The Myth of Exchange Traded Funds

The Ark Innovation Exchange Traded Fund is down just over 20% YTD, yet Cathie Wood seems unfazed. Just Friday, ARKK investors were told that they could expect..

The Ark Innovation Exchange Traded Fund is down just over 20% YTD, yet Cathie Wood seems unfazed. Just Friday, ARKK investors were told that they could expect a 40% annualized return in the next five years. 

The prediction drew the mockery of retail and institutional investors alike, but it makes sense why Wood would say that—for every dollar put into ARKK, 0.75 cents is taken as a fee. At a current gross asset value of 18 billion dollars, ARKK generates annual revenue of over 135 million dollars for Wood and her firm. 

Whether or not your investment into ARKK is winning or losing one is inconsequential to Wood. What is important for her is that you believe that ARKK will win. 

Capitalizing on TSLA hype and the collective oedipal complex of the WSB crowd, Wood has been extraordinarily successful in marketing ARKK as a winner—and has achieved a celebrity status seldom seen for an investor. 

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But unlike rockstar financiers like Warren Buffett and Jack Bogle, who are known for emphasizing sound financial principles, Wood is principally an evangelist for her fund—not to mention, for her profit. 

It might seem that the Wood effect is symptomatic of the current ETF paradigm, but it’s easy to forget that long before ETFs were invented there were mutual fund managers who pooled the hard-earned dollars of retail investors into losing equities in exchange for trading commissions. 

Shaking off the stigma of “mutual fund” while capitalizing on the benefits of being listed on an exchange, ETFs have become the latest, coolest way to consistently underperform the market.

What the retail investors of today seem to neglect is the decades-long crusade against active funds by the likes of rockstars like Buffett and Bogle. More than fifty years ago, Bogle, the founder of the Vanguard Group—the largest mutual fund provider in the world—proved that actively-managed funds are simply not a good investment. 

In his eleventh, and final, book, The Little Book of Common Sense Investing, Bogle outlined exactly why actively-managed funds are a bad investment vehicle. The same reasons hold for active ETFs like ARKK or the upcoming MEME: high costs, low long-term returns, and regression to the mean.

Compared to ARKK, Vanguard’s VOO—an ETF that tracks the performance of the top 500 companies in America—charges a fee of only 0.03%. Moreover, in the long-term (think, twenty years or more), VOO is more than likely to outperform ARKK by a substantial margin.

Almost every actively managed fund has failed to outperform the top 500 companies in America, tracked by the S&P 500 index, over the long term. Funds that undergo tremendous short-term growth in five or ten years are likely to tank in the following years in a process Bogle calls “reversion to the mean”. 

Looking at the state of funds across two five-year periods, 2001-2006 and 2006-2011, he found that “only 15 percent [of the top funds] remained in the top quintile, while 20 percent fell to the bottom. Even worse, 13 percent of the funds—45 funds—failed to survive.”

Doing the same analysis for 2006-2011 and 2011-2016 yielded similar results. For an even longer-term analysis, Bogle looked at all of the active funds (355) in the year 1970 and compared their performance to the S&P 500 across 46 years to 2016. The result? All but two funds failed to beat the S&P by a significant amount, with the majority of them going bust.

It’s unlikely that Wood’s ETFs constitute the 2 in 355. Statistically, the average investor in stocks can’t beat the market. 

Bogle’s parable of the Gotrocks family is a powerful demonstration of this fact. The Gotrocks is a family whose members collectively own the entire stock market of an entire country. Every year, the Gotrocks increase their net worth by the earnings of the companies that they own.

One year, a stockbroker friend of one of the Gotrocks tells her that a certain company she owns is overvalued and that she can make a profit if she allows him to help sell the stock to another Gotrocks family member. She does so and makes a profit, while her cousin makes a loss.

The parable demonstrates two things: One, the equities market is a zero-sum game. Whenever a seller makes a winning trade, the corresponding buyer must have made a losing trade as well. Therefore, the median investor must make no loss or gain—the average investor does not make money.

Two, because the stockbroker friend was able to earn a commission off of broking the trade, the Gotrocks family as a whole made less than what all of the stocks they owned earned in that year. Because each trade incurs a cost, the average investor loses money. 

When the Gotrocks realize that they’re not making as much as they could be making, they fire all of their brokers and instead enjoy the earnings that all the companies they own make year after year. 

This is what buying VOO or any other low-cost index fund does. It ensures that the earnings you reap are from the financial growth of an economy and not from zero-sum trades that both incur costs and are not guaranteed to make you a profit.

Indeed, Bogle finds that the average mutual fund slightly underperforms the market—that underperformance resulting from fees. Assuming an efficient market, the average mutual fund performance is simply the sum of the earnings of all the equities traded divided by the number of mutual funds, which averages out to become the performance of the entire stock market minus the costs.

It’s possible, but unlikely, that Wood is among the top 1% or so of fund managers who can regularly beat the market long-term while factoring costs into account.

It would, however, be inaccurate to assume that her past successes as a fund manager will guarantee a 40% annualized return. Don’t take my word for it, the ARKK web page specifically states:

“Past performance does not guarantee future results.”

-ARKK Investment

You might, then, be tempted to time her successes, buying when the price is going up and selling right before the price reversion. The thing about this strategy is that you’ll have no idea when to buy or sell. 

Being the retail investor that you are, you’ll probably trade according to market sentiment, headline news, and information that’s available to you—which means that millions of people would’ve already had the same ideas as you by the time you’re thinking about executing an order.

Trading is a zero-sum game, and as a retail investor, you’ll probably be the one at the short end of the stick.

The solution to all of this? Simple.

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“Buy everything (i.e. an S&P 500 index fund) and hold it forever.”

-John Bogle

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Writer: Heng Yi Ong
Editor: Evelyn Tobing

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