How ETF investors sabotage themselves

We’ve all seen the type. You know, the guy on the golf course who’s got a beautiful Callaway 3-wood, but can’t hit a straight tee shot. Or the amateur chef who bought a perfectly balanced German-steel knife before she learned how to dice an onion. Watching folks like this is a reminder that simply owning high-quality equipment doesn’t make you good at your craft. Turns out that’s also true in investing. A recent paper called “Abusing ETFs“, published earlier this year in the Review of Finance, focuses on “one of the most successful financial product innovations of the last 20 years,” praising ETFs for their low cost, broad diversification, ease of trading, and tax efficiency. But the researchers went on to find that once you put these excellent tools in the hands of DIY investors, most of them made a mess of their portfolios. “Our conservative conclusion,” they write, “is that individual users of ETFs do not improve their portfolio performance by using ETFs.”

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There is no question that ETFs have helped countless investors, particularly those who previously were trapped in high-cost mutual funds. By simply tracking the market at rock-bottom costs, traditional index ETFs tend to deliver higher returns than the vast majority of comparable funds. But that’s only half the story: just because the funds perform as promised, it doesn’t follow that the humans using those ETFs will be successful. Like a duffer with an expensive golf club or a kitchen klutz with a well-honed blade, it’s easy for investors to make mistakes even if they’re using the right products.

What could go wrong?

The authors of the paper suggest a few potential problems with ETFs. One is that there are now so many choices that investors may have difficulty selecting good funds. Another is that ETFs make it easy to time the markets because you can buy and sell entire indexes in real time. (This is harder to do if, for example, you’re buying and selling a few individual stocks.) These are both reasonable arguments for how and why investors screw up, but they’re difficult to prove. After all, it’s easy to know how well (or poorly) individual funds perform because they’re required to publish their returns. But how can we accurately measure the returns of folks who invest on their own?

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That’s what makes this paper so interesting: it purports to be the first to analyze a large sample of DIY investors using data from more than 7,000 clients of a large brokerage in Germany over a five-year period. Some held ETFs in their accounts, while most others did not. Using a number of methods for comparison, the authors concluded that investors using ETFs did not show improved performance relative to non-users. Even more surprisingly, investors who held both ETFs and other types of securities in their accounts actually did a worse job managing the ETF part.

The methodology was quite fascinating. To understand the reason for the poor performance of ETF investors, the researchers constructed hypothetical portfolios to make comparisons. Say, for example, an investor bought five different ETFs, making 20 trades over the course of two months. The authors would compare his results to a hypothetical portfolios that assumed he instead simply bought a global index fund on each of those days. Another comparison assumed he invested the whole amount in a global index fund on the day of the first trade. A third hypothetical portfolio assumed all of the investor’s purchases were confined to the first ETF he bought, and so on.

The researchers were trying to tease out where the ETF investors were going wrong. Were they selecting the wrong funds? (In this context, a “wrong” ETF is one that tracks a narrow segment of the market, or one that does a poor job of matching its benchmark index.) Or were they using the right ETFs but buying and selling at inopportune times? The results suggest it was a bit of both, but mostly the latter. The underperformance “occurs mostly from buying ETFs at ‘wrong’ points in time rather than choosing ‘wrong’ ETFs,” the authors write. “Therefore, adopting a buy-and-hold strategy is more important than selecting better ETFs.”

Focus on what really matters

I can add some anecdotal support to these findings. I’ve corresponded with hundreds of investors over the years, and I’m struck by how much time and effort they spend on product decisions that will have almost zero effect on their long-term returns. That’s not to say that choosing the right ETF building blocks is unimportant: there is no shortage of pricey, narrowly focused, and unduly risky funds that should be avoided. But if you stick to the most broadly diversified, lowest-cost index ETFs for each major asset class, it’s hard to go too far wrong. Certainly it’s not a decision to agonize over if it prevents you from putting your investment plan into action.

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But you know what will have huge impact on your returns? Trying to time the markets by waiting for a pullback in stock prices, or guessing where interest rates or currencies will move. You might get lucky once in a while, but mostly you’ll find yourself in the wrong place at the wrong time. Better to carry out a disciplined, long-term strategy using less-than-perfect ETFs than actively buy and selling the best products. It’s important not to take away the wrong message from this research. The authors were careful not to argue that people should avoid ETFs. Rather, they encourage investors to choose well-diversified funds rather than those focused on a narrow sector of the market, and to stick to a simple buy-and-hold strategy rather than trying to time their purchases and sales. Pretty standard advice, really. Now, if we could just figure out a way to follow it.