will continue to chip away at the mutual fund universe. With only one out of every eleven dollars currently invested in ETFs, mutual funds will be around for awhile. But they will be forced to improve. And when they do, they’ll look a little more like ETFs. Mutual funds need to learn how to repackage themselves and the only way to do that is investor eduction. To do that, steal a page from the ETF playbook.
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