This advantage relies on the indexes having solid rules that they stick to. For the most part, indexes simply do not change their rules even when the pressure builds up because of some hot trend.
“If we have some rule and we change it overnight, we have riots on our hands. There are situations that naturally happen in the capital markets, which put those rules under pressure, but they are relatively rare. People like what we do to be stable and reliable, and we can’t just change the rules on them at the drop of a hat.”
Passive Investing
Lack of emotion is related to the overall move to passive investing. More and more people are losing faith in a manager’s ability to pick winning securities. And why shouldn’t they – it is very difficult to beat the market.
This dips into a concept known as efficient market hypothesis, which is that at any given time the market has already priced in all the available data, and thus it is nearly impossible to know more than the market. This is not a hard concept to fathom when you consider all the manpower dedicated to analyzing securities. For example, Amazon alone has 40+ analysts covering it. These are people that do nothing but look at Amazon and the industry it operates in. Many U.S. stocks have 40+ analysts, as shown in Figure 1.3.
Figure 1.3 Total Analyst Recommendations for Large U.S. Stocks
Source: Bloomberg
The broad analyst coverage makes it difficult to gain any kind of an edge. Other areas such as fixed income and emerging markets may have less coverage and may present more opportunity for a stock picker. And that’s why in those areas – plus fixed income – you will find institutions tend to go active, while going passive with U.S. equities.
Just look at the top 5 funds in the world (including ETFs) as shown in Table 1.7 and you will see that literally all of them are passive stock index funds.
Table 1.7 The Top 5 Largest Funds in the World
Source: Bloomberg
Index investing gets associated with Average Joes using their 401(k) plans. But some of the most successful people in the financial industry who know the most about Wall Street are index investors when it comes to their own personal money. I call them “celebrity indexers.” They include Jack Lew, Janet Yellen, Michael Lewis, and Ben Stein. We know this from what they’ve said in interviews or their financial disclosure documents. Heck, even Bernie Madoff endorsed index investing from his jail cell as the least likely way to get ripped off.
But perhaps, the most famous fan of indexing is Warren Buffett. Here’s what Buffett said in a recent letter to shareholders about what he would invest in right now:
What I advise here is essentially identical to certain instructions I’ve laid out in my will. My advice to the trustee could not be more simple. Put 10 % of the cash in short-term government bonds and 90 % in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, individuals – who employ high fee managers.”3
Buffett specifically points to pensions and other institutions. Given who is saying this, you have to wonder why institutions don’t just follow the Oracle of Omaha and use the Vanguard S&P 500 ETF (VOO) and the iShares 1–3 Year Treasury Bond ETF (SHY), two very liquid ETFs with a blended fee of 0.06 percent a year. Not to mention a 10-year annualized return of 7.5 percent, right in line with the bogey most institutions are trying – but typically fail – to hit. I will be referring to this mini-portfolio as the “Buffett Special” throughout the book.
Flexibility
Flexibility is huge to institutions. This is what the book is about. See, there are many ways ETFs can be used besides a long-term investment. This book covers about a dozen of those usages. You can go long or short with an ETF. You can use them as portfolio adjustment mechanisms. You can do tax-loss harvesting with them. You can use them as placeholders or lend them out to generate income or use options with them. The list goes on.
“We use ETFs in a lot of different ways here. And flexibility is really the nice thing.”
ETFs also allow investors to access both beta (market return) and alpha (excess return). On one hand, ETFs can be used to grab as much beta as possible for those who simply want to own the market(s). Sort of like the aforementioned Buffett Special portfolio. This is a worthy pursuit for sure, especially for buy-and-hold investors.
But for those investors looking to find alpha, or excess return above the market, ETFs are useful for that, too. Alpha can be generated in two main ways using passive ETFs. First is by organizing your ETFs in such a way that you overweight or underweight different sectors, countries, or factors that you think will outperform. Many have called this “alpha through beta.” This is what ETF strategists have built a $100 billion industry doing.
The other way is through buying an ETF that is designed to try and generate alpha on its own, either through different weighting schemes – frequently called “smart beta” – and/or actively managed ETFs. We will discuss this in great detail in Chapter 7.
Anonymity
As an ETF analyst, I’m always asked, “Where did the flows come from?” or “Who did that big trade?” My answer is always the same: “I don’t know.”
No one knows. Even the issuers don’t know. There’s an anonymity and privacy to ETF investing. Anonymity – and freedom – are advantages that I never really noticed until I spent some time chatting with institutions. These advantages were brought up time and time again in discussions with institutions themselves and the ETF issuers.
While ETFs are bought and sold all the time, it is unknown who is doing the buying and selling. This is a beneficial feature to larger institutions – especially ones doing active management – because it keeps their moves on the down low. Even massive block trades that send billions into an ETF in one shot are anonymous.
“With an ETF, no one knows exactly what you are doing and you can hide behind the ETF without having to show your hand.”
Figure 1.4 shows a list of the largest trades in the WisdomTree Europe Hedged Equity ETF (HEDJ) during a three-month stretch. You can see that five of the trades are over one million shares, yet it is unknown who did them. We know the when, the where, and even the how (exchange order versus creation). But we don’t know the who, and we also don’t know the why. And that’s just how institutional investors like it.
Figure 1.4 The Largest Trades for HEDJ from March 19, 2015, to June 19, 2015
Source: Bloomberg
Price Discovery
If you want to know what the market really thinks about something, just look at where the ETF is trading. This real-time information