ETFs are for experienced securities traders


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ETFs are for experienced securities traders with open eyes

Some of my time, I work directly with paying clients to develop comprehensive lifetime financial plans and investment plans. I always explain the virtues of a globally diversified, fully passive, very low cost, index fund investment strategy. This is consistent with this website and with my other public writings.

I enjoy working with clients who want to understand valid investment strategies. However, I avoid working with people who just cannot get the various naïve “beating-the-market” strategy concepts out of their heads. On their own, these people can continue to waste their money and chase their tails on the plentiful, expensive, and exhausting hamster wheels of active investing provided for them by the financial industry. There is little I can do for people who are not willing to kick the active investment industry out of their investment wallets.

I always suggest a very low cost, broadly diversified, passive, low tax, low effort, and long-term buy-and-hold-and-hold-and hold investment strategy. For course, this completely passive investment strategy needs to be tuned to individual risk preferences, to appropriate asset allocation strategies, and to a person’s current and projected financial resources. Custom analysis is also required for “captive” assets in 401k, 403b, 457, SEP, Simple and other employer-sponsored retirement plans where a person must choose from a limited list of fund choices, which may not always be the most desirable.

I always provide to clients lists of mechanically screened low cost, no load mutual funds from which they can select low cost mutual funds for their particular needs. However, I have decided, as a general policy, NOT to provide any similar lists of low cost ETFs to just any client, unless they have reasonably extensive trading experience, and they understand what they are doing. In short, I prefer low cost, not load index mutual funds for their relative simplicity in comparison with ETFs.

However, if more experienced clients wish to use low cost ETFs to implement a very low cost, broadly diversified, passive, low tax, low effort, and long-term buy-and-hold-and-hold-and hold investment strategy, then appropriate low-cost ETFs could do the job for them, as well. As with any other investment product, anyone considering ETFs should determine whether they are appropriate to their background, knowledge, and experience. In summary, it is my general perspective that ETFs/ETPs may have unnecessary complexities and pitfalls, that passive, low cost no load index mutual funds may avoid more easily.

The May 6, 2010 US stock market “flash crash” harmed some individual investors

The May 6, 2010 US stock market “flash crash,” however brief, demonstrated that naïve traders inadvertently can do real damage to themselves when not trading knowledgeably. Many of those hurt the worst in this extremely brief, but severe, stock market fiasco (followed by an almost immediate and almost full recovery in the same day – if not the same one hour period) were naïve individual retail traders. They were trading ETFs or stocks with market orders or held a stop order without a limit that converted automatically into a market order once collapsing trading prices passed rapidly through the stop order price they had set.

(A stop order has a price but does not limit the price if the market price fell below the stop price. In volatile, falling markets, a stop-limit trading order is more protective, because it combines a stop order and a limit order and prevents a stop order from being executed at a market price below the stop price. See this SEC consumer page:  http://www.sec.gov/answers/stoplim.htm)

On May 6, 2010, in less than half an hour, market prices crashed dramatically and substantially for some stocks and ETFs. Prices collapsed so rapidly that many market orders were executed at prices far lower than expected. Some stop orders could not and did not get filled anywhere near the expected stop price point. The volume of selling orders skyrocketed in the panic and many buyers stepped away from the market until things settled down. Briefly, some supposed market makers were nowhere to be found.

Many high frequency traders exited, demonstrating that their much-vaunted contribution to increased market liquidity is mostly take and not much give. In short, there were too many hot potatoes and too few buyers willing to wear oven mitts during this interlude. After the dust settled, exchanges took the generally unheard of step of canceling some ridiculously low trades, but many very low trades were sustained and were not cancelled.  In a flash, some naïve traders found themselves to be a little or a lot poorer.

Imagine if you had owned a particular $100,000 ETF position in the morning and that this ETF was a noticeable part of your retirement portfolio. Imagine that you had placed a market order to sell during the flash crash without having current ticker information or that you had a standing stop loss order without a limit that would convert to a market order. In minutes, your sell order or unlimited stop loss order could have been executed at a market price of $50,000. You would have lost $50,000 and would have experienced the double financial insult of seeing the market price of that ETF recover by the end of the day to perhaps $95,000.

Moreover, this tragic order would not have been cancelled. Canceling executed orders is almost unheard of in securities markets. However, in this flash crash, exchanges did cancel some bizarrely low-priced trades. However, the exchange decided arbitrarily only to cancel trades that cleared greater than 60% away from their pre-crash prices. Does this very real situation give you a lot of confidence in your ability to trade safely?

By the way, regulators and exchanges have been studying this flash crash and have been taking some possibly corrective steps. Nevertheless, what was perhaps most striking about this clash was the general lack of specifics and clarity as to its causes. It has been well over a year since this flash crash. While reports have been issued, the vagueness about causes and the continuing uncertainty over the efficacy of the limited corrective measures that have been taken or have been proposed do in inspire great confidence in the securities markets.

Securities markets continue to look like a snake pit – at least concerning whether naive individual investors can participate with limited knowledge and not get bitten on occasion. Correlated with this crash, direct “retail” investor participation in stock market trading dropped off noticeably and has been slow to recover.

I doubt if you will ever see a TV ad with that insulting and vomiting E*Trade baby attempting to explain the danger of an ETF market order or stop loss order without a limit during a market free-fall. Trading is not really so simple that a baby (or an adult without knowledge and experience) can do it – at least not without some occasional and possibly major diaper soiling along the way.

Because ETFs add complexity to the situation, they are inappropriate for most do-it-yourself investors. If investors do not understand ETF nuances and trading concerns and do not wish to learn to trade properly and defensively, then the more straightforward alternative is to use only passive low cost no load index mutual funds. Stay away if you do not know what you are doing with securities trading. Do you really think that the securities industry has made all this under-ten-dollars-a-ticket retail trading by individuals so easy for your benefit and your best interests? When retail traders interact with professionals, who do you think wins most often? Who is likely to be the easiest mark around the trading table?

If you intend to buy-and-hold-and-hold-and-hold and in effect, never to trade, then you probably do no need to learn about ETFs anyway.  Instead, you could just buy passively managed, low cost no load index mutual funds, and let the index mutual fund’s professional traders do the bare minimum of trading for the portfolio.

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