ETFs Avoid the Worst

The markets are littered with disasters this summer, so why are ordinary ETF investors not grimacing? Because broad market ETFs which comprise the vast majority of their holdings held up reasonably well while highly paid hedge fund managers lost billions for their sophisticated clients.

The typical buy-and-hold ETF investor took some hits, to be sure. Broad-market ETFs were volatile and generally flat during this difficult period, and some industry sector ETFs such as financials took it on the chin. But only a handful of very specific sub-industry ETFs lost in double digits which would have comprised a small portion of most portfolios. (We don't count leveraged ETFs just as we do not count margin investors in this comparison). The true carnage was reserved for relatively few individual company stocks and the actively managed funds which heavily overweighted them:

Not quite fitting into this performance comparison was one exceptionally poor performing ETF, iShares FTSE NAREIT Mortgage REITs (NYSE: - ). It represented the eye of the storm, firms specializing in lending for mortgages. Launching May 4, it promptly lost 38% through August 24. Damage was minimal, however, since the fund has only $4.7 million in total assets. Extrapolating this figure back in time suggests investors collectively lost only a few million dollars. Total assets held in all ETFs approach $500 Billion or about 100,000 times larger than REM.

How ETFs did it is no secret. They shielded their investors from individual company risk with an age-old recipe: diversification. Many ETFs held disaster stocks such as Countrywide, but almost always in tiny amounts. The percentage holdings by this ETF sample of Countrywide and Bear Stearns, the two most notorious financial sector failures, shows this clearly:

Source: Fund providers.

Admittedly, these percentages are smaller than they would have been before the companies' valuations took a dive, but even then they were quite modest. Even in a financial sector ETF they would barely have broken a percent or two.

Hot-shot hedge fund and mutual fund managers scoff at diversification, claiming that their talent and independent thinking allows them to correctly pick winners. And indeed some will. But as a group they displayed neither talent nor independent thinking in this most critical test, a down market. On August 24 the Wall St. Journal reported ("How the Quant Playbook Failed") that quantitative strategy funds tended to own many of the same stocks as evidenced by the latest SEC filings. It's not as if they reveal their secrets to competitors. It's just that the nature of the strategy tends to turn up similar stock targets.

Exacerbating the problem, these multi-billion dollar funds stampeded for the door at the same time, driving down prices further perhaps than fundamentals might justify. Apparently some were forced into these sales against their better judgement to meet investor withdrawals. Never pressured into a fire sale and never overloaded on any one stock, the typical ETF portfolio weathered the storm just fine.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com. Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.