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Dubroff: Investors should be skeptical about exchange-traded funds

By   /   Friday, September 11th, 2015  /   Comments Off on Dubroff: Investors should be skeptical about exchange-traded funds

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Exchange-traded funds are the newest, latest, greatest Wall Street creation.

In the past decade and a half, they’ve grown from a niche product with just $72 billion in assets invested to a behemoth totaling $2.7 trillion. Thanks to real-time daily pricing and low fees, ETFs are rapidly supplanting mutual funds in retail accounts.

But the ETF is not as simple and easy a tool as it appears to the millions who’ve bought them — often after a fairly cursory chat with a robo-advisor. And, as the ETF phenomenon grows, price discovery in the small- to medium-cap companies that are the backbone of our regional economy has become far more complex.

That’s the view of Gerry Frigon, head of San Luis Obispo-based Taylor Frigon Capital Management in San Luis Obsipo. In a recently prepared paper and a lengthy phone conversation on Sept. 8, he explained why investors everywhere should be skeptical about embracing ETFs as a one-stop panacea for investors.

Frigon is not a disinterested party. ETFs are a significant competitor to his firm, which is one of the larger independent money managers in the region. Their indexing approach is radically different from his bottom-up analysis based on fundamental analysis of individual stocks.

But Frigon thinks the problem with ETFs is more than just stylistic differences. ETFs are “a very complicated product which is marketed using simplified descriptions,” he wrote in his white paper.

“Anytime somebody tells you something is simple and then sends you a prospectus that’s 60 or 70 pages long, a red flag should go up,” he said over the phone.

Indeed, a bit of research into ETFs indicates how complex they really are. ETFs can only be created by a large investment house. Because they are essentially synthetic products, they allow the creators to constantly arbitrage price differences between the ETFs themselves and the constantly changing values of the underlying securities.

Most of these changes are quite small — the trading profits, says Frigon, enable large firms to offer them at such low cost to investors. However, on days like the ones we saw in the highly volatile August market meltdown, price differences between the ETFs and their underlying securities can get wider and wider. To the dismay of the average investor, an ETF can trade at a substantial discount to its underlying securities.

ETFs can also pile on the leverage, always a dangerous development when Wall Street is concerned.

Finally, there is the impact on smaller cap securities. A July paper by three academics titled “Is There a Dark Side to ETF Investing?” suggests that if ETFs own as little as 3 percent of a company’s outstanding shares, trading patterns suggest the ability of analysts to predict stock price performance based on earnings and other fundamentals gets disrupted.

The result is less analyst coverage for regional companies and less predictable pricing.

Frigon thinks the growth of the ETF phenomenon is in part due to Sarbanes Oxley and Dodd Frank rules that have made it harder and harder for Wall Street firms to make money the old-fashioned way — by merger arbitrage and hedging for their own accounts. Instead, they have turned to the ETF as a vehicle for arbitrage, leveraging retail investors’ money rather than their own capital.

It may be premature to blame the ETF phenomenon for the spike in volatility that we’ve seen in the markets in August through September. But in my view, Wall Street never does things in moderation.

The sharp rise in capital at risk in ETFs and the ability to hedge, leverage and arbitrage raise some big red flags. Better and more simplified disclosure would help investors understand what they are really buying.

Mutual funds are clunkier when it comes to prices and they have disadvantages because they distribute capital gains to investors, creating potential tax issues.

But the inherent dangers in ETFs are potentially far more serious. For one thing, they may have contributed to the August outbreak of market volatility.

• Reach Editor Dubroff at [email protected]

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