Are ETFs Becoming Too Complex?

Exchange traded funds have surged in popularity as more investors realize the benefits of lower investment costs and broad diversification. They started out as a way for investors to tap into the returns of major stock markets using a nice convenient low-cost package that trades like a stock.

With passive investment management, a computer could literally manage the portfolio because all it has to do is hold the same stocks that the market holds in the same proportion. In their purest form, ETFs provide low-cost diversification and efficient access for individual investors to various asset classes, industries and countries.

Traditional stock indexes select the largest and most frequently traded companies and weigh them by their market capitalization (stock price times outstanding shares). This is called a cap-weighted index and is the cheapest and most common.

The go-to index for the broad Canadian market has been the S&P/TSX Composite, which includes about 250 stocks, and the S&P 500 for US stocks.

Two to four broad market ETFs will give an investor an easy to manage, low cost and diversified portfolio that will give exposure to thousands of stocks across the globe. That, plus regular contributions, rebalancing as necessary, and staying invested is an effective strategy that would make a successful investor out of anyone.

But this doesn’t seem to be good enough. Why merely settle for market returns? Why not tweak the portfolio composition with a few very specific subsets of funds that use various active management styles or delve into some smaller, atypical sectors (e.g. individual countries, digital currency, alternative harvest, gender diversity to name a very few) in order to generate a bit more return?

This tendency does not only affect DIY investors. Investment advisors, knowing the psychology of their clients, also tend to over-populate portfolios promising increased returns but often those two or more pages of funds contain very similar underlying investments.

Not only are these sector funds much more risky, having tiny percentages of several different funds can make it a nightmare to rebalance your portfolio. And, note that even though these funds may closely track their underlying index, that doesn’t mean that they are good investments. How do they compare to the overall market?

Active strategies making ETFs too complex

The number of Canadian ETFs now exceeds 600 and the number of new entrants is expected to accelerate in 2018, so clearly there is a demand for the new and unusual.

There is an increasing trend towards creating ETFs using more active strategies designed to beat the market, as well as a growing number of niche products and exotic strategies that seem to go against the very idea of passive investing.

• Fundamental indexes are based on a company’s total sales, cash flow and dividends.
• Equal-weighted indexes allocate each security to a fixed equal weight.
• Leveraged ETFs use a range of strategies such as derivatives, futures contracts and options to amplify the moves of the underlying index. They attempt to achieve daily returns of 2 or 3 times the index.
• Inverse ETFs are similar, but opposite, meaning they will gain double or triple the loss of a market.
• There are funds whose primary purpose is to short specific stocks or sectors, and funds that hedge one asset class against another.

Many of these are definitely not appropriate for long term holders.

The bottom line

ETFs have undoubtedly improved the investment choices available to individual investors.

The original purpose of ETFs was to passively track an index in a low cost, diverse and tax efficient manner. Investors were looking for simplicity and transparency.

The industry has very competent marketers who are increasing the number and the complexity of your choices.

What was once a simple and efficient investing strategy is now becoming more confusing.