In recent years ETFs have moved beyond passive index tracking. There are many actively managed and thematic ETFs that claim to offer retail access to the edges of institutional investing and hedge funds. Recent experience with many of those ETFs shows that when a strategy or theme becomes popular, it can hardly maintain an edge.
In a world of financial alchemy, the old wisdom about trading and investing is forgotten. In the past, traders and investors knew that edges disappear after they become public. Some attempt to counter this argument by bringing the example of the momentum anomaly in the stock market, or the trend-following edge of CTAs.
As I argued recently in a Twitter Space by legend CTA Jerry Parker, momentum and trend-following traders are rewarded because they are disciplined and use a strict risk and money management method. The edge is not so much due to the formation of trends in prices; trends and trend-following are not the same things. The CTA job is hard, both the execution and the management, and an ETF cannot easily replicate that although it has been tried with no success in my opinion.
The WisdomTree Managed Futures Strategy Fund (WTMF) is trading 16% below 2012 highs.
Year-to-date the ETF is up only 2.6% although on the average CTAs are up more than 8%. This shows an ETF cannot replicate the average wisdom of those disciplined fund managers.
Another example is the ARK Innovation ETF (ARKK). It’s 71% below all-time highs.
In my opinion, the innovation theme was probably a promising one but as soon as it was popularized, it lost any edge it might have had.
The mechanism of arbitraging edges is complex. When a strategy or theme becomes too popular, unless there are extrinsic factors to prevent the edge from diminishing, market forces cause reversion to the mean after the initial excitement wanes. This is what happened to ARKK in my opinion. In most cases the fundamentals are irrelevant: as I have argued in this blog many times the market cannot provide profits to everyone and some people will have to lose for others to gain. Those who gain are the early investors and those who lose are the latecomers to the game.
The frenzy to convert every idea, and strategy to an ETF is driven by greed and it will end badly. When investing and trading ideas become popular and easily accessible, sophisticated market makers just change their strategies to profit from a large potential pool of future bagholders. Many don’t realize how sophisticated these professionals are. I was lucky to have met a few in the past and understand you don’t want to mess with those people. You have to stay under the radar. ARKK investors did not.
A trader who is following me on Twitter sent me a DM yesterday after I posted some metrics about the six strategies we use for our informational signal service and joked about making them an ETF. These strategies operate in the weekly timeframe and are a mix of trend-following, momentum, mean-reversion, and long-short.
This is an excerpt from the DM (permission granted.)
I have recommended your service to many people who need help but they simply don’t want to deal with the trades themselves even if only weekly. An ETF would be great for them.
This was my reply:
Lazy people won’t do well, whether it’s an ETF or trades. This business is about hard work, as you know.
ETFs, thematic or actively managed, are not designed to make anyone rich. They are designed to provide income to their developers in the form of fees and some are expensive. Themes and strategies can lose their edge and investors in these ETFs can turn into bagholders. It would be nice to be able to buy an ETF and become rich. Maybe some lucky ones will succeed.
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Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
Charting and backtesting program: Amibroker. Data provider: Norgate Data
