Never Buy Top Performing ETFs

I love lists and am fascinated with lists such as this recent list of top performing ETFs for the first half of 2020 by Sumit Roy of ETF.com.

The winners returned between 30% to over 55%. And that list excludes ETFs that use leverage and inverse ETFs.  

Had the list included these, then an ETF like the VelocityShares 3X Inverse Natural Gas ETN (DGAZ) would have clocked a return of more than 135%.

Best-Performing ETFs Of The Year (ex. leveraged/inverse/VIX ETPs)

Data measures returns through the end of June 2020

Yet again, the ETFs I own are shut out of any top-performing ETF list. Here’s why.

To be a winner, an ETF must be very narrow to outpace the entire market. The winner in this COVID-19 economy was the ARK Genomic Revolution ETF (ARKG) cloud and e-commerce ETFs.

In hindsight, it makes perfect sense why ARKG would prosper in the age of COVID. If only I had a working crystal ball, I would have owned it. But then again, I’d be a billionaire socializing (at a distance) with Jeff Bezos and other top billionaires rather than writing and doing hourly financial planning.

How The Math Will Kill You
The two problems with top-performing ETFs are that they are very expensive and typically far more volatile.  We all know expenses take from return, but people are surprised that volatility can do far more damage. Let me start with a theoretical example followed by a very recent real-world example.

Say a broader ETF goes up 20% in one period and down 10% in another. Though the simple average return for the period is a 5% gain, the investor in the period got a return of 8.0% for the two periods, or 3.9% for each period.

Now compare to a narrow ETF that gained 40% in one period but lost 30% in the other. Again, the simple average return is a 5% gain, but the investor actually lost 2% over the two periods, or is down 1% each period.

Real-Life Example
If you regard this as a nonrealistic example, let’s look at the volatile ProShares levered S&P 500 ETFs. Through the first half of the year, the S&P 500 total return (including dividends) lost a bit under 3.1%. But the ProShares UltraPro S&P500 (UPRO), which provides 3x leveraged daily exposure to a market-cap-weighted index, lost far more than three times that 3.1% loss. In fact, it turned in a 36.5% loss, or roughly 12 times the index loss. It lost 60.44% in Q1 and gained 60.55% in Q2.

You might think that using leverage to bet against the S&P 500 in a down year would turn in great returns, but think again.

The ProShares UltraPro Short S&P500 (SPXU) does just the opposite, by providing (-3x) exposure to a market-cap-weighted index of 500 of the largest and most liquid U.S. companies. Rather than a handsome gain, it actually turned in a worse return than the long, triple-levered version clocking in a loss of 41.0%. It’s like playing a game of heads you lose badly, but tails you lose more.

This is why levered funds do especially poorly in volatile times. Cinthia Murphy recently wrote that most of the ETF closures in Q1 were leveraged or inverse funds.

My Advice
I define investing in eight simple words: Minimize Expenses and Emotions; Maximize Diversification and Discipline

Every ETF on this list and future lists will fail all four criteria. They are expensive and we buy because our instinct tells us to. They are undiversified, and typically our lack of discipline has us buy them after they have made such a top-performing list.

So I’m sticking with the broad low-cost ETFs such as the Vanguard Total Stock Market ETF (VTI) or the iShares Core S&P Total U.S. Stock Market ETF (ITOT). Both own thousands of stocks at a low 0.03% annual expense ratio.

When someone brags about owning a top-performing ETF, I’ll just smile and be glad I’ve never had such a winner.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.