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The dark side of the ETF revolution

Read David Berman's commentary at Inside the Market at

Financial innovations don't have a great reputation for making the investing landscape safer and more profitable for small investors - and exchange-traded funds are no exception.

Sure, in theory, these enormously popular products are things of beauty. They track a basket of stocks or bonds, they can be bought and sold throughout the day on stock exchanges and their management fees are razor thin relative to mutual funds.

They can be perfect vehicles for diversifying at low cost and they take away the pressure to select individual stocks - something that few investors other than Warren Buffett seem able to do consistently well.

Unfortunately, though, exchange-traded funds have effects on investor behaviour that outweigh many of their benefits. They have a disturbing tendency to turn investors into speculators, encouraging them to jump in and out of the market in vain attempts to avoid downturns and catch updrafts.

The full impact is only beginning to be felt.

The first U.S.-traded ETF, the SPDR S&P 500 fund, managed by State Street Global Advisors, began trading 20 years ago, with modest expectations on the part of its creators.

They hoped it would attract $1-billion in assets. The fund instead has grown into a $124-billion behemoth, marking the start of a global fixation on ETFs that is showing no sign of slowing down.

Thousands of funds are now available worldwide, with combined assets of $2-trillion.

Last year alone, ETF assets grew by 15 per cent worldwide as the mutual fund industry struggled. Clearly, investors have found something to like here - and it's not just the low-cost diversification that ETFs offer.

It is becoming increasingly obvious that investors are also attracted to ETFs because they make it easy to jump in and out of the stock market with a single click.

That sounds appealing, but it allows us to act on emotional impulses, moving out of the market when we fear the worst and moving back in when we're tempted by greed. Too often, we get the timing wrong: We sell low and buy high - persisting through downturns but missing out on sharp rallies.

"There is a dark side," said Utpal Bhattacharya, a professor at the Kelley School of Business at Indiana University.

"One temptation, which is stock picking, has been curbed with ETFs. But another temptation, which is market timing, has increased."

Investors are acting on this temptation. With colleagues, Mr. Bhattacharya recently studied the impact of ETFs on German retail investors and discovered that ETFs made portfolio performance worse: They transformed investors into bad market-timers.

You can see market-timing at work with the SPDR S&P 500 ETF. An average of 133 million units of this ETF trade each day, enough to cover the entire number of outstanding units in the fund each week.

That's an astounding turnover rate - nearly 10 times the turnover rate of a single stock like Apple Inc. - and it speaks volumes about efforts by institutional and retail investors to beat the market with nimble moves. Most fail.

ETFs wouldn't be the first financial innovation that looked good in theory but, in practice, delivered unintended consequences - in this case, poor portfolio returns.

That said, their popularity has given us a lot to celebrate 20 years after the biggest one began to trade. They've driven down management fees and raised diversification.

Perhaps the biggest lesson over the past two decades is this: ETFs are not bad by design, but rather in the way we use them. To get the most from this investing revolution, it's necessary to keep your emotions in check. That is one skill that financial innovation has not yet rendered obsolete.

© 2007 The Globe and Mail. All rights reserved.

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