DURING THE PAST DECADE, the principles of the traditional index fund (TIF) have been challenged by a sort of wolf in sheep’s clothing, the exchange-traded fund (ETF). Simply put, the ETF is an index fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund.

If long-term investment was the paradigm for the original TIF designed 42 years ago, surely using index funds as trading vehicles can only be described as short-term speculation. If the broadest possible diversification was the original paradigm, surely holding discrete—even widely diversified—sectors of the market offers far less diversification and commensurately more risk. If the original paradigm was minimal cost, then this is obviated by holding market-sector index funds that carry higher costs, entail brokerage commissions when they are traded, and incur tax burdens if one has the good fortune to trade successfully.

But let me be clear. There is nothing wrong with investing in those indexed ETFs that track the broad stock market, just so long as you don’t trade them. While short-term speculation is a loser’s game, long-term investment is a proven strategy, one that broad market index funds are well positioned to implement.

ETF traders have absolutely no idea what relationship their investment returns will bear to the returns earned in the stock market.

The quintessential aspect of the original paradigm of the TIF is to assure, indeed virtually guarantee, that investors will earn their fair share of the stock market’s return. ETF traders, however, have nothing remotely resembling such a guarantee. In fact, after all of the selection challenges, timing risks, extra costs, and added taxes, ETF traders can have absolutely no idea what relationship their investment returns will bear to the returns earned in the stock market.

These differences between the traditional index fund—the TIF—and the index fund nouveau represented by the ETF are stark (Exhibit 15.1). Exchange-traded funds march to a different drummer than the original index fund. In the words of the old song, I’m left to wonder, “What have they done to my song, ma?”

The creation of the “Spider.”

The first U.S. exchange-traded fund, created in 1993 by Nathan Most, was named “Standard & Poor’s Depositary Receipts” (SPDRs), and quickly dubbed the “Spider.” It was a brilliant idea. Investing in the S&P 500 Index, operated at low cost with high tax efficiency, priced in real time but held for the long term, it held the prospect of providing ferocious competition to the traditional S&P 500 Index fund.¹ (Brokerage commissions, however, made it less suitable for investors making small investments regularly.)

The Spider 500 remains the largest ETF, with assets of more than $240 billion in early 2017. During 2016, some 26 billion shares of the Spider S&P 500 were traded, a total dollar volume of an amazing $5.5 trillion, and an annual turnover rate of 2,900 percent. In terms of dollar volume, every day the Spider was the most widely traded stock in the world.

Spiders and other similar ETFs are primarily used by short-term investors. The largest users, holding about one-half of all ETF assets, are banks, active money managers, hedgers, and professional traders, who trade their ETF shares with a frenzy. These large traders turned over their holdings at an average rate of nearly 1,000 percent(!) in 2016.

ETF growth explodes.

From that single S&P 500 ETF, ETFs have grown to account for fully half of the asset base of all index funds—as 2017 began, $2.5 trillion of the $5 trillion total. That 50 percent market share is up from 41 percent in 2007 and only 9 percent in 1997.

ETFs have become a force to be reckoned with in the financial markets. The dollar volume of their trading sometimes constitutes as much as 40 percent or more of the total daily trading volume on the entire U.S. stock market. ETFs have proved to meet the needs of investors and speculators alike, but they have also proved to be manna from heaven for stockbrokers.

The amazing growth of ETFs certainly says something about the energy of Wall Street’s financial entrepreneurs, about the focus of money managers on gathering assets, about the marketing power of brokerage firms, and about the willingness—nay, eagerness—of investors to favor complex strategies and aggressive trading, continuing to believe, against all odds, that they can beat the market. We shall see.

The ETF stampede.

The growth of ETFs has approached a stampede, not only in number but in diversity. There are now more than 2,000 ETFs available (up from 340 a decade ago), and the range of investment choices available is remarkable.²

The profile of ETF offerings differs radically from the profile of TIF offerings (Exhibit 15.2). For example, only 32 percent of ETF assets are invested in broadly diversified stock market index funds (U.S. and international) such as the Spider, compared to fully 62 percent of TIF assets. There are 950 ETFs offering concentrated, speculative, inverse, and leveraged strategies holding 23 percent of ETF assets. But there are only 137 such TIFs (holding 5 percent of TIF assets).

There are also 669 ETFs focused on smart beta and factor strategies, 244 based on stock market sectors, and 156 concentrating their assets in particular foreign countries. There are also 196 broad-based bond ETFs and 422 utilizing high leverage (enabling speculators to bet on the stock market’s direction and then double, triple, or even quadruple daily swings in the stock market!), tracking commodity prices and currencies, and using other high-risk strategies.

What is more, investor cash flows into ETFs are exceptionally volatile, especially when compared to the relatively stable cash flows experienced by TIFs. During the 24 months from the stock market high in April 2007 to April 2009 (shortly after the low of the 50 percent market crash), TIFs experienced not a single month of negative flows. Flows into ETFs, however, were negative in 10 of the 24 months, ranging from inflows of $31 billion in December 2007 (near the market’s high) to outflows of $18 billion in February 2009, when stock prices hit bottom. Counterproductive investor behavior writ large.

Yes, in almost every respect, most ETFs have strayed far from the concepts of buy-and-hold, diversification, and rock-bottom cost that are exemplified by the traditional index fund.

The renowned Purdey shotgun is great for big-game hunting in Africa. It’s also an excellent weapon for suicide.

Broad-market ETFs constitute the only instance in which an ETF can replicate, and possibly even improve on, the five paradigms listed earlier for the original index fund—but only when they are bought and held for the long term. Their annual expense ratios tend to be comparable to their TIF counterparts, although their transaction commissions erode the returns that investors earn.

The early advertisements for the Spider claimed, “Now you can trade the S&P 500 all day long, in real time.” And so you can. But to what avail? I can’t help likening the ETF—a cleverly designed financial instrument—to the renowned Purdey shotgun, supposedly the world’s best.

The Purdey may be great for big-game hunting in Africa. But it’s also an excellent weapon for suicide. I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting.

The temptation to chase past returns.

But whatever returns each sector ETF may earn, the investors in those narrow ETFs will likely, if not certainly, earn returns that fall well behind them. There is abundant evidence that the most popular sector funds of the day are those that have recently enjoyed the most spectacular recent performance. But such success does not endure. (Again, remember reversion to the mean [RTM].)

In fact, such after-the-fact popularity is a recipe for unsuccessful investing. That was the lesson of Chapter 7—that mutual fund investors almost always do significantly worse than the funds they own, and do still worse when they choose funds that are less diversified and more volatile. That pattern is likely to be repeated, even magnified, in ETFs.

Among the 20 best-performing ETFs, for 19 funds, investor returns fell short of ETF returns.

To illustrate this point, consider the records of the 20 best-performing ETFs during 2003–2006. Only one ETF earned a better return for its shareholders than the return reported by the ETF itself. The average shortfall in shareholder returns was equal to 5 percentage points per year, with the largest gap fully 14 percentage points (iShares Austria reported a return of 42 percent, but its investors earned just 28 percent).

“HANDLE WITH CARE” should be the first warning on the ETF label, though I have yet to see it used. Or perhaps: “CAUTION: Performance Chasing at Work.”

A “double whammy”: betting on hot market sectors (emotions) and paying heavy costs (expenses) are sure to be hazardous to your wealth.

And so we have a “double whammy.” Investors who choose, or are persuaded by their brokers, to actively trade ETFs face the near-inevitability of counterproductive market timing, as investors bet on sectors as they grow hot—and bet against them when they grow cold. Second, those heavy commissions and fees accumulate over time, as expenses take a growing toll on ETF returns.

Together, these two enemies of the equity investor—emotions and expenses—are sure to be hazardous to your wealth, to say nothing of consuming giant globs of time that you could easily use in more productive and enjoyable ways.

Beginning in 2006, ETFs became the cutting edge of the alleged “market-beating” strategies that I’ll describe in the next chapter. The entrepreneurs and marketers of these so-called smart beta strategies seem to believe that their “fundamental indexing” and “factor” approaches are winning long-term strategies. Yet by choosing the ETF format, they strongly imply that bringing stockbrokers into the distribution mix—and encouraging investors to actively buy and sell their ETFs—will lead to even larger short-term profits. I doubt it.

ETFs are a dream come true for entrepreneurs and brokers. But are they an investor’s dream come true?

ETFs are clearly a dream come true for entrepreneurs, stockbrokers, and fund managers. But is it too much to ask whether these exchange-traded index funds are an investor’s dream come true? Do investors really benefit from being able to trade ETFs “all day long, in real time”? Is less diversification better than more diversification?

Is trend following a winner’s game or a loser’s game? Are ETFs truly low-cost vehicles after we add their brokerage commissions and taxes on short-term profits to their expense ratios? Is buy-and-sell (often with great frequency) really a better strategy than buy-and-hold?

Finally, if the traditional index fund was designed to capitalize on the wisdom of long-term investing, aren’t investors in these exchange-traded index funds too often engaging in the folly of short-term speculation? Doesn’t your own common sense give you the answers to these questions?

The interests of the business versus the interests of the clients.

On the broad spectrum that lies between advancing the interests of those in the investment business and the interests of their clients, where do ETFs fit? If you are making a single large initial purchase of either of those two versions of classic indexing—the Vanguard 500 ETF or the Spider 500 ETF—at a low commission rate and holding the shares for the long term, you’ll profit from the broad diversification and the low expense ratios that both offer. You may even enjoy a bit of extra tax efficiency from these broad market ETFs.

But if you trade these two ETFs, you’re defying the relentless rules of humble arithmetic that are the key to successful investing. And if you like the idea of sector ETFs, invest in the appropriate ones, and don’t trade them.

Answering my question.

Let me now answer the question I asked at the outset of this chapter, “What have they done to my song, ma?” As the creator of the world’s first traditional index fund all those years ago, as I observe the ETF phenomenon I can only answer: “They’ve tied it up in a plastic bag and turned it upside down, ma; that’s what they’ve done to my song.”

In short, the ETF is a trader to the cause of the TIF. I urge intelligent investors to stay the course with the proven index strategy. While I can’t assure you that traditional index investing is the best strategy ever devised, I can assure you that the number of strategies that are worse is infinite.