More Useful Commandments

ETF Think Tank posted an article titled The 10 Commandments of ETFs. I think it was more pointed to ETF providers and other people in the ETF business as opposed to investors or advisors. Maybe we can come up with a list that is more useful for investors and advisors.

1) Understand what is in your ETF

This is different than know what you own. Understanding is more than just knowing. For example, S&P 500 ETFs, as many people know have evolved into being very lopsided exposures into large tech/communications companies. The top ten stocks add up to 31% of the index with the so called magnificent 7 totaling a little over 28%. Or if you own something like the Consumer Discretionary SPDR (XLY), which is a client holding, you've got 40% combined in Amazon and Tesla. That's not bad or good, it is just important to understand. 

2) Watch out for overlap

This goes with number 1 on the list. Look through to ETF holding to account for how much exposure you might have to a single stock. Robotics is an interesting theme. The largest holding in the Global X Robotics ETF (BOTZ) is Nvidia (NVDA) with a 15% weighting. It also has a 3% weighting in the S&P 500. There's about a dozen ETFs where NVDA had close to a double digit weighting up to 20% in the Van Eck Semiconductor ETF (SMH). Some of those funds are thematic or actively managed so it would be easy to blend a broad fund, an active fund and thematic fund and end up with 10-15% in NVDA. It's not for me to say whether that is good or bad but if you don't know, that is bad. 

3) Understand the strategy

This is a big one we talk about all the time. You should not expect a covered call fund to keep up with a raging bull market. In 2021, the JP Morgan Equity Premium ETF (JEPI) lagged behind the S&P 500 by 700 basis points. At the 2023 highs for the index, JEPI was trailing by 13 percentage points. JEPI was down a good bit at the lows of 2022, it was down far less than the index but a decline nonetheless. 

With plain vanilla, you are going to ride the market all the way up and down. At times that will be great and at times, it will be very uncomfortable. That is what you are signing up for. I write all the time about client/personal holding AGFiQ US Market Neutral Anti-Beta ETF (BTAL). I think it is a fantastic hold but if you understand what it does, then you expect it to go down when stocks are going up. 

4) Is the ETF doing what they said it should? (expectations)

We recently looked at the Alpha Architect Tail Risk ETF (CAOS). At a very high level it owns short term cash proxies, so ok that means it doesn't really take interest rate risk like the Cambria Tail Risk ETF (TAIL), and it has a put strategy for tail events. It's a little more nuanced with the options part of the fund to avoid the slow bleed of continually buying out of the money puts. That makes sense but God help me, every day that I check in on it, it is going the same direction as equities. I am writing this post on 10/25 when the S&P 500 was down 1.43%. CAOS was down 47 basis points. I see this sort of thing more often than not. It is possible, maybe even probable, that I don't understand the strategy. It is possible that the strategy is just having a bad run, being distorted by some temporary factor. Maybe, it just doesn't do well in an ETF wrapper? 

 

CAOS was down less in early October which is why I think the one month result shows favorably but when you look closely you can see what I am talking about. Maybe CAOS can be a proxy for something else but I'd expect more up days for it than we've had. For three months, Yahoo shows CAOS as exactly flat versus a decline of almost 7% (more than 7% after today) for the index. 

5) Don't buy it if you don't understand it

You may think you understand a fund and then later realize you didn't. That's different. If you're looking at a fund and you just don't get it even though it might be doing well, doing what it is "supposed to do," you're better off avoiding it. 

6) Know if you're a sucker for a good or intelligent story

That's me. I'm a sucker for a good story, they all sound good but fortunately knowing this about myself saves me buying all of them and ending up with a portfolio of alts hedged with a little equity that gets no market upcapture. 

There are many funds that sound very interesting, that are clearly devised by very smart people who make very compelling arguments for their sophisticated strategy ETFs and mutual funds. As someone who has invested a lot of time trying learn about these exact sorts of funds, I am telling you they do not all work. They do not all add value to a diversified portfolio. Take the time to learn about them yes, this is both fascinating and fun for me, but I've said at least 100 times, I learn about many more of these than I ever use. I use very few actually. I will always want to learn about sophisticated strategies and funds but this is definitely an area where diminishing returns comes quickly. 

7) Understand liquidity

This might be for advisors more than individuals but a fund that trades 5000 shares per day is not necessarily illiquid. Yes, you should probably talk to a trading desk to look through to where a trade can get done or if large enough, to get a create made for you to complete your order. When they say not to use market orders,, that's correct. From my trading days, I use what used to be called marketable limit orders. Maybe they are still called that. If you're a buyer and you are essentially willing to buy at the market but don't want a bad fill, a marketable limit order would be a limit at the ask or maybe a penny above the ask. If you want to try to work an order in the middle of the spread then maybe be prepared to stay with it in case you get a partial fill and then the market moves away from you.

8) Be skeptical

Not every sophisticated idea can easily package into an ETF or mutual fund. 

9) Be orthogonal to faddish ideas no matter how mainstream they might appear

ESG might the best example. I have not mentioned ESG too many times but it has never resonated as an investment concept. Same as various socially themed ETFs, funds tied to political affiliations and so on. I'm not bagging on the themes but I am very dismissive of bundling these ideas into investment products.

10) Not Just ETFs

One idea from way back that I repeat every so often is to not limit yourself to just ETFs. There can be room for individual issues and traditional mutual funds. It is not logical that one wrapper can be best for all strategies and exposures. I started saying that in the earliest days of the original blog site, long before I used any mutual funds in client accounts. I don't use a lot  but have always been open to the idea and the ones I do use have very specialized exposures.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.