ETF’s started out as a noble idea, they were meant to reduce the cost of diversifying a portfolio. Diversification is an attempt to reduce “overall risk”. We know from great investors like Warren Buffett that this idea of risk can be mitigated through simply understanding what you’re invested in, as well as paying a really good price for your investment. That way if things go wrong, you’ll most likely still do okay.
The financial industry’s idea of risk is definitely one of great debate. I personally think it’s utterly irrational and illogical at best. Portfolio risk, according to financial “experts” is defined by something called “Beta”, which simply means that a stock is risky as measured by how far the price traveled up and down compared to the movement of the S&P 500 index. This is illogical for several reasons. 1. There’s no mention of business risk, this is important, because, oh I don’t know, we’re investing in businesses!? 2. If the business value stays the same, the idea that something is more risky the less you pay for it makes no sense whatsoever. What’s riskier for your financial health? Paying $100,000 for an asset that produces $10,000 per year, or $50,000 for that same $10,000?
“ETF’s have big hidden costs called LTE’s or ‘Look Through Expenses’. These are very difficult for you to see, and the company selling the fund does not have to disclose them.”
So the first thing to think about is that ETF’s have big hidden costs called LTE’s or ‘Look Through Expenses’. These are very difficult for you to see, and the company selling the fund does not have to disclose them. These significantly reduce returns, and I personally believe they are immoral. There are several fees, but the biggest culprit of these LTE’s is dilution of stock to pay the management. These shares are basically created out of thin air to be able to pay the CEO with stock of the company, and these shares make your piece of the pie worth less. Over time this is becomes a huge expense.
Companies will also sometimes buy back these shares to offset dilution, which also costs money to do, and the money isn’t coming from the ETF company, it’s coming from you and your ownership stake. Buybacks of shares are often seen as a good thing for investors, but only if their piece of the pie grows because other pieces were taken out of circulation so that they would be entitled to more profit per share. But with these buybacks, 50% of the time it’s just to cancel out the CEO’s pay package shares that were created. I think this is incredibly misleading to investors. Maybe you don’t want to own an individual company that does this? Too bad, ETF’s don’t have many choices. According to Wintergreen Advisers, the average look through expense in 2016 was 4.3%. This is way higher than your 0.04% you thought you were paying! The effects on your returns as the years go by is staggering. If that 4.3% LTE grows at 6% a year, by year 30 you’re paying a 25% look through expense. That’s insane!
“Market Weighted Indexes and ETF’s create artificial bubbles, and basically do the opposite of what they were intended for, which is to reduce risk by diversifying at a low cost.”
Number Two: Market Weighted Indexes and ETF’s create artificial bubbles, and basically do the opposite of what they were intended for, which is to reduce risk by diversifying at a low cost. Market weighted means the biggest companies in the index get more of the people’s money invested in them, but this is only because they’re much bigger than the other companies, and not because they’re a good investment. Because of the structure of Market Weighted Index Funds, they are required to put the most money in the biggest companies, which creates this self fulfilling momentum that artificially pumps up the price of the stock. Think of it like shopping at your favorite clothing store, instead of buying clothes that are on sale and getting really good value, Market Weighted Indexes and ETF’s are buying them at huge multiples of the retail price. Like buying $10 t-shirts for $100, and not because the price of the t-shirt is $100. When new money comes in from new investors, they have to buy that same t-shirt for $110. This is thought to create less risk because the thinking is the bigger the company, the less risky. The opposite is true because the risk comes from paying too much, and ultimately from not understanding what you’re investing in. It also creates something called a liquidity issue, which I’ll get into in another post. Don’t get me wrong, these big companies could be great, but remember, we can’t pay an infinite price, and that’s essentially what ETF’s and Market Weighted Index Funds do. This is an utterly irrational way to try to ‘reduce risk’ in my opinion.
“The opposite is true because the risk comes from paying too much, and ultimately from not understanding what you’re investing in.”
The last thing to think about is how the people running the index funds vote in favour of management recommendations, 99% of the time. This leads to a big conflict of interest, and big costs passed on to you, the investor. Say the board of a big company puts forth a recommendation to increase the amount of shares outstanding so they can pay the CEO a big bonus. They’re basically creating shares out of thin air, and reducing the size of your piece of the company. The company running the ETF’s or the Market Weighted Index Funds could care less that you’re paying through the nose. They get paid by you, the investor, not the companies they’re investing in on your behalf. And because these managers control a huge portion of the shares in the company, most companies on the S&P 500 have ETF’s and Index Funds as their top five biggest shareholders, these ETF’s and Index Funds have a big voice in the decision making of the company. But instead of using these votes to improve the business for the minority owners, you the shareholder, there is a big conflict of interest between their incentives and yours. So because all they care about is how many people are investing with them in the ETF, and they get paid based on the amount of money they’re managing, they vote yes something like 97% of the time on these CEO pay packages, and basically completely ignore all the look through expenses that are passed on to you.
“To put LTE’s in perspective, It was thought that look through expenses amounted to $908 Billion in 2016, which is equal to the 16th largest economy in the world, Indonesia.”
To put LTE’s in perspective, it was thought that look through expenses amounted to $908 Billion in 2016, which is equal to the 16th largest economy in the world, Indonesia.
Personally, I think the best solution to avoiding these fees is for people to take control of their own investing, and start putting their money into companies they believe in, that are run by strong management whose incentives are aligned with theirs, including how they are paid.