The problem with ETF managers. They lose money.

To begin, the passive index fund industry has exploded to over $13 trillion as of December 2023. And with it, comes the good and the bad. The good is some expense ratios have gone to zero, performance has become consistent and they are easy to purchase.

The bad? Excess liquidity, high fees and underperformance. Yes, the fee structure is contradictory but let me explain. Let’s begin with the problems ETF investors need to consider.

Why one ETF is enough

Here’s the problem with ETFs. You only need one. If you own more, chances are your portfolio is over diversified.

You see, ETFs offer a convenient and diversified way to invest, but there are challenges to consider. While they typically have lower upfront costs, high ongoing expense ratios can eat into your returns. Additionally, unlike actively managed funds, ETFs passively track an index, so they won't necessarily outperform the market. We highlight one such example below.

However, the biggest challenge lies in diversification. Having too many ETFs can lead to redundancy and dilute your returns. It's important to find a balance. One ETF like the S&P 500 can provide good diversification across asset classes, while keeping things manageable.

That S&P Index alone has 500 stocks invested across 11 industries. Do you really need to invest in the 14th emerging market microcap stock from Indonesia? No. 

Here are some tips on what to avoid when investing in ETFs:

• Highly Leveraged or Inverse ETFs: These amplify market movements and are riskier, especially for new investors. Avoid them unless you fully understand the risks involved.
• Thematic ETFs: While these can be appealing, their performance heavily relies on the success of a specific theme. Carefully evaluate the theme and fund manager's long-term potential before investing.
• ETFs with High Turnover Rates: Frequent buying and selling within the ETF can lead to higher capital gains distributions, which can be a tax burden. Look for ETFs with lower portfolio turnover.

When investing money, it is important to focus on who you hire (fund managers vs broad market indices, etc). Look beyond the themes and industries.

The problems with some ETF managers

I break down the industry into three parts: broad markets, specialized fund managers and thematic industries.

Blackrock’s iShares is an example of a broad market manager with too many ETFs. A diversified portfolio only needs ~30 stocks across multiple industries. Do you really need to own that ten thousandth stock in an emerging market? Probably not if the return profile will be <1%. Blackrock needs to shut down any poor performing iShares products. Sometimes it seems they focus more on selling ETFs than investing in great companies.

Next let’s look at a specialist: Cathie Wood’s ARK Investment funds. Investors have lost money, year over year with ARK’s funds. None of these innovative portfolios are unique. Nor are they unique. You can invest in many of the ETF holdings yourself. In fact, if you invested those funds yourself, you would pay less in fees and probably make money. I break down her ETFs below.

Lastly, are the technology sector ETFs. Ask yourself, who manages these funds? Are they industry specialists or are they simply diversifying across industries to sell more financial products? Chances are it is the latter. But there are two problems with this.

The first is that if you own more than two tech sector ETFs, you are probably over exposed to specific names like Apple and Tesla. But are paying an uneven fee structure across two different ETF managers. The second problem is these returns are all over the place. If you don’t know about the holding structure or turnover ratio, chances are you underperforming the market. Either way, not good.

There are a few things we want to look out for when it comes to investing in ETF managers:

1. Hidden Costs: While expense ratios are a major cost, some ETFs might have hidden fees like bid-ask spreads or commissions charged by brokers. Be aware of all potential costs associated with the ETF.
2. Underlying Holdings: Some complex ETFs might invest in a mix of assets or use derivatives, making it difficult for investors to understand the true underlying holdings. Focus on transparent ETFs with clear breakdowns of their holdings.
3. Tracking Error: While ETFs aim to track an index, they may not perfectly replicate its performance due to expense ratios and the need to hold slightly different assets. Investors should focus on expense ratios and how closely the ETF tracks its underlying index.
4. Liquidity Risk: Not all ETFs trade as heavily as individual stocks. Less liquid ETFs might be harder to buy and sell quickly, especially in volatile markets. Focus on ETFs with high average daily trading volume to avoid liquidity issues.

The Problem with Ark

In the past five years the S&P 500 has gone up 91.54%. The SPY S&P 500 ETF is up 91.19%. And with an expense ratio of 0.09%, investors would earn a return almost identical to the market with the SPY ETF. Now in comparison, let’s look at ARK invest, run by the famous Cathie Wood. They offer several actively managed ETFs.

For starters, the underperformance is real. Below we have a list of eight ARK ETFs. Each one is underperforming at a serious rate over a 5-year period.

Here are a few points worth observing. First this table is as of Apr 30, 2024 and the oldest ETF was launched in 2014. The top two performing ETFs (ARKW and ARKQ) that delivered a paltry 7.69-9.39% annualized return have Tesla and Coinbase/Crypto. Both ETFs have very high expense ratios of 0.88% and 0.75%, respectively, when compared to the SPY ETF expense ratio of 0.09%.

The question to ask is, why are investors deploying billions of dollars into ETFs that are underperforming and overcharging? The reality is that no one thinks twice about these investments. Investors believe passive investments = good investments. But that’s not true.

In fact, ARK’s Active ETFs are ARKK, ARKW, ARKG, ARKQ, ARKF and ARKX. Just look at the Fintech Innovation ETF which delivered 3.81% annualized returns when an individual investor could have significantly outperformed by investing in a broad market index itself.

Stop investing in poor performance

It’s your money, and you need it now. Stop overpaying for underperforming assets. Some of these ETF managers should not be in business anymore. They are taking advantage of uneducated investors. So do yourself a favor and educate yourself. Invest in better performance with lower fees.

Actively managed ETFs with high expense ratios tend to underperform the market after fees are taken into account. I find this because ETF managers are not industry specialists but salesmen in most cases. It's crucial to be aware of the limitations with ETFs and choose them carefully based on your risk tolerance and investment goals.

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