Across America, millions of would-be investors have grown disillusioned with the stock market. Seeing it as a rigged game, they've decided that rather than trying to beat Wall Street professionals at their own game, they'll instead be content merely to match the performance of major market benchmarks by jumping onto the latest hot product: exchange-traded funds.
Passive index investing certainly has its advantages, including instant diversification, low costs, and tax advantages compared with higher-turnover actively managed funds and ETFs. But one set of value investors believes that ETF investing has some significant flaws, and that savvy investors can take advantage of the inefficiencies that so many people buying the entire market can create.
Finding value in the market
Last Friday at the Columbia Student Investment Management Association Conference, one of the panel discussions among the dozen or so high-profile value-investing money managers addressed the relevance of the traditional value-investing principles of Benjamin Graham and David Dodd in driving investment decisions in the modern world. Clearly, conditions have changed a lot since the time that Graham and Dodd wrote their landmark book, Security Analysis, in the 1930s.
Several members on the panel argued that Graham would likely have viewed ETFs as being speculative in nature. The reason: The nature of ETFs involves investing in dozens or even hundreds of different stocks in a single basket. Because it's impossible to analyze all of the stocks in such a basket, you can't evaluate whether you really want to own all the stocks an ETF holds. By indiscriminately buying stocks throughout an given industry, market benchmark, or asset class, you're voluntarily taking on some stocks that you would likely avoid if you were choosing stocks on an individual basis.
Are ETFs investors dumb?
The tension between active value investors and passive investors comes from a fundamental difference in philosophy. Value investors believe that it's possible to determine an intrinsic value for any stock, and therefore that by comparing that intrinsic value with the current share price, you can find stocks that provide a margin of safety and a better chance of superior returns.
By contrast, many passive investors avoid company-specific analysis. Some are merely trying to gain access to the returns available from basic asset allocation strategies. Others invest at an intermediate level, using their analytical skills to find attractive industries but then using sector ETFs rather than individual stocks to try to profit from their analysis.
Obviously, that approach has pros and cons. Take the example of coal stocks, which have been beaten down due to the plunge in natural gas prices and the ensuing conversion of many electric utilities from coal- to gas-fired power plants. If you think that coal stocks in general will benefit from rebounding natural-gas prices, then investing in Market Vectors Coal ETF (NYSEMKT:KOL) should give you good diversified exposure to the industry. By owning stakes in many different coal stocks, you won't maximize your returns, but you won't get stuck with the worst performer, either.
By contrast, a value investor might drill down further to try to discover which particular coal stock was most likely to do well. For instance, if natural gas prices stay low but a rebounding Chinese economy pushes demand up, then Peabody Energy's (OTC:BTU) Australian operations and Teck Resources' (NYSE:TECK) access to the Pacific Rim from western Canada could do extremely well. By contrast, Appalachian-focused Alpha Natural Resources (NYSE: ANR) and CONSOL Energy (NYSE:CNX) could see continued weakness as they have to pay higher costs to get coal moved to higher-demand areas of the world.
How do you want to invest?
The rise of ETFs opens up opportunities for astute value investors. By paying attention to the stocks that make up the indexes that ETFs track, you can identify which stocks in a particular industry will have ETF-related demand, and which will be largely ignored by institutional investors. By focusing on those overlooked stocks, you'll have the best prospects to discover great stocks that others miss.
The big trend toward ETFs and low-cost investing makes plenty of sense, and ETFs are still smart investments for millions of investors. If you want to take the next step, though, looking to take advantage of ETFs' rigidity in tracking their indexes could make you a lot of money.