Why ETF Investors Are Such Lousy Market Timers

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[dropcap]E[/dropcap]xchange-traded funds (ETFs) have taken the asset management industry by storm. Since the launch of the first ETF in 1993, the funds — which are essentially index funds that can be traded throughout the day — have taken in so much money so quickly that what was once unthinkable is now well within the realm of possibility: There might one day be more assets in ETFs than in equity mutual funds.

That day is likely well into the future, given that stock mutual funds, with some $6 trillion in assets, still retain a healthy advantage over ETFs, with $1 trillion. But the fact that it’s even a possibility is a testament to how quickly ETFs have been adopted by investors, advisors, and the financial media. In fact, you’d have to look long and hard to find anyone with a critical word to say about ETFs.

Well, here’s one.

For all of their popularity, the evidence indicates that investors in ETFs, to their detriment, aren’t using them very wisely.

ETFs v. mutual funds

First, it’s important to note that there’s a difference between the returns reported by mutual funds and ETFs and the returns actually earned by their investors. The former is calculated as the growth of $1 that was invested at the beginning of the period, and remained in the fund for the duration.

But most of us don’t invest that way. Cash flows into and out of our investments any number of times during a period of years, which ends up producing a gap between the returns reported by our investments and the returns investors ultimately end up earning.

Consider, for instance, the ten years ended June 2011. Mutual fund investors actually acquitted themselves quite well, trailing mutual funds’ reported returns by just 0.18 percent per year. Cumulatively, mutual fund investors captured 95 percent of the return earned by the funds they owned during this period.

ETF investors didn’t fare so well during this period, lagging the return earned by the ETFs they owned by nearly 1.5 percent per year in that same decade. Cumulatively, their return was just 70 percent of average ETF return during that period. Quite frankly, it’s been tough enough making money in the stock market over the past decade without leaving 30 percent of the potential return on the table.

So why are ETF investors earning such a lower share than mutual fund investors? In a word, trading.

The real culprit (no surprise): Human error

The fact of the matter is that the primary difference between an ETF and an index mutual fund is that the former can be traded throughout the day, while the latter can only be traded at the close of the market each day. But that seemingly small difference gives rise to rather enormous differences in how the two are used. Investor holding periods for the typical equity mutual fund are about 2.5 years. That’s hardly anyone’s definition of long term, but it makes mutual fund investors look like they have the patience of Job in comparison to ETF investors, whose holding periods are most typically measured in days.

But judging by their returns, ETF investors are pretty lousy market timers, largely because they follow their emotions. They load up on stocks when the market is soaring — preferring, of course, those styles and sectors that have done particularly well — and bail out when the market falls. Buying high and selling low is no one’s prescription for building long-term wealth, which is why we see the gap described above.

Further harming investor returns is the sort of ETFs that have been launched over the past few years. Early ETFs tracked broad market benchmarks, such as the S&P 500 and the MSCI EAFE indexes. But the newer breed of ETFs have been focused on much narrower slices of the market — specific sectors, styles, or regions of the world. Setting aside the wisdom or value of owning a fund focused on the water industry or the palladium market, for instance, the fact is that these narrower investments are a great deal more volatile than their broad-based kin. And that volatility only further encourages investors to act upon their emotions, which of course ends up eroding their returns even more.

Does this mean that investors should avoid ETFs? Absolutely not. Chosen prudently and used as part of a well-reasoned portfolio, ETFs can play an important — even the primary — role. But be aware that temptation lurks, and because ETFs are oh-so-much easier to trade at the click of a mouse, they make it that much easier to fall prey to the perils that plague all investors — doing precisely the wrong thing at precisely the wrong time. That’s a far better way to destroy wealth than it is to build it.

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Contrarian Advisor

After spending decades in the financial services industry studying both investor behavior and the broad array of investment alternatives that they can choose from, the Contrarian Advisor is convinced that the surest route to long-term investment success is driven by simplicity and low costs.

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