Allan Roth: Use ETFs to Invest, Not to Speculate

Exchange-traded funds are a thing of beauty. Since the first U.S. ETF was lunched 30 years ago, they provided investors with diversification and the ultimate in tax efficiency at rock bottom costs. Their tax efficiency comes from the creation and redemption process. In many brokerage platforms, you can buy fractional shares which formerly could only be done in the mutual fund wrapper.  

I own over 12,000 companies across the globe with a mere two ETFs. While there are multiple providers, I own the Vanguard Total Stock Market ETF (VTI) and Vanguard Total International Stock ETF (VXUS) with annual expense ratios of 0.03% and 0.08%, respectively. Each has passed through zero capital gains in at least the past several years. Sometimes my heart swells when I think of how easy and inexpensive it is to own my share of the $109 trillion global stock market.   

The Illogic of Sector ETFs

Then came sector ETFs. The value proposition was diversification. The pitch went something like this – “Why own one bank when you can own the entire banking sector?” Indeed, etf.com Research Lead Kent Thune recently wrote about the 10 Best Performing ETFs of the Last 10 years. Not surprisingly, all ten came from the technology sector earning annualized returns between 19.36% and 28.18% for the ten years ending June 10, 2024. Those ETFs trounced the 12.04% annualized return of my total stock ETF over the same period.  

Of course, when I say it isn’t surprising that all ten came from the tech sector, I’m using hindsight. A decade ago, I didn’t know what sectors or companies would be the stars. So, when I heard the commercial giving a compelling argument to own the entire sector rather than one company, my immediate reaction was to think, “Why own one sector when you can own every sector?”   

While the returns of these ten tech funds are spectacular, few investors achieved them. That’s because many investors poured money into these funds after they had already performed well. Morningstar’s recent research shows that the average sector fund earned 10.80% annually for the decade ending December 31, 2022. Yet investors earned only 6.42%, or a 4.38 percentage point shortfall.  

Perhaps the best example is Cathie Wood’s ARK Innovation ETF (ARKK) which had spectacular performance when it was small and then crashed after investors poured billions of dollars into it.  

Even Narrower ETFs With Gimmicks

Wall Street figures they can make even more money by making even narrower ETFs and throwing in some derivatives to boot. You can currently buy a single stock ETF. There are now 60 single stock ETFs that have attracted over $7 billion of investor funds. They use derivatives to lever or create income with covered calls or create inverse products. ProShares even has a Short Bitcoin Strategy ETF (BITI). It lost 66.17% in 2023, and another 39.1% so far this year, as of June 18. 

Now there are some narrower ETFs that could make sense. I’ve written about the iShares defined maturity TIPS ETFs as a simpler way of buying TIPS and building a TIPS ladder with a reasonable 0.10% annual expense ratio. While I’m not a fan of Bitcoin, it could make sense to own it in an ETF for simplicity and security benefits.  

The Right Way to Invest in ETFs

I strongly believe that the right ETFs accomplish two goals—to minimize expenses and to maximize diversification. The majority of investors understand this as illustrated by the largest ten ETFs. All are relatively diversified, and all but one have annual expense ratios of 0.09% or less. 

Low-cost total stock index funds are never going to make the list of top performing ETFs. More importantly, they will never make a list of the worst-performing ETFs. And most importantly, they will almost certainly best most ETFs in their class.  

In my experience, investors maximizing diversification and minimizing expenses are also more disciplined and less likely to make emotional mistakes. 

Use ETFs to invest, not to speculate.