Do ETFs Negatively Impact Portfolios?

In a recent paper studying ETF investors using data from a large German brokerage,the authors found that ETFs do not improve portfolios with the ETF portion of a portfolio underperforming the non-ETF portion of the portfolio by -1.16% and investors using ETFs used all investment products sub-optimally.  All investors in the study had refused free financial advice and were self-directed investors.  Poor timing in buying and selling accounted for .77% of the underperformance.   When compared to a market portfolio buy and hold strategy, the majority of the underperformance was due to security selection behavior. (See tables VII and VIII in the paper.)  The study found no investor distinct group benefited from, or increased diversification with, ETF use.  When trading costs were included with gross returns, the results were worse.

The authors suggest that it would be better to invest in a buy and hold strategy with a low cost diversified market investment.

This means, in my opinion, that the self-directed investor approaching or in early retirement should look for a low Beta (1.00 or lower) and a high Sharpe Ratio (the higher the better) market investment as well as review cost and performance through the years.  An investor with a long time horizon might include Alpha (the higher the better) in the criteria.  There are several that should pop up on an ETF criteria screen for deeper analysis.  If you have a fiduciary, fee only, financial financial advisor, there might be more portfolio options in a buy and hold strategy which is allowed to slowly grow.

The study concluded: "We find that the portfolio performance of individual users relative to non-users of ETFs slightly worsens after ETF use. The loss comes mostly from buying ETFs at the “wrong” times rather than choosing the ex-ante “wrong” ETFs. Therefore, adopting a buy-and-hold strategy is more important than selecting better ETFs. The benefits from a buy-and-hold strategy are twofold. First, as our analysis reveals, a buy-and-hold strategy would prevent investors from trading ETFs at “wrong” points in time. Second, the positive effects on gross performance are amplified for net performance as trading costs in buy-and-hold strategies are naturally lower.

"Our paper thus points out that the wonderful innovation of passive ETFs, with its enormous potential to act as a low cost and liquid vehicle for diversification, may not help individual investors to enhance their portfolio performance if they actively abuse passive ETFs by buying and selling them at “wrong” times. Ironically, the low cost and high liquidity of these ETFs seem to encourage their trading, and this aggravates an individual’s temptation to engage in some sort of timing. Our finding should make regulators, consumer protection agencies, companies with 401k plans, and financial economists more cautious when recommending ETF use. From a policy perspective, therefore, promoting savings on well-diversified ETFs that simultaneously limit the potential to actively trade in them might be beneficial to individual investors." 

This is the fifth post is a series on ETFs.  The fourth post, which has links to the first three in its first paragraph, on synthetic ETFs can be found here.


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