Brown: ETFs—Sleeping With the Enemy

To paraphrase Joan Jett, as a financial advisor I hate myself for loving ETFs. It’s complicated.

My love/hate relationship with Exchange Traded Funds stems from their simultaneous ability to both help me with my practice and destroy the market as we know it. Can’t live with ‘em, can’t service my clients without ‘em.

This week the Kauffman Foundation set off a firestorm with a studyblaming ETFs for everything from flash crashes to a lack of new IPOs to restless leg syndrome. And while ETFs are incredible in terms of efficiency and low internal costs, there are inefficiencies and external costs to these products that even a fan like myself must acknowledge.

It is an incontestable fact, for example, that the onslaught of these baskets is engendering hyper-correlation and playing havoc with underlying stocks. It is also undeniable that the commoditization of stocks (treating Intel shares and Transocean shares as though they are interchangeable bushels of wheat) has completely altered the dynamics of investing. The net effect has been to bolster the “rigged game” argument, thus contributing to the already in-progress exodus of retail investors from individual equities.

And yet, I still love them.

Despite this litany of market-distorting characteristics, for the purposes of running money professionally, ETFs are perhaps the greatest financial innovation since the ATM machine.

In the olden days (the 90’s), back when we traded stocks in sixteenths (ask your dad) and listened to Ricky Martin (ask your hairdresser), only the most sophisticated and well-capitalized traders could put on a sector trade with ease. If you wanted to “own energy” going into a crude oil inventory report, you had to ladle on different sized positions of 8 or 9 individual oil stocks. This could involve multiple calculations, symbol look-ups and order tickets.

Fast-forward ten years later and I can express that energy trade with a click. I can make that trade dance - going long the integrated's and short the oil service names. With two clicks I can be long the natural gas exploration stocks and short Brent crude futures. Because of the liquidity and variety of ETFs, I can take exposure on or off, to any style, sector or asset class you could think of.

Are there too many ETFs?

Surely we don’t need a vehicle to play Vietnamese biotechs, do we? Can we agree that a fund of gold miners with CEOs born in April is probably overkill? Sure we can. But who am I to stand at the head of the assembly line and decide which of these bundles gets to make it out of the chute to find an fan base?

And so as we watch them ETF everything that moves and produce me-too versions of existing funds each month, we must acknowledge that this is a bargain. We are getting the convenience of choice and stock-like liquidity in exchange for a risk-on/risk-off seesaw of a market.

I could lament the new reality of this environment all day, but alas, I have ETFs to trade. With $945 billion currently invested in these funds, I’m guessing you guys do, too.

Joshua Brown is a New York City-based financial advisor at Fusion Analytics and the author of The Reformed Broker blog. The opinions he expresses are his own and do not constitute an invitation to buy or sell any securities.