Why ETFs Will Remain in the Background

Most Investors are Not Do It Yourselfers

Among investors who are willing to actively participate to some degree in directing their investment portfolios, ETFs have become a very popular vehicle indeed.

These are the sort of investors who used to shop mutual funds, compare returns among them, and perhaps even look deeper into the simple prospectuses that all mutual funds must maintain. Even though these prospectuses are required by regulation, and the detail that even a simple prospectus goes into is pretty deep, very few mutual fund investors pay attention to this stuff or would even have a good idea of what this all means.

Why ETFs Will Remain in the BackgroundWith all of the focus on these fine details, there is so little focus on investor education, although the less education an investor has, the more mutual fund companies like it. The ideal situation for them is investors just saying yes to their funds, and when they start comparing options, including looking at ETFs as an alternative to mutual funds, well there are a lot of options out there and it’s far better to capture them through having them being sold by an advisor, where they just take direction and don’t ask too many questions.

A lot of investors don’t play any role at all in their investments, they don’t select anything really, they just go along with the retirement plan that their employer has selected for them. When the employer is kicking in money to the plan, while employees are free to invest their money elsewhere, there’s just too much of an incentive to go with whatever the company has set up for you.

It’s just not efficient to have employees deciding very much with these plans, as this is a lot like health insurance, it’s far better and cheaper to just come up a plan with very limited choices, or even better, a one size fits all approach.

All in all, a great percentage of the money that individuals invest does not involve very much thought on their part, let alone having them play an active role in the selection and management of their portfolio.

This Isn’t Necessarily a Bad Thing Though

In spite of how much money people put into their portfolios generally, people do not tend to view making decisions about this as something that they are qualified enough to do. It’s not that it would be all that difficult for them to become at least qualified enough to participate in the process somewhat, it’s just that they aren’t motivated enough to do so.

This is due to a large extent with the investment industry’s painting of all of this as being all rather difficult and not something that people who do not have the qualifications and training should become too involved in, or involved in at all. This does serve their interests though, as the sales process is not one that you want clients making too many choices, and certainly not choices beyond what you are looking to sell them.

For those who do go beyond whatever they have set up at work and look to supplement their investment portfolio beyond that, more often than not they will want someone holding their hand, and the hand holders will have a vested interest in not wanting to empower these investors to forage off on their own too much because this will lead to less business for them.

For those who nonetheless wish to become a little empowered at least, as they say, a little knowledge can be dangerous, and there are certainly many tales of people who have messed up their portfolios by assuming they know more than they do, which in actual fact tends to be very little indeed.

The approach that the investment industry takes with managing people’s money en masse does tend to be pretty terrible if we apply the highest standards to it, standards like what they should be doing to both drive performance and manage risk, but to be fair, they do at least a decent job overall given the severe regulatory restraints that they are on, regulations that are much more concerned with promoting their long bias in the markets than the well being of individual market participants.

You aren’t going to just read an article or two and be prepared enough to take the reins and look to significantly outperform the returns and the risk management of these mutual funds though, and this is an area which is not something you just want to be meddling around in with no real skills or knowledge about what you are doing, much like you wouldn’t want to just get behind the wheel of a car and drive in traffic without the proper lessons or knowledge of the rules of the road.

Buy and Hold is At Least a Steady Course

When investors look at ETFs, they generally aren’t taking quite the same buy and hold approach as they would take with their employer sponsored investments or their mutual funds. The employer backed investments do not allow for the possibility of anything else, you are in our you are out, if you want them to back you that is. Mutual funds dealers do their utmost to promote you just holding their funds because when you switch, chances are you’ll be switching to something else, and at best this requires some work on their part if you select another one of theirs. With so many no load funds, there just isn’t any real incentive for them to see you switch, at least initially, although ultimately if investors are in the right funds they will be less likely to become disenchanted and leave.

It one is seeking this buy and hold course that is so widely promoted by the industry, then there really isn’t much of an advantage to trade ETFs over mutual funds, and the ability to close your position today rather than tomorrow isn’t going to matter to those who have no intention of closing them for years, and for whom a day isn’t going to really matter or at least does not seem to matter.

In situations where the market is crashing, this could matter to them a great deal, but few people contemplate such things and the plan often isn’t to sell even then. In order for this to matter much, one requires an exit strategy first, beyond when one retires or some other non-market driven situation.

For a lot of investors, in their current state, it’s probably best that they not become involved at all in managing their investments, and turning things over to an advisor who will direct them toward, hopefully, a suitable mix of mutual funds is not a bad idea at all.

This is especially true if they are using a regular investment strategy, investing a certain amount every pay or every month, and if they can do this without transaction costs, this may be more suitable than paying commissions every time you add to an ETF position.

The Leap to ETFs

In spite of all of this, we have seen a tremendous growth, percentage wise, of investors who do wish to participate in the decision making of their investments, and ETFs both allow for and require this.

There is no incentive though for advisors to promote ETFs like they get for selling mutual funds, because ETFs are self directed. They certainly can sell people on the idea of opening up self directed trading accounts, where they can then place their own trades for the ETFs they desire to be in.

For the most part though, when one invests in ETFs, they are on their own, and therefore very much subject to second guessing. Second guessing is a very appropriate term here since the first decision tends to be a guess as well, although this is not an enterprise that is given over to too much guessing, and especially poor guesses.

Investors who do have a sufficient amount of discipline can migrate successfully from mutual funds to ETFs, although the key here is to stay within your sphere of ability and knowledge and not just assume you have more of these skills than you actually do. This is where people get into the most trouble.

Managing one’s own investments does require a sufficient level of interest, and this is really what’s lacking the most among individual investors. They may want to do this but they may think that there’s nothing to it, but once they take the wheel they may discover that these decisions may not be as easy as they thought.

This is especially true when one starts to question one’s positions in the face of poor performance. People tend to blame their advisors when the market goes against them, even when this doesn’t make much sense, and this blame gets transferred over to them to a large degree when they are trading ETFs.

The pressure and the fear that is involved here is hard enough to manage for them when they have their hands held by these advisors, but when they become the advisor, there is a greater tendency to panic and make poor decisions.

The potential for being guided by emotions and not rational thought is the undoing of most short term traders, where this pressure is greatly amplified due to the increase in decisions that are involved. Longer term investors are subject to less events like this, but when they do arise, they are even more unprepared for them and may be even more prone to make mistakes.

In spite of all of the shortcomings of the buy and hold approach to investing, it is at least a plan, and if one is looking to execute something else, one needs a plan as well. Making investment decisions that are not based upon planning but on reacting, especially reacting to strong emotions such as fear and frustration, is not a good recipe for success.

The surprising thing about ETFs is that they have grown as much as they have given the challenges that this type of investing faces. There are no doubt a lot of investors who have ventured off into the world of ETFs who are either unprepared or for whom this type of investing is simply not suitable, much like so many traders get into trading when they are not sufficiently prepared for it.

You don’t know what you don’t know though. Seeing more investors become more empowered is a fabulous thing, but should an investor wish to become more involved, they owe it to themselves to consider this properly and be prepared to make the proper amount of effort to put themselves in a good position to profit from the decision and especially to avoid harm from it.

When we account for the level of commitment that most investors have to managing their own investments, which is pretty minimal, managed investments like mutual funds are not going anywhere anytime soon and ETFs will likely remain a lesser strategy, in spite of all of their growth, and perhaps they should remain so as well.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: [email protected]

Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.