Q&A With Will McClatchy of ETF Zone.com

by on May 13, 2009

Will McClatchy is the editor of ETFzone.com, a Web site devoted entirely to exchange-traded funds. He is also the author of two investment books, Strategies for Investment Success: Index Funds and Exchange-Traded Funds. Mr. McClatchy was gracious enough to discuss common sense investing, obsolete indices, ETFs’ race against mutual funds, and more in an exclusive e-mail interview with ETF Database.

ETF Database: You obviously have a lot of expertise on the subject of indexing (having even authored a book on the subject). Some of the most ardent proponents of passive indexing in the past have been buy-and-hold style investors. During the recent bear market however a lot of traders utilized ETFs that track indices to make short-term bets. (And if you look at the most traded ETFs, a lot of them are obviously used for short term trading.) Long term, do you see ETFs as a tool primarily used by short-term traders, or by long-term investors? Or does it simply depend on the ETF?

Mr. McClatchy: Yes to all the questions! Buy-and-hold investors have always dominated assets under management. You can see this in data from Investment Company Institute going back to at least 2000, where low-cost, broad-based equity ETFs get the lion’s share of new money but modest transaction volumes. Investors come in, put their money on the US economy and sit tight for many months if not years. Assets under management pays the bills of providers through low-cost, broad-based index equity ETFs, so this is good.

At the same time, traders have always had an outsized influence on liquidity simply because they buy and sell so many more times per dollar of asset held. This is good, too, because it pays the bills of authorized participant/specialists who keep the ETF market flowing, and it shrinks bid-ask spreads for all. Clearly some classes of ETFs, such as leveraged or hot sector ETFs, almost exclusively attract traders (as they should). But all ETFs have day traders to some extent. The ETF is a marketplace, so all players help make the market more efficient, each in their own way. It is not a zero sum game.

ETF Database: It seems every month sees the issuance of more “niche” ETFs–some of which track dubious indices. Obviously the more exotic and novel ETFs sometimes have trouble building or finding an efficient index to track. Should ETF investors be worried about this? When an ETF diverges from its target index, is this something to worry about, or is it just the nature of the beast?

Mr. McClatchy: Investors should assess the relevance and efficiency of the underlying index of any ETF. Broad-based ETFs can have problems, too. Relevance is simply a matter of asset allocation or strategy. Does the asset class make sense for an investor? It’s a binary problem and one which all stock investors face; although many don’t realize it. We would argue that the Dow Industrials or the Nikkei, two hugely popular legacy indexes (or indices for the English majors), are obsolete for most portfolios.

Efficiency is more ETF-specific, and problems occur with niche indexes but not exclusively. The common theme usually is when large amounts of money move quickly in predictable ways. When that happens, arbitrage traders inevitably step in front and give ETF investors a haircut. This has clearly happened with USO, an oil ETF buying huge amounts of one type of future contract at predictable times. Arbitrageurs also attack the giant S&P 500, however, when it announces stock additions and deletions.

ETF Database: You co-founded IndexFunds.com, and now operate ETFzone.com. I have to ask: which do you like better, indexed mutual funds or exchange-traded funds? Which is your default recommendation for a long-term investor who wants to buy the market in a diversified portfolio?

Mr. McClatchy: Vanguard’s position is that index mutual funds and ETFs are essentially the same thing packaged in different vehicles for convenience, and for them the funds are actually commingled. I agree. If you buy and hold for longer than a decade, then a mutual fund is perfectly convenient. However, if you do tweak your portfolio regularly and if you work through a brokerage firm, then ETFs become more convenient. My simplest default recommendation is to pick one global total equity market ETF and one global market bond ETF, allocating between the two with the help of a financial planner or on-line service. Many do this for free.

ETF Database: The past decade has been one of incredible growth for ETFs (both in the number of issuances, and in the amount of total asset inflows). Will this continue indefinitely? Will ETFs eventually overtake mutual funds?

Mr. McClatchy: ETFs will probably overtake mutual funds, mostly by taking market share away from actively managed stock picking mutual funds. At some point every manager underperforms, and they charge big fees during down years as well, so there is a constant exodus. They tend not to go back.

ETF Database: Any words of wisdom–perhaps an unconventional investing tip–you could share with our readers?

Mr. McClatchy: Know yourself, which is age-old wisdom. One of the most powerful concepts of investment is utility theory. Essentially it means establish goals and pick tools which you understand to meet those goals and ignore what others are doing because they probably have different goals and different levels of expertise.

I think most investors would benefit from tapping their common sense. It’s looked down on as unscientific, but my impression is that most investors, even professional ones, don’t understand how nuanced investment theory actually is. There is no magic formula. Common sense helps avoid misinterpreting investment theory and following it over a cliff.