Exchange Traded Funds | A good idea turned bad

When a good idea turns bad

Published on:
February 16, 2019
Reading time: 4 Minutes.
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About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Buying an exchange-traded fund (ETF) does not make you automatically a passive investor. The kind of ETFs you buy, and your trading behavior, determines how well you will do over the long term. The goal of this essay is to distinguish between the investable- and the speculative-type of exchange-traded funds. 


The investable exchange-traded funds

If you believe the U.S. population is aging, the Vanguard Health Care ETF (VHT) is a simple strategy to follow. VHT includes companies involved in providing medical and health care products, services, and equipment. It consists of 359 stocks with a median market capitalization of $81 billion. By buying shares in VHT, you will be tracking the performance of companies such as Johnson and Johnson, Pfizer, Inc., and UnitedHealth Group Inc.

Or are you bullish on energy consumption? Then Vanguard Energy ETF (VDE) is one option to go long the energy sector. For a minuscule management expense of 10 basis points, VDE tracks the performance of companies involved in the exploration and production of energy products such as oil, natural gas, and coal. It includes 141 stocks with a median market capitalization of $50 billion. Some examples of the names include Exxon Mobil Corp., Chevron Corp., and Phillips 66.

Agnostic about macro-global trends but convinced that corporations are becoming more efficient and that people will be consuming more? Vanguard Consumer Discretionary ETF (VCR) tracks the performance of stocks of companies that manufacture products and provide services that consumers purchase on a discretionary basis. VCR includes names such as Amazon, Inc., Home Depot Inc., Nike Inc., Starbucks Corp., and even Tesla Inc.

You can buy practically any segment of the economy. Some ETFs track financial companies such as JP Morgan and Bank of America. Other ETFs track the value of utility companies such as Duke Energy and Dominion Energy Inc. 

Or consumer staples companies such as Proctor and Gamble and Coca Cola, industrial companies such as Boeing, 3M, and Caterpillar, or technology companies such as Apple and Microsoft, telecom companies such as Verizon, ATT, and Comcast, or material companies such as PowDuPont, Lind PLC and Ecologic and the real estate sector such as American Tower Corp., Simon Properties and Prologis.

Adequate rate of return usually follows a sound investment strategy. If you had bought any of these sectors, you would have done reasonably well. The financial sector 10-year rate of return was 15%; both the healthcare and the real estate sector was return was 15%; the technology sector rate was 20%. The worse performing sector over the past ten years was the energy sector, with a rate of return of 5%.

Adequate rate of return follows a sound investment strategy.


The speculative exchange-traded funds

But any good idea can be turned into a bad one [see the Netflix documentary about Fyre Festival for a recent illustration]. And just as ETFs can serve the value, prudent investor, they develop into a co-dependent relationship with the speculator. 

Consider the Global X Millennials Thematic ETF (MILN) as an example. This ETF aims to benefit from the spending power and preferences of the U.S. millennial generation (defined by those born in years ranging from 1980-2000.) The ETF invests in companies that millennials use, such as Snap Inc., Twitter Match, and Zynga.

But value investors act on principles, not on trends. The MILN prospectus omits any discussion on fundamental value-oriented concepts such as price to earnings, leverage, seasoned management, or return on invested capital.

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A NOTE FROM NOAM 

In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.

Buying a stock is easy. But it requires a lot of effort and discipline to keep track of the company's performance. And no matter how much a stock appreciates, you're not capturing those returns until you sell. Join the waitlist to get real-time updates.

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Value investors act on principles, not trends.

The Obesity ETF is another example of a good idea turned bad. This ETF  opened in June 2016 and tracks the performance of the Solactive Obesity Index. It "provides investors with the opportunity to invest in companies that may benefit from the transformational forces changing our future," the prospectus says.  

The Obesity ETF tracks the stock of companies that claim to fight obesity. A partial list includes Arena Pharmaceuticals, MannKind Corp, and CyroLife (a distributor of cryogenically preserved human tissues for cardiac and vascular transplant applications). 

The third example is Ark Innovation ETF (ARKK). The ETF's prospectus uses Silicon Valley nomenclature, such as "disruptive innovation" and "network effect." And this passively-managed ETF (with actively-traded fees of 0.75%) has about a billion dollars in assets under management. ARKK owns companies such as Grayscale Bitcoin Trust, Editas Medicine, and Organovo Holdings.


Epilogue

ETF investing began almost thirty years ago to reduce active management fees. When I heard John Bogle, of blessed memory, speak at a CFA conference last year, I learned that he was surprised by the popularity of passive investing. He was worried, too. He said that ETFs serve nowadays as a means to speculate, which is the exact opposite of what he had originally intended.

This essay was inspired by one of his last interviews. That interview is a reminder for us all that products are not necessarily good or bad. It is how we use them. It reminds me what former President Franklin D. Roosevelt said: 

"The principle on which this country was founded and by which it has always governed is that Americanism is a matter of the mind and heart; Americanism is not, and never was, a matter of race and ancestry. A good American is one who is loyal to this country and to our creed of liberty and democracy."
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