[Editor's Note: This article originally appeared here on March 23, 2017. Click here to watch Jim Cramer's July 28, 2017 critique of ETFs.]
Todd Rosenbluth is director of ETF and mutual fund research at CFRA.
On Jim Cramer’s CNBC Mad Money Show Tuesday night, he spoke passionately against the use of ETFs.
While CFRA believes investors have a variety of strong investment opportunities to consider, we contend that lower-cost ETFs can be helpful to reduce risks and provide liquid exposure to a variety of trends. Our approach focuses on the holdings and leverages our stock research capabilities. Below we recap Cramer’s take, and offer our perspective.
Cramer cited the “hideous” number of ETFs that have been launched in recent years, and noted that ETFs can be used to short stocks that you, the individual investor, may have in your portfolio.
CFRA notes 432 equity ETFs launched since March 1, 2014, in addition to 2,047 mutual fund share classes.
Financial advisors, ETF providers and CFRA regularly tout the diversification benefits available via ETFs and mutual funds. They also note that ETFs can be a good way to get tactical sector exposure without relying on just one stock.
Cramer questioned ETFs’ diversification benefits, noting that even an ETF could own a stock like Enron, which subsequently went bankrupt due to corrupt accounting. He advised his listeners to buy a stock because it is the best in a sector that is growing, and avoid ETFs that would also include other “mediocre” names that could potentially drag down the returns.
ETFs Can Limit Single-Stock Fallout
CFRA has a different take. While the diversification benefits of ETFs will not prevent an investor from getting caught up in fraudulent accounting, it will limit the damage when a stock falls out of favor.
For example, Sears declined sharply this week after acknowledging that bankruptcy risk looms large. Investors who owned Sears through an ETF like the SPDR S&P Retail ETF (XRT) were protected by the ETF’s stakes in Amazon, Netflix, Walmart and other retailers with stronger fundamentals.
With ETFs, investors have choices. Some ETFs, like XRT and others offered by ETF provider SSGA, are equally weighted, meaning they own all stocks in the benchmark index in equal amounts. Others are market-weighted.
Take for instance, the Health Care Select Sector SPDR (XLV), which has a 12% weighting in Johnson & Johnson and a 7% weighting in Pfizer. The Vanguard Information Technology (VGT) has a 14% weighting in Apple and a 10% weighting in Google parent Alphabet. CFRA encourages all investors to determine what’s inside any specific ETF before committing money; our ETF reports help investors do just that.
Not Just A Money-Making Scheme
Cramer attributed the rise in the number of ETFs to the financial services industry looking for a new way to make money; CFRA attributes the rise in assets in ETFs to investors tiring of underperforming active managers.
We think ETF products continue to roll out as investors pull money out of actively managed equity funds and into passive products. In the one-year period ended February, U.S. equity and sector equity passive products gathered $285 billion and $58 billion, respectively. Meanwhile, active peer offerings shed $264 billion and $30 billion, respectively, according to Morningstar.
While low fees play a role in these decisions, CFRA thinks that continued struggles by active managers to keep up with the index has resulted in more investors being comfortable with consistently average returns.
Nothing Wrong With Niche ETFS
Cramer touched on specialty ETFs, citing “wind power” as one investment trend that can be tracked through an ETF.
CFRA thinks Cramer was referring to the First Trust Global Wind Energy ETF (FAN), which has 42 holdings, including Vestas Wind Systems. FAN has $77 million in assets and trades 40,000 shares on a daily basis. We would agree that this is a niche product, but don’t believe such limited trading activity is likely to affect the overall market much.
Cramer also discussed that despite identifying a strong company, listeners have seen stocks decline after being weighed down by other stocks inside an ETF. One such example he highlighted was with stocks inside the PureFunds ISE Cyber Security ETF (HACK).
HACK has gathered just $150 million of new money in 2017, but the performance of top-10 holdings has not gone in the same direction. For example, Palo Alto Networks is down a double-digit percentage thus far in 2017, while fellow HACK holding Symantec is up more than 20%.
CFRA notes that active stock-pickers (professionals or individuals) often fail to keep up with market benchmarks. Index-based ETFs, most of which trade for a modest fee, offer an easy way to get exposure to various indices, from large well-known indices like the S&P 500 as a core holding to much lesser known indices that can be used tactically.
As of March 16, 2017
Cramer also railed against leveraged ETFs, a point that CFRA agrees with completely. Leveraged ETFs can be volatile and create risks for investors that hold them for longer than a day.
However, inverse and leveraged ETFs had just $44 billion in assets as of May 16, according to ETF.com data. This is just 1.5% of the total $2.8 trillion in assets and, as such, is hardly representative of the broader ETF industry.
At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA