TAKING STOCK: The ups, downs, ins and outs of ETFs and IFs

Dear Mr. Berko: Why is it that you never or very seldom recommend exchange traded funds or index funds in your column? I have an account managed by a small boutique brokerage firm that primarily uses exchange traded funds and index funds in my $425,000 portfolio. And in the past three years, these managers were up 6.8 percent in 2009, 8.6 percent in 2010, and 7.5 percent in 2011 all after fees. I know these are not great numbers, but the truth is that I have done better in the market than most others I know, and I don't get hit by the violent swings in the market that drive my friends against the wall. My wife and I are retired, and we take out 5 percent of our account every year. So we'd rather have these low returns with exchange traded and index funds than have an account that is up 10 percent one year, down 30 percent the next year and then up 25 percent the following year. We are happy to give up the volatility of individual stocks for the stability of these funds. And I think you would be doing your readers a service by telling them about these funds. GT in Elkhart, Ind. Dear GT: Have you noticed that in the past dozen years the stock market has endured some of the most horrific swings in its 220-year history--so frightening that a growing number of Wall Street brokerages, investment banks, mutual funds and hedge funds now employ full-time financial psychiatrists on their staffs. In addition to having a medical diploma, this new genre of psychiatrists possesses MBAs and degrees in accounting or finance. The Fed, under Alan Greenspan, was the first financial organization to employ financial psychiatrists, and Mary Schapiro, who thinks she runs the SEC, may require FPs on the staffs of most financial firms over a certain size. ETFs, as well as index funds, are an important component in increasing this volatility. Ten years ago, there were some 270 IFs and 120 ETFs that owned $350 billion (not managed) in stocks, which at that time accounted for 15 percent of all the assets of managed stock mutual funds. Today, according to Morningstar, there are 350 IFs and 1,200 ETFs holding $1.5 trillion in stocks or 36 percent of the total money in U.S. stock mutual funds--and they seem to grow in numbers like "Maddy's Rabbits''! Here is the problem. The stock market works best when investors think and act independently. But when investors put money into an IF or ETF, that fund must blindly purchase every security (good and bad) in the Index it represents, no matter the price. And when investors pull money out of an IF or ETF, that fund must sell every security (good and bad) in that index across the board. This causes significant and "outsized consequences" that increase volatility by orders of magnitude. The phenomena is confirmed by Morningstar's Jimmy Xiong, who noted that this correlation has roughly quintupled since the late 1990s, which coincides with rise of IF and ETF trading. So if the only index fund you own is linked to the S and P or the drug issues or tech, too much of your money is always riding on stocks that move in lockstep with the index. So these funds are usually less volatile in a down market; however, their performance is usually disappointing in a rising market. Unless you have a professional who is index-fund knowledgeable (and few investors are), the odds are that you will not do well. However, it seems that you have done better than the market, certainly with much less volatility, but this success is due to the brokerage that manages your account and specializes in the world of IF and ETF. I know the firm that manages your money. They are good guys, and you can trust them. ---------- Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or e-mail him at mjberko@yahoo.com. Visit Creators Syndicate website at www.creators.com. © 2012 Creators Syndicate Inc. Published: Fri, Apr 6, 2012