The state of ETFs

When a good idea turns bad

Published on:
February 16, 2019
Last Update:

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Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

"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," said former President Franklin D. Roosevelt. "A good American is one who is loyal to this country and to our creed of liberty and democracy."

The spirit behind exchange-traded funds (ETFs) investing is similar. What is required of the ETF investor is (1) to form an opinion and (2) to understand the investment. And if we agree on conditions (1) and (2) then it logically follows that the ETF investor can participate in many forms of investments, from foreign-domiciled stocks to small, U.S. capitalization stocks; from investing in ETFs that track the performance of widely known indices - such as the S&P 500 and Dow Jones - to ETFs that follow the performance of energy or commodity prices.

Exchange traded funds - the good kind      

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

Are you determined that the world will consume more energy with time? Then you can buy Vanguard Energy ETF (VDE). For a minuscule expense of 10 basis points, the Energy ETF tracks the performance of companies involved in the exploration and production of energy products such as oil, natural gas and coal. The ETF includes 141 stocks with a median market capitalization of $50 billion. Some examples of energy companies 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. In this ETF you will find Amazon, Inc., Home Depot Inc., Nike Inc., Starbucks Corp. and even the controversial Tesla Inc.

You can buy any segment of the economy. There are ETFs that track financial companies such as JP Morgan and Bank of America, or utility companies such as Duke energy and Dominon energy, 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. If you had invested in any of the 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 year was the energy sector, with a rate of return of 5%.

Exchange traded funds - the bad kind  

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 exchange trade vehicles serve the value, prudent investor, they may develop into a co-dependent relationship with the speculator. Last week I came across a few ETFs that the value investor should avoid.  

The Global X Millennials Thematic ETF (MILN) is one 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 the value investor acts upon principles, not trends. Nothing is mentioned in the ETF’s prospectus about fundamental value-oriented valuation concepts such as price to earnings, leverage, seasoned management or return on invested capital.

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

Simply put, the ETF tracks the stock of companies that claim to fight obesity. This list of companies includes Arena Pharmaceuticals (a company that develops a molecule drug), NxStage Medical Inc. (a company that develops systems for the treatment of end-stage rental disease), MannKind Corp (a company that aims to fight diabetes) 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 buzz words such as "disruptive innovation" and "next generation Internet." This passively managed ETF (with actively-traded fees of 0.75%) has about a billion dollars in assets under management. This ETF owns Grayscale Bitcoin Trust, Editas Medicine and Organovo Holdings.

Epilogue

ETF investing began almost thirty years ago with the goal of reducing active management fees. When I heard John Bogle speak at conference last year, I learned that he was surprised by the immense success of passive investing. He was also worried, mentioning that ETFs serve nowadays as a means to speculate, which is the exact opposite of his original intention.

This week's meditation on ETFs was inspired by one of the last interviews Bogle, of blessed memory, gave. This Bogle interview is a reminder for us all that products are not necessarily good or bad. It is how we use them.