Are Exchange Traded Funds Riskier Than Mutual Funds?

I  came upon this question while listening to David Stockman make his pitch for his Bubble Financing newsletter. Evidently he made some money by correctly anticipating the downfall of a biotech exchange traded fund(ETF) and was now predicting the demise of the 3 trillion dollar ETF market. The problem I had with his argument was that the risks facing a small, single sector ETF comprised mainly of startup biotech companies are considerably different than the risks facing a large ETF based on a well diversified portfolio of stable, liquid stocks.  It was especially ironic that Agora Financial was sponsoring the Buble Financing video since another one of their advisers, Jim Rickards, has been recommending an ETF that I have owned for several years as part of my large company asset category, Schwab US Dividend Equity ETF (SCHD). I doubt anyone would make the argument that an ETF like SCHD is as risky as a biotech ETF. This comparison becomes even more stark when you look at the liquidity and diversification of the largest ETF, SPY.

Then we get to the mutual fund question. Although ETFs are relatively new, mutual funds based on indexes have a long history. Is Mr. Stockman really saying that a large, stable ETF based on the S&P 500 such as SPY is significantly riskier than a mutual fund based on the same index such as the Vanguard 500 Index (VFINX). History has shown these two assets have similar risk and performance and brokers and customers look at them as being equivalent. As an old school MBA who constructed his retirement portfolio with large, stable ETFs, I thought I should do a little investigating. Was there a higher mis-pricing risk or other risk associated with ETFs that is not present in mutual funds or was this just another rant by a stock picker against the index funds strategy?

To put this investigation in perspective I started working in the 1970s. In the 1970s many defined benefit pension plans were under attack for under-funding by businesses and by embezzlement and fraud by the fund managers. It comes as no surprise that 401k plans were born to add a bit more honesty and accountability to the ugly retirement funding situation. In the 1980s private companies quickly replaced their defined benefit plans with 401k plans and added better fund performance reporting as a safeguard against the misdeeds of the past. Typically these companies offered their employees four investment options, company stock, a mutual fund stock plan, a bond plan, and a money market fund. The 401k plans became popular and reasonably well-understood. It did not take long before it became common knowledge that most of the stock plans consistently under-performed the S&P 500.  By the end of the 1980s the HR directors got fed up with the employee complaints and the repeated excuses by poor performing fund managers. Since the academic research said that index funds out-perform most fund managers their solution was too either add index funds as an investment option or to require a significant portion of index funds in the stock portfolio option. The battle lines were drawn. Fund managers needed to start beating the S&P 500 on a long term basis to justify their fees or the HR directors would going to divert even more of the investments to the very efficient S&P 500 index funds. In the quest for higher performance for retirement accounts, low cost index mutual funds and ETFs grew into a 3 trillion dollar behemoth. In the last eight years most of the growth has come via index ETFs.

So what was David Stockman complaining about?

  • As far as I can determine both the ETF, SPY, and mutual fund, VFINX, fall under the same SEC rules. If there is a systemic risk with SPY then that same risk affects VFINX. Since VFINX was created in 1976, history tells us that the systemic risk for this asset class is very low.
  • I agree with Mr. Stockman that an ETF such as SPY will occasionally have times the in which the ETF does not accurately reflect the value of the underlying securities. The mis-pricing risk is a problem for market makers and day traders. I am not sure how much a long term investor cares about daily fluctuations.
  • If an ETF such as SPY is faced with a severe drop in the underlying assets, I am not sure why Mr. Stockman thinks the fund managers will be forced to redeem ETF shares and sell stocks into a declining market. The liquidity risk in Mr. Stockman’s doomsday scenario is real but this is the same risk as a run on a company stock like Apple or Exxon. Although making a market in a declining or rising security may be scary or painful, market makers having been doing this in good and bad markets for a very long time.

Just when I had written off Mr. Stockman as just another stock picker who thinks indexed funds like SPY are boring and risky, I ran into this Planet Money podcast, Episode 688: Brilliant vs. Boring, which describes the million dollar bet between Warren Buffet and hedge fund managers in which one of the all-time best stock pickers said the S&P 500 would outperform a sampling of hedge funds.  According to Fortune:

Through the seven years, Vanguard’s 500 index fund, as represented by its Admiral shares, is up 63.5%. That’s the portfolio carrying Buffett’s colors. Protégé’s five hedge funds of funds are, on the average—the marker the bet uses—up an estimated 19.6%.