Capital Flows to Where it is Treated Best: ETFs & Index Funds Have Treated Investors Most Excellently
“Capital flows to where it is treated best.” Many of you have probably heard this quote more than once, and should easily understand it, even if you don’t embrace it as universal truth. I like this quote because it just makes good common sense. The quote is normally used in the context of macro-economics, but I believe it is equally valid in the realm of actively managed mutual funds, index funds and ETFs.
You may not have heard about my website called the DeepValueETFAccumulator.com, but with a name like that, you will surmise correctly that I am an advocate of using ETFs. How I became a blogger about ETFs is a long story, but let’s just say it had something to do with being an unsuccessful stock trader. Through the loss of a significant amount of money (to me) I set out to gain an education on wealth building and leave alone the numerous books and ideas on stock trading. This education has cemented in me confidence that I can build wealth over a long period of time. And I can do so without taking extreme risks and without excessive amounts of time dedicated to watching the markets or learning the fundamental and technical attributes of many individual companies.
My journey from stock guru wannabe to an index investor is like many other individual investors, trial and error. If you haven’t notice already, the retirement systems in the U.S. have gone through major transformations over the last few decades. Gone are the days where most people had pensions to look forward to. I don’t lament that fact, but it is now in every investor’s best interest to get at least a basic education on investing.
Fortunately, not only has the way we save for retirement changed, but so has the ease in which people can gain the education needed to make informed investment decisions. The internet, of course, has brought us podcasts, books, articles, webinars, and full length video lectures on investing with a few simple clicks of a mouse. Also, the financial industry has kept up with the times by creating investment products and services that are more transparent, more efficient and cheaper than ever before. There are robo-advisors, low commission brokers, flat fee advisors, ETFs, index funds, free trading at Robin Hood and you can even build your own mutual fund at Motif Investing. The financial services industry has changed and there some people that aren’t very happy about it.
One of the main reasons that some aren’t happy is that their gravy train has been taken away from them. No longer can they get away with charging exorbitant fees without adding value. The consumer, in mass, has become enlightened. Capital is flowing to where it is treated best and this flow will not stop until most of it has been satisfied that is being treated very well.
The vehicle of choice for all this capital flow is the index fund and the ETF. There is nothing like it. No other investment vehicle on earth is seeing these kinds of inflows. The genie cannot be put back into the bottle and this is making many individuals and companies nervous. This seismic shift in the industry has created a new breed of financial guru. I call them the ETF Armageddon pundits. These pundits are getting louder and more ominous by the day.
Being a student of the financial world around me, I have been taking notice of these ETF Armageddon pundits that warn us regularly about the gigantic $3T financial asset bubble that the ETF industry is causing. I’ve heard them say ‘investors are just blindly buying the index.’ Or, ‘there isn’t enough liquidity in ETFs if “something” happens.’ Or, ‘if everybody indexes, who will do the necessary analysis to distinguish a good company from a bad company?’ Or, ‘don’t you remember what happened to ETFs during the flash crash of May 2010, August 2011 or August 2015?’ I don’t have the answers for every question raised by the apparent opponents of ETFs, but I do think their worries are exaggerated if not completely unfounded. I also don’t have the expertise or the desire to debunk the ETF Armageddon pundits, so I won’t try. Rather, I will make the case that ETF’s are simply treating capital better than any other investment vehicle available.
Can we at least agree that ETFs are not risk-free assets? I think the ETF Armageddon pundits really believe they are doing some sort of good-work by warning poor, innocent, ignorant investors of this $3T bubble that is about to explode at any moment. Were investors not warned at some point that an equity index fund has risk, including risk to their principal? I think most investors are aware of the risks involved, but I admit, some will not act in their own best interest when the manure hits the fan. Many will buy high and sell low. This is the nature of the market. Weak holders sell their shares to wise buyers who have cash. The wrapper of these equities, index or managed funds, does not change investor behavior. A good financial advisor might help, but the wrapper cannot.
The ETF Armageddon pundits are very concerned about liquidity. No matter how you slice this onion, ETFs are far more liquid than real estate, art work, commodities, precious metals and many individual stocks. Additionally, I question the liquidity of actively managed funds compared to index funds. If there are too many outflows in actively managed mutual funds, it can really upset the manager’s applecart and that is why many funds restrict outflows with high fees and other mechanisms. If I want to sell my 5 shares of SPY today, I just push the sell button and the fund manager doesn’t care a whit. If you need more liquidity than that, maybe you shouldn’t be putting your money in the stock market. I know the pundits are actually concerned about the liquidity of the underlying assets, but that didn’t seem to be a big problem in 2008 and it was less than a blip on the map during the ‘horrendous’ flash-crash of August 24, 2015. Most people don’t even know about that and don’t care. I was an ETF owner on that day and I was fortunate enough to have some cash and bought some shares at a sweet discount. Market orders are not your friend, limit orders are. The pundits might have some valid points about liquidity in certain ETF sectors and I’m not debating that. But, investors with a solid investment plan, good diversification and/or a good advisor should come through a liquidity calamity of some sort relatively unscathed.
Most ETF investors are not just blindly buying the index. Many of them have an allocation plan. They get paid; they save; they invest according to their plan. If they have a halfway decent plan, and they stick to it month after month, and year after year, their chances of success are quite high due to the benefits of dollar-cost-averaging, periodic rebalancing and compounding. Once again, it’s not the wrapper that gets them where they’re going, it’s the value of the equities in the wrapper, and the plan that they stuck to in good times and bad, that does.
Would the ETF Armageddon pundit recommend to a new investor to go out and buy individual stocks? Will the new investor choose Snap Chat on IPO day and be discouraged if he never gets all his money back? Maybe he’ll get lucky and buy Acacia Communications on IPO day and congratulate himself on his investing prowess. Or, would they rather have this new investor go do some ‘light’ homework and find a great actively managed equity mutual fund? I think the new investor’s luck in finding a great actively managed fund might be just as elusive as finding and buying Acacia at just the right time. I say this because actively managed funds change over time. Managers come and go; funds get large inflows or outflows and can change the style of the original fund; or the track record that first attracted new investors begins to erode due any number of reasons such a cyclicality. Additionally, this new investor gets to pay a significant premium for the privilege of owning actively managed funds.
Given all the investment vehicles that investors can put their capital to work, where is it treated best? I believe they a putting their money where it is treated most excellently, which is inside index funds and ETFs. A buyer of an ETF doesn’t have to worry whether they have a great fund manager, which in my opinion is like finding the needle in the haystack. The track record of the ETF speaks for itself. It performs relatively close to the index it tracks. An ETF investor doesn’t have to have $5k or $10k or even $100k to get the special treatment share class discount. A middle-class investor of ETFs pays the same exact expense ratio for his 5 shares of SPY as his wealthy neighbor who might buy 500 shares. The small and the large investor will also pay the exact same commission depending on their broker of choice. There are no front-end, back-end or hidden-in-the-middle somewhere load fees. This is called transparency in the financial industry, but I just call it fair.
As for the ETF Armageddon pundits concern about the importance of stock pickers, I think their concerns are once again exaggerated. Exaggeration in the financial news room is rewarded with clicks, tweets, likes and potentially financially. If you think stock picking is dead, go visit some of my friends at StockTwits.com. I assure you, those people like picking stocks, and many of them use fundamentals to do so. Additionally, the biggest players in the industry must buy individual stocks and not indexes due to the amount of money they manage. Moreover, so long as capitalism stands, there will always be people who believe they can do better than the market averages. Some will succeed in beating the market and some will not. Some will chase stocks up and push the prices even higher and some will short them on the way down. I will also add that many financial giants have seen the writing on the wall and have already entered the ETF space with actively managed and smart-beta ETFs. These types of funds will help to continue the separation of the wheat from the chaff in the stock market.
In conclusion, I would like to point out that investors who are making the conscious choice to buy ETFs and index funds over actively managed funds are not to blame if you think the market is overvalued right now. They also won’t be the ones to blame when the market inevitably goes through a downturn. The blame, if there is anyone or anything to blame, should go to same place it has in the past: fear, greed, FOMO, TINA, irrational exuberance, recession, wars and rumors of wars. ETF and index fund investors have simply observed the lay of the landscape and sensibly decided to invest their capital where they believe it will be treated most excellently.
Thank you for reading.
The Deep Value ETF Accumulator, aka Micah McDonald