Why I don't like ETFs

"I play that with ETFs" is a frequent comment I hear when people talk about their investments. Exchange Traded Funds as originally conceived (like the S&P 500 SPDRs) offered an inexpensive way to gain exposure to a popular index.

But we've moved well past that, and today there are hundreds of ETFs representing everything from Australian Real Estate to Japanese Appliances to Worldwide Water Resources.

I'm not a fan.


1) If you can't pick a stock, what makes you think that you can pick a sector? Often people invest in sector ETFs like biotech or semiconductors because they like the industry but don't want to take the risk of owning the wrong stock (i.e., one which underperforms). I would much rather own a company than an industry. The sector ETF is a diversification strategy, which will reduce your risk of that 50% plunge in a stock when news breaks that the Phase III trial for the lead drug has failed. But diversification works in both directions, reducing both losses and gains. My answer is to not buy a stock with that much risk. If you like biotech, look for some leading biotech stocks. If you can't find any individual stocks that you're willing to invest in, what makes you think that you'll make money with a bunch of them?

2) Do you know what you own? I'll bet that most investors in sector and country ETFs can't name most of the stocks in the ETF. And if you saw a list, there's almost certainly some that you wouldn't consider buying as an individual holding. So why tolerate holdings in your portfolio that you don't like?

But the bigger "know what you own" problem comes with the more exotic ETFs. Let's start with gold. If you own a long gold ETF, you probably want the protection that gold has historically offered in times of great financial stress. But who guarantees your investment if things get really bad? Some financial firm like Bear Stearns or AIG? Citibank? Lloyds of London? And how do you know that there's actually real gold backing your investment? Lots of recent news about once-trusted financial entities that met "black swan" fates. Same goes for other commodity ETFs: do they really own that oil, or corn, or copper?

And then we come to the leveraged ETFs, the "double long" and "triple short" variety. Have you ever asked the sponsors how they manage their positions? It's not simply a matter of buying or selling stocks equal to the ETF position. They use derivatives, and one thing that we've learned in the past year is that derivative instruments can sometimes have unintended consequences. A friend once called one of the sponsoring firms to get the details on how they managed the fund. He was told that they did not disclose that information. So how do we know that, when oil plunges from 147 to 32, your short oil ETF doesn't go bankrupt because of bad hedges?

Quiz question: If I was smart enough to have invested in the double-short Financial Sector ETF (symbol SKF) on the first trade in January 2008 and held that position through the year, how much money would I have made? We all know that financial stocks had absolutely miserable performance in '08. So by being double short, I must have killed it, right? Actually not. In fact, the SKF rose from 99.88 to 103.01 in that 12 month stretch (plus a small dividend). Check it out. The math is a bit complicated, but let's just say that the up days hurt more than down days help. Same thing is true for many leveraged ETFs. My point is that many investors don't really know what they own (until they learn an expensive lesson).


Portfolio update
I'm putting PG on the watch list. It's a great company, and it meets most of my criteria, but until now the stock hadn't come down enough to get me interested. With yesterday's selloff, I'll be looking for a chance to buy it if it continues to decline.

Return to their Rightful Owners

"In bear markets, stocks return to their rightful owners"

--old investment aphorism, variously attributed to J.P. Morgan and others



Who are the "rightful owners" of stocks?

When I started in the business, it was fairly uncommon for individuals to own stocks. 401k accounts were a relatively recent innovation, and mutual fund ownership was picking up, but not many people owned individual common equities-- just "rich people".

By the time the tech bubble peaked, it seemed as if everyone had a stock portfolio. Remember the cocktail parties of that era, when the guys would talk not about sports or women but about stock tips? Much of that vanished with the bubble, but stock ownership by middle-class households remained high.

The hedge funds had been around for a long time, but they only became a major influence in the stock market in the past 10 years. They own plenty of stock, but it would be hard to call them rightful owners.

I believe that the rightful owners are those who are long-term investors based on an informed opinion of the company's prospects. It's a key difference between investors and traders.

Today I saw several market opinion comments about how dull the market had become. The Dow has been up or down less than 100 points in 7 of the last 10 trading days. My guess is that we're getting close to a stretch of dull market days as investors gradually give up on equities. Many traders will exit if a low volatility environment limits short-term opportunities. But many individuals, currently waiting hopelessly for the rebound in their 401k funds, will also throw in the towel.

That's what will create the bottom. It won't necessarily be a technical (chart) condition or a spike down to a level where everything is just silly cheap. Rather, we're likely to be endure a period where market participants gradually get bored with the market, volume drops, and nobody cares anymore. By that time, stocks stocks will mostly be back in the hands of their rightful owners. May take a while, and it will probably be accompanied by a slow grind lower. But it will be a necessary condition for the bottom.


Portfolio update: I started a position in CAT yesterday following their earnings report as it dipped below my targeted entry point. I like the company and will look to add if it trades down to 30. I began a very small position in GE last week, and I'm waiting for them to lose their AAA rating or cut the dividend before adding. I don't really trust GE, so I'm being very cautious. Other portfolio holdings: ABB, BA, CSCO, DD, GOOG, INTC, SLB, and SYY.

Me and Thain get whacked

I started my first "real" job in late 1978.  Counting that one, I've worked for three companies in the last 30 years.  During that time, I've had vacations, but I've never been away from work for more than about two weeks at a time max.  For the vast majority of that time, the alarm clock has sounded at around 4:30am and I've been at work by 6.  Tomorrow, I'll be sleeping in.

Today John Thain and I (and a large number of my Merrill Lynch colleagues) got laid off, fired, riffed, whatever you want to call it.  Footnote:  at Bank of America, coworkers are known as associates, not colleagues.  Same as WalMart.

Of course, I'm not suggesting that there was any connection between my fate and that of Mr. Thain.  But it was an interesting coincidence.  I'm sure that he'll do well in his future endeavors.  I will too.

I entered the financial services industry in the mid 1980s with a manager trainee job at EF Hutton.  I worked as a  private client broker to learn the business while preparing for a job in sales management.  Hutton was truly a great firm back then.  I was proud to be in the business, and proud of my firm.  (another footnote:  at B of A, it's "the company", not "the firm").

I was young, and in awe of the idea of being a stockbroker.  The Dow was around 1300, and the NYSE had recently recorded its first 100 million share day.  

But even as a rookie, one thing that I clearly noticed was the grudging respect that my coworkers had for Merrill Lynch.  They would tell me how much better we were compared to firms like Paine Webber, or Kidder Peabody, or Smith Barney.  But they obviously envied ML.  Even the Merrill softball team dominated the local broker league.  And as I came to understand the industry, I could see that Merrill brokers were head and shoulders above everyone else in metrics like average production per broker.

I remember well a speech given by a former boss at my first (pre-Hutton) employer.  He said "if you don't think that you're working for the best company in the industry, you should quit your job and go to work for the best company."  Merrill Lynch was the best in the industry.  So when I had an opportunity to take a position at Merrill in 1987, I was quick to move.

I was truly very fortunate to have the chance to spend 21 years at Merrill.  It was a great job.  I worked with some outstanding people.  I grew personally and professionally.  My life was truly much richer for the experience-- in fact, it defined my life.  I enjoyed some great experiences, and I had an opportunity to do some wonderful things.

But things changed.  The economy, the stock market, the world.  The firm that was the best in the industry was destroyed by a combination of bad judgment, bad management, and bad luck.  The number one job of the CEO of any firm is to avoid blowing up the firm.  Merrill blew up.  Fortunately, the BankAmerica deal came along (although perhaps not so fortunately for the BofA shareholders).  

Lots of good people lost their jobs today.  It's a sad time.  It feels like a death in the family.  But it's not the sudden, tragic kind of death.  This one feels like the death of a long-suffering relative; we've long ago reconciled ourselves to the ultimate outcome, and when it comes it's seen as a blessing.  

How sad that on my last day I listened to some buffoon on CNBC make toilet jokes about this once-proud firm.  

This is a good thing in my life.  I'm looking forward to moving on.  I'm looking forward to spending more time with my family.  I'm looking forward to teaching my 15 year-old son to drive.  Next time you see me, I'm hoping that I'll be thinner and healthier.  Maybe even the gray hair will be a bit darker.  My golf game will be better.

Last week on MLK day, I was driving and heard on the radio a speech from Dr. King entitled "The Drum Major Instinct". In one part, Dr. King imagines his legacy: "I won't have any money to leave behind. I won't have the fine and luxurious things of life to leave behind. But I just want to leave a committed life behind."

I have often thought, as I've charged almost blindly down the path of my Merrill Lynch career, about my own legacy. Will my kids say "Dad made a lot of money, but we didn't get to spend much time with him?" Will people in the community say "He was always too busy to get involved?" Will I reach the end of my life and regret that I didn't take time to learn another language, or volunteer at a shelter, or travel to Africa, or spend more time with my parents? Now I've got the chance.

To all of my friends, best of luck.  The current dark days will pass.  My life is richer for having known you, and I hope that you'll keep in touch.  

Benchmark Bullsh*t

Q: What do you call an investment manager who substantially outperformed his benchmark in 2008?

A: a big loser.  

In most of the past years, your manager would crow about his performance if he beat his benchmark at all.  And if he exceeded it by 100bp or more, he would beat his chest with pride.

So last year the S&P 500, the most common benchmark, was down by about 40%.  How do you feel if you were down 30%?  Happy?

I recall a conversation with a portfolio manager several years ago:

Me:  What do you think about XYZ?

PM:  We hate it.  It's a lousy company in a poor end market.  Bad management, an overlevered balance sheet, and selling at an unsustainable valuation.

Me:  Well, I notice that you own about a million shares.

PM:  Yes.  But we're underweight relative to our benchmark.

Forget about your benchmark.  Buy stock in high quality companies with good future prospects and attractive current valutions.  Maybe you will underperform next quarter.  But in the long run you'll make an attractive return.

We're All Contrarians

One thing that bothers me quite a bit is the possibility that I'm just one of the sheep blindly believing in a stock market revival.  I read lots of newspapers, blogs, and research reports, and I realize that there's no shortage of bullish talk.  That emboldens the bears, who  say that the market can't possibly go up when so many are predicting it.

There's an old, probably apocryphal story about about a sell-side strategist who was making a speech to a group of buy-siders.  He asked for a show of hands by those who considered themselves to be contrarian investors.  Almost everyone raised his hand. 

The bearish argument is always more elegant, more reasoned, more rational.  If bulls can give you three general reasons for expecting a higher market, bears can offer ten very specific and seemingly irrefutable points to guarantee a fall.  

We're all contrarians now.  We've all learned that the path to profit is the one less traveled.  We all look to fade the consensus.  The problem is that, as everyone fades the consensus, they become the consensus.  

Not Another Year Ahead Piece!

I want to publish my thoughts about 2009- not because I think I can see the future, or because I want to give advice. Rather, I want to have something in print so I can refer to it in coming months and see a snapshot of where I was at the start of the year. That might help me to understand where I made mistakes, and what unanticipated developments caused me to change my thinking.

I think that the stock market made an important bottom on November 20, 2008 at around S&P 750. I allow for an undercut of that bottom. Although every bear market is different, I wouldn't be surprised if we see something like the 2002-03 experience, when the market made its primary low in October (at about 800), rallied to 927 on Jan 10, then fell back to a classic double bottom around 828 on Feb 7 and March 7.

But I do think that the market is presenting us with an extraordinary opportunity over the next 2 or 3 years. I believe that there are many very high quality blue-chip stocks with bulletproof balance sheets and franchise businesses selling at once-in-a-decade valuations. Many offer substantial dividends. I think that these companies could rise 50 to 100% or more in value over the next 2 or 3 years. I'm currently invested in ABB, BA, CSCO, DD, GOOG, INTC, SLB, SYY

If I'm right, I'll almost certainly underperform "the market". In the next bull market, some of the best performers will be high beta names: maybe airlines, or miners, or E&Ps, or beaten-down retailers. But I think that I've found the easy money trade, with very good upside and less risk. If I'm wrong and the market continues down, I'll definitely perform better with these more stable names.

I'm currently about 33% invested in my high-quality portfolio, with the balance in cash. I've been looking for a chance to add to those positions and start a few others, but the market's runup in the past two weeks has taken most of them beyond my target buy points. If the market goes straight up from here, I'll miss an opportunity (although I do have more equity exposure in my retirement accounts). If a new bull market has already begun, I'm willing to take the chance that I'm underinvested. I could easily see more downside, and real losses are more painful than missed gains.

My best guess is that the market trades in a range for at least the next few months. Maybe 750 to 1000 or so, but that range is just a guess. I'll look for a chance to add at the lower end of the range. If it gets up near 1000, I'll consider selling calls on existing positions.

I'm thinking hard about energy stocks. I've only got one (SLB) in the portfolio now. Although I wouldn't expect oil to make a V bottom and charge straight back above 100, I was interested in some recent investor surveys which showed a distinct lack of appetite for energy. The most bullish forecast for oil in 2009 was about $75/barrel , and most expected something around 40 or 50. I'm no expert, but I know that oil is an essential commodity, and recent prices of 40 or lower lots of supply became uneconomical to produce. It wouldn't take much in my opinion to see a slight pickup in demand push prices well above most expectations. It's probably a good "fat tail" trade, buying far out of the money calls. I'll try to play it by adding to SLB and finding one or two more high-quality energy companies that are down 50% or so from recent highs and have great balance sheets.

I'm avoiding beta names. I don't want anything in the portfolio that could get slammed if we find that the drug didn't work, or the hole was dry, or they couldn't roll over their revolving line of credit. No triple short ETFs-- which are really just coinflip bets anyway. No emerging markets, although I wouldn't be surprised if China turns out to put up some great performance in 2009. No small caps, although some very smart smallcap managers with great research will probably have a career year. I don't have great research, so I don't want to own stocks where the smart money sells well before the dumb money (me) discovers a problem. Smart analysts and hedgies can get a great informational edge with many small stocks, but much less so with BA or DD.


I expect that the recession will continue through 2009, and that it will be one of the most severe on record. I think we'll be able to see light at the end of the tunnel by year-end or maybe earlier. I do allow for the possibility--say 10%-- that the current economic malaise extends for much longer than I expect, perhaps 5 years or so. I'll keep some cash around to avoid blowing up, but I certainly will suffer if that happens.

Interest rates and gold should both go up. It's a consensus viewpoint, but I just can't see how all of the government stimulus won't eventually induce significant inflation (although much more dangerous is the possibility that they can't inflate). I don't like bonds. Even with historically wide spreads, higher interest rates will hurt bond prices, and I can get bondlike yields from the dividends on some of my stocks. Munis scare me. I think that many state and local governments are underfunded or worse, and the recession will exacerbate their problems. I don't think that the state of California will default on its debt, but its 6% 30 year paper doesn't interest me.

Finally, a few other names on my stock watch list: CAT, WAG, UNH, PFE, COST, GE, COP, and IBM. I've got some levels in mind if they sell off. No financials. Although I'm certain that the financials will have an absolutely rip-roaring rally at some point, I don't know when. I suspect that they're pretty well washed out, but they don't fit my criteria for bulletproof balance sheet.

So, in summary, there's plenty of money to be made from here in relatively safe stocks. Don't get greedy, and look to add on dips.