"Nobody goes there anymore. It's too crowded" — Yogi Berra
Exchange Traded Funds (ETFs) are a simple concept which makes getting exposure to shares, bonds, property (e.g. REITs), commodities (e.g. gold) and currencies — easy.
Most people think of ETFs as vanilla index funds, tracking something like the S&P/ASX 200 (INDEX: ^AXJO) (ASX: XJO) line for line, stock for stock. But one of the key features of ETFs is their flexibility.
I recently covered the difference between index funds and ETFs here.
An ETF is flexible because it is simply the wrapper around an investment strategy. For example, Magellan Financial Group Ltd's (ASX: MFG) super-successful super-active and concentrated global investment strategy can now be bought through an ETF, found on Google Finance as MAGELLGEF TMF UNITS (ASX: MGE).
That's right, you can buy into Magellan's active strategy in exactly the same way as you can buy into Vanguard's index-tracking Vanguard MSCI Index International Shares ETF (ASX: VGS) strategy.
In fact, you can buy into all manner of weird and…errr…'interesting' strategies. For example, as I wrote here, you can even buy into ETFs (read 'managed funds') that are supposed to do the exact opposite of the ASX 200. Found on Google Finance as BETA BEAR ETF UNITS (ASX: BEAR), the aptly named 'Bear' fund uses futures contracts to take the opposite position of the market.
"What's a futures contract?" You ask. It's simply a contract to buy or sell shares (or almost any asset) in the future at a pre-agreed price.
But ETF strategies can get far more complicated than that. And they are not without risk.
As Evans & Partners International portfolio manager, Nicholas Cregan, CFA, recently wrote: "ETFs have not resulted in a systemic breakdown in financial markets yet, however if their relative size continues to grow in line with the 30% pa growth rate of the last decade, the ETF liquidity freezes of 2010 & 2015 may be a precursor of events to come."
You are probably wondering what happened in 2010 and 2015.
Back in May 2010 the U.S. sharemarket crashed 9% in 20 minutes — representing a loss of $1 trillion (with a 't') before recouping most of the gains. It is estimated 21,000 trade orders to buy or sell shares were pulled from the market as prices collapsed. For ETFs, which are required to track the market by buying and selling a proportion of shares in the index, that type of market puts their trading systems under pressure. An estimated 68% of the trades cancelled that day came from ETFs. No one was selling!
Alternatives to index ETFs (or any ETFs) include buying your own stocks or getting an active manager to do it for you.
"S&P noted that over the year to June 2016, 85% of U.S. active funds underperformed the S&P 500 index," Mr Cregan noted. "This in itself is not surprising, investors as a group cannot beat the market because in aggregate they are the market; net of fees and transaction costs the majority of funds will mathematically underperform."
Foolish Takeaway
If you own shares in index or active ETFs you are NOT immune from market crashes or adversely weird things happening to your investment. Always read the fine print, and understand the risks before investing because there are plenty of them.
I'm perhaps a little bias, but I think investors with an active and concentrated portfolio, meaning you buy just a few good businesses in large sums regardless of the market weighting, will do best over the long run.
And maybe, just maybe, it's time we stopped taking investing advice from Yogi Berra and saved ourselves some heartache in the future.
