Make Sure You Look Under The Hood

The Wall Street Journal ran an article over the weekend called Beware of Professors Bearing ETFs. It took a reasonably skeptical look at the various funds backed by academic research including Jeremy Siegel's relationship with WisdomTree.

The important quote from the article;

Yet WisdomTree LargeCap Dividend Fund has posted negative average annual returns of 8% over the past three years, compared with 6.7% declines for the SPDR ETF, which tracks the Standard & Poor's 500-stock index, and 6.3% declines for the iShares Russell 3000 Index ETF.

WisdomTree started out with dividend ETFs and then along the way added earnings based ETFs, currency ETFs and recently an emerging market fixed income ETF. I have written a lot about their funds and use a couple for clients. The ones I use were chosen because of my belief that for the segments they capture they are the best way to go. We were impacted when they closed most of their sector funds which was both a disappointment and nuisance.

To the quote above it underscores a crucial point which is understanding what is under the hood of an ETF and so what that ETF is then vulnerable to. Every ETF is vulnerable to something, every thing you have ever invested in is vulnerable to something. The point is not to avoid all vulnerabilities but to understand what you are vulnerable to, assess whether or not this needs to be mitigated and if so, how.

Many of WisdomTree's broader dividend funds were very overweight financials versus various cap weighted benchmarks. As I started to write about these funds when they first listed I almost always included a mention of the weighting to financials. WisdomTree came on to the scene shortly before the financial sector was starting to crack. Here is one example. That last link is to an article about a fund that four years ago was 43% financials. Someone using a fund like that as a broad proxy for US equities did not necessarily have to be able to predict the financial crisis to see that 43% back then compared to about 22% for the S&P 500 at the time and so it should be obvious that if something was going to happen to the sector then this fund would have gotten hit hard.

For a long time I have expressed the same concern about the iShares FTSE/Xinhua China 25 ETF (FXI) because it is 46.7% in financial stocks. BTW this also applies to the newer albeit less popular iShares FTSE China (HK Listed) Index Fund (FCHI) which is 45.3% financials. Financial stocks are the last place I want to be in China. So far the sector has not been a real problem and may never be but clearly some sort of implosion in that sector will hit any fund that is very heavy in financials. You don't have to be a great analyst to realize that sector concentration becomes a risk factor for a fund. If someone buys FCHI and financials never do badly ever again they are still taking the risk of being over exposed to the sector, the risk doesn't go away just because the consequence is never realized.

A problem that seems to repeat over and over is people getting caught with too much in what turns out to be the wrong thing; tech ten years ago or financials three years ago. I would have thought this would have been obvious after the tech wreck ten years ago but many people got caught with too much in the financial sector. That some fund you might own is 60% financials is not bad if that 60% is considered in picking the other funds such that the total financial exposure from all holdings adds up to an acceptable number.

Figuring what sort of number is acceptable can start with comparing to some broad based benchmark and either overweighting, underweighting or equalweighting versus that index. Making this sort of decision requires forward looking analysis which not everyone may want to do but if some index has 15% in financials and you have 38% then maybe you draw a conclusion or two from that.