Dan Caplinger of The Motley Fool returns to discuss how exchange-traded funds have evolved—and why that evolution can matter more than most investors realize.
Jeffrey Snyder, Broadcast Retirement Network
Well, we’re going to welcome back to the program, Dan Caplinger of The Motley Fool. Dan, always great to see you.
Thanks for joining us on the program this morning. You bet. Glad to be back with you, Jeff.
I always feel privileged when I’m joined by astute journalists like yourself, so I really appreciate you coming back on the program. I didn’t chase you off. Dan, there’s a lot that I love to chat with you about, but today I really wanted to focus on the evolution of exchange traded funds.
When I grew up in the retirement industry, ETFs were really just baskets of stocks that represented indexes, S&P 500, Russell 2000. But from talking to you and others, there’s been this evolution where there are actually probably more ETFs now than there are actual stocks on exchanges.
Dan Caplinger, The Motley Fool
Yeah, that milestone just happened pretty recently, Jeff. I find it a little bit alarming just because I feel like we’ve lost our way. Like you, I was raised with the idea of exchange traded funds being a beneficial alternative to traditional mutual funds.
We have these index mutual funds that gave everybody the chance to invest rather than trying to beat the market with individual stocks, just matching the market with baskets of stocks. The ETF wrapper introduced the innovation of letting you have access to those items throughout the day. Used to be with those mutual funds, you can only trade once a day, you’d get the closing price.
If there was a big opportunity in the middle of the day, you couldn’t get it. And so the ETFs let you do that. But nowadays, the ETFs seem to be moving away from that diversified exposure.
There’s still big ETFs out there. You can still get the indexes if you want. But there are a whole bunch of these new ETFs that are folks that are drilling down much more closely, some even at the individual single stock level.
Jeffrey Snyder, Broadcast Retirement Network
Yeah. And, you know, I kind of echo your sentiment. I mean, I would use it to replace, for example, an S&P 500 large cap blend fund in my portfolio.
And we’re not giving financial advice here, we’ll be very clear, or investment advice. We’re just talking, you know, at a very high level. But, you know, Dan, what’s the rationale as to why?
Is this a natural evolution in the ETF industry that, hey, you know, like anything else, you just take it to the next iteration, the next level. And so this, you know, there’s a thousand different ways to create these structures.
Dan Caplinger, The Motley Fool
I think there’s a couple of things going on, Jeff. One is that you have alternatives to ETFs that allow retail investors, ordinary folks, to make very leveraged investments on even individual stocks, moves in those stocks in the short term, you know, in time periods of a day or less. There are plenty, whether it’s prediction markets, whether it is single stock futures, whether it is the options market, there are a lot of ways for investors to try to get a big bang for their buck really quickly.
I think that ETF providers see this and they say, hey, look, we want a piece of that action. The other thing, Jeff, is you kind of have to look at where the money goes, because those ETFs that we were talking about up front that track S&P 500, a whole bunch of other indexes, they are huge, but they also collect very small expense ratios for the companies that manage them. I’ve seen some ETFs, you know, you’re talking 0.03 percent, 0.04 percent, you know, on billions and billions of dollars, that adds up to real money. But with these newer ETFs, with these leveraged plays, these ETF companies are able to command easily, often 10 times the expense ratios, the management fees that they’re able to get on an S&P 500 index fund. Match that with the demand from the investment side. Investors want access to products like this.
And it makes sense that ETFs are trying to build that bridge and connect the investors with what they want.
Jeffrey Snyder, Broadcast Retirement Network
So, Dan, I, as you know, I come from the retirement industry, 32 years of experience with 401k pension plan. So I’ve always thought about the long term. But what you’re, when you mentioned prediction markets, the first thing I thought about was gambling.
So, you know, most investors, people like me, they just want to put money away for a rainy day, you know, when they retire, or maybe they want to buy a home, right? So there’s a long term element. This to me, forgive me, and I need education here, this sounds a lot more analogous to gambling, like sports betting, or some of the other things that we see on TV now.
Dan Caplinger, The Motley Fool
Well, look, Jeff, I mean, you and I are in the same boat in the sense that I think both of us have more of that long term investing strategy, you’re looking for long term goals, like saving for retirement, saving for down payment for house, whatever it is, you’re not expecting to get there tomorrow, you’re not expecting to get there next week. But you’re expecting if you stay disciplined, you’re going to get there in five years, 10 years, 20 years, whatever your time horizon may be. These products, they aren’t that.
Whether they’re gambling or not, I think some people would, you know, reasonable people might disagree with it. But the thing that troubles me with investments like this, you know, there’s a particular type of ETF, we call them leveraged ETFs, and you can get them, they try to provide the daily return of an index or, you know, some sort of underlying, maybe it’s an individual stock, whatever it might be, but they try to double or triple whatever that move is. And Jeff, oftentimes, there are opposing pairs of ETFs.
So there’s one that you can buy, if you think that the stock is going to go up, there’s one that you can buy, if you think the stock is going to go down. The whole point of these is to capture daily moves. What’s interesting about this is if you look at these ETFs on a longer term basis, on periods of years, oftentimes, what you will find is both the bullish ETF and the bearish ETF lose money.
There’s no long term winner. These products designed entirely for short term trading. And if you’re a short term trader, if that’s what your strategy is, then that’s that’s what they’re there for.
But if you’re a long term investor, and you just happen to fall into this trap of thinking that these ETFs are for traditional retirement investors, it can be a costly lesson.
Jeffrey Snyder, Broadcast Retirement Network
But Dan, isn’t the winner, the ETF manufacturer who creates the product and therefore they’re getting an expense ratio, don’t they ultimately win to the detriment of the investor?
Dan Caplinger, The Motley Fool
It’s the ETF manager that’s collecting the fees, for sure. It’s also the financial institutions who are taking the other sides of these trades. They are providing what they call financial engineering to make these products available and out there.
And more often than not, yeah, I mean, there are occasional situations where just the right combination of circumstances plays out. And these things make a whole bunch of money. But in an ordinary seesaw up one day down the next and up a month and down a month kind of markets, more often than not, it is the house in the form of these institutional financial institutions, investors that end up ahead.
Jeffrey Snyder, Broadcast Retirement Network
So how are people buying? Let’s talk about the type of investor. Are they accredited investors?
So are these people, you know, ultra high net worth? Well, you know, can that usually have a financial advisor or someone who’s an expert? Are they buying these?
Are those the types of investors that are in these products? Or are there people like me that just earn a wage, put money away, and they’re just like, hey, I’m just going to game the system.
Dan Caplinger, The Motley Fool
There’s no consumer protection out there to prevent ordinary investors from buying these ETFs. For sure, there are specialized leveraged investments out there that are only available to accredited investors, only available to institutions that have the experience and the know-how to understand that the risks involved. But a lot of these ETFs increasingly, they just, they trade on the exchange.
If you have a regular brokerage account, you can buy these things. And, you know, I think that there is, you know, part of the issue is that if you’re doing your own research, if you’re looking at lists of, okay, yeah, which fund has done the best so far this year, which fund has done the best over the past one year period, oftentimes it’s going to be these leveraged ETFs that stand out because, again, over these relatively short periods of time, one or the other of these is going to be the big winner because either the stock goes up or the stock goes down. One of those, like I said, when you have those opposing pairs of ETFs, one of those funds is likely to go way up. The other one’s likely to go way down, but we don’t pay attention to that one.
We just look at the winner. That’s kind of human nature, the way that a lot of investors have done their research in the past, looking for past performance, not really internalizing that just because it did well in the past doesn’t mean that it’s going to keep doing well in the future.
Jeffrey Snyder, Broadcast Retirement Network
Yeah. Well, that old line, hey, look, I was, I worked for a mutual company. Past performance is not indicative of future results.
And that was pretty much on every disclosure, on every fund, every prospectus, every advertisement.
Dan Caplinger, The Motley Fool
It’s still there, Jeff. It’s just on page 128 of the 212-page document that nobody ever reads.
Jeffrey Snyder, Broadcast Retirement Network
I mean, the prospectus probably isn’t mailed anymore because that’s too expensive. It’s probably like a PDF, but who reads that thing?
Dan Caplinger, The Motley Fool
You just click the checkbox and yeah, you’re done.
Jeffrey Snyder, Broadcast Retirement Network
Well, that’s true. That’s a good point. So is the answer here, I hate to go back to this, but it sounds like the answer is more education.
So it’s content that you’re putting out at The Fool, stuff that we’re doing at the Broadcast Retirement Network, that there are a lot of other people out there. Is it really investor education? And by the way, there’s also education that’s probably needed on the sports betting marketplace that you and I are talking about today.
But is that really what has to happen here? The investor needs to be more knowledgeable before he or she invests.
Dan Caplinger, The Motley Fool
Yeah. I just think that a lot of what it takes is a healthy skepticism of those top returns, that when you see a fund that’s doing really well, you should be asking yourself, why? And understanding how the fund works and why the fund participated in a winning trend.
The other thing you can do, I don’t want to cast financial advisors in a negative light because I’d say the vast majority of financial advisors out here, they would look at these products and they would say, hey, this is not for you. You have a long-term time horizon. You don’t need to be swinging for the fences and risking it all to try to make a bunch of money tomorrow or next week.
And so if you are tempted by these things, getting a second opinion from a financial pro, especially somebody like you were talking about, who’s familiar with retirement and other long-term investment objectives, that’s going to be able to give you the confidence that you have to say, OK, yeah, this one’s not right for me. OK, yeah, maybe this fund is going to get me there. It may take a little longer, but hopefully without the bumps and risks along the way that can derail you permanently from reaching the financial goals that you’ve set for yourself.
Jeffrey Snyder, Broadcast Retirement Network
So Dan, just to kind of come full circle, is that where the F-word comes in, fiduciary? You want to make sure that if you’re partnering with somebody, that they have your best interest in mind versus their own self-interest. Is that where fiduciary is just so important when you’re looking at a financial advisor?
Dan Caplinger, The Motley Fool
It definitely is. And I think that there are definitely, many of these exchange traded funds, there aren’t going to be advisor incentives for a financial pro to recommend them to clients. So there’s not necessarily going to be that direct conflict of interest.
But nevertheless, I think that you’re always better served by somebody who has undertaken the legal obligation to put their own financial interest behind those of you, the client, making sure that the guidance and advice that they’re giving you is personalized to your needs, not to theirs, and that it’s for your best interest, not theirs, not their companies, not their bosses, but you as the client are getting the full attention of the pros who are working for you.
Jeffrey Snyder, Broadcast Retirement Network
Yeah, I like that you brought up critical thinking. I think that’s something that in today’s digital age, a lot of people maybe need to work on that and improve upon. Dan, we’re going to have to leave it there.
Thanks so much for joining us. Always appreciate what valuable insight you have. And we look forward to having you back on the program again very soon, sir.
Dan Caplinger, The Motley Fool
We’ll see you next time, Jeff. Thank you so much.