Thursday, January 20, 2011

ETF Mania, or: A Study of Herd Behavior

Nestled on page B11, in this weekend’s Wall Street Journal was an article, “Social” Funds Embrace Emerging Markets.

One of the fads that’s irked me for some time is Socially Responsible Investing.  
Surely, that must go against the whole capitalist ethos, no?
What does Socially Responsible Investing even mean? And I don’t mean the wikipedia definition. I mean,  you’ve got 30 secs to explain it to me........... go!

Uh huh, thats what I figured. Sounds good though, right? All you need is a prospectus plastered with an image of giggling children frollicking in a field of daisies, under a sun filled sky et voila.
This whole ETF and theme-based fund frenzy is really getting out of control.

This one fund in particular, the MMA Praxis International Fund(MPIAX), aims for 20% Emerging Markets exposure, screening for companies that produce alcohol, tobacco and weapons. Therefore, mining and sweatshops that employ cheap efficient labor have a free pass.

Talk about coming to the party late and with nary so much as a cheap bottle of plonk. While procrastinating over how the write researching this post, along comes the WSJ with Here Comes The Dumb Money (hat tip stonestreetadvisors). Gee, I wish i’d thunk o’ that title.  

Because over the last year, the MSCI Emerging Markets Index has risen over 35%:

And since 2008 over 142% - Not to also mention that HUMONGOUS Volume spike during Sept of last year:

And inflows for the week ending Jan 14th 2011 show that the leading Emerging Markets ETF, Vanguard’s Emerging Markets ETF (VWO) was once again among the ETFs with the highest inflows ($840mn).  Admittedly, the iShares MSCI Emerging Markets Index (EEM) was among the ETFs with the highest outflows (-$1.1bn).   

However, I believe the outflows from EEM has more to do with cost of VWO (ubercheap), and EEM lagging the MSCI Emerging Markets Index. Perhaps, lately a third reason - How EEM is structured.

VWO uses a replication strategy (it seeks to own as many of the underlying stocks in the index as possible),  holding as many as 800 stocks. EEM on the other hand uses a sampling strategy designed to deliver the index’s returns without owning all the securities in it and “optimizes” - a not-so-clever euphemism for backing the truck up on derivatives.  

Understanding ETF methodologies is an important criteria that is often overlooked by both professional and retail investors.  Of the roughly 1200+( numbers change frequently with additions and closures) ETF and ETNs that can be traded, maybe 75 are truly understood and should be traded.   
The rest are an exercise in futility, pandering to the masses desire for an investing elixir.
This is all part of the greater trend of investors missing out on a rally, and getting into the latest fad/innovation to jump start gains. Ordinarily, you would chuckle at the "dumb money", but plenty "smart" money gets in on the act too. 
You’ll know we hit bottom when there is an art mutual fund/ETF or worse an ETF that allows investors to Put Money on Lawsuits to Get Payouts.  Look carefully before you leap. 
Happy Trading

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