When Exchange Traded Funds ( ETF’s) first were introduced they were compared very favourably to mutual funds. Much lower management fees, no deferred sales charges, better performance, more strategic tax efficiency were factors that investors needed to make the switch out of mutual funds.
Today there are so many types of ETF’s that many investors really do not understand what they are invested in and how much risk these investments incorporate.
The basic principle of mutual funds and ETF’s is risk reduction through diversification. The influx of sector and active ETF’s both on the long and short side of the market has materially added a level of risk that was not the case for passive index ETF’s of the overall major market indices.
New ETF’s are being created every day that supposedly satisfy client’s needs for equity participation in sectors of the market such as biotech, pot stocks, country specific emerging markets and cyber security. The list is endless and expanding continuously.
Despite the benefits of these trends, the traditional advantage of risk reduction from market diversification is being overshadowed by the sharp increase in unique risk. This risk is not being adequately conveyed to retail investors by the creators of ETF’s who are principally driven by increasing their revenues at the expense of everything else.
In addition, index funds do not perform well in a declining stock market as there is nowhere to hide. Well informed investors that can foresee a market correction can take risk off the table by adding more cash and reducing the equity exposure to more volatile sectors and increasing the weight in more defensive sectors like utilities, Reits and consumer staples. Stock picking becomes even more important at this time.
Individual stock investing has unfairly received a bad rap for being too risky for many investors. However as long as one is sufficiently diversified across all eleven equity sectors, combined with spreading the risk by investing in both value, growth, small, large cap and international companies, stock investing can produce superior returns and lower risk than many ETF’s.
Furthermore, analyzing individual companies is much easier than attempting to do research on ETF’s Lack of transparency, limited disclosure of material factors and a short historical track record make ETF investing much riskier than a disciplined investment of individual stocks. Basic fundamental stock analysis is just not possible with ETF’s. In most cases the security regulators only require the top ten holdings and this is simply not sufficient to accurately determine the level of risk assumed. Secondly the holdings can change frequently and this makes the investment analysis even more difficult.
Good fundamental stock selection on individual companies produces a factor called alpha that is the unique advantage that one company has over its peers. Alpha is defined as the excess returns created by investing in companies that beat their benchmark indices. This is the factor that the best money managers such as Peter Lynch, John Templeton and Warren Buffet use to create their superior long term performance. An investment in an ETF largely ignores or greatly diminishes the benefits of alpha, although there are some active ETF’s with this goal in mind.
Frequently during my thirty years in this money management business, I have heard many retail client advisers belittle the benefits of stock picking. Clients deserve better. The decision to invest in an ETF that may hold a small investment in a superior stock will almost always water down the benefits of investing directly in that stock. Retail clients think they are getting superior stock picking from their adviser, but in many cases this is clearly not the case.
In conclusion, many retail investors are branching away from their investment advisers in order for them to improve their performance, lower their fees and lower their risk.
Investing in individual stocks is one investment approach we cannot afford to ignore.
Peter McMurtry, BCom, CFA
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