You read correctly, ETF investing is no walk in the park! The main motivation behind investing money into ETFs is to broadly diversify one’s stock portfolio. But is this really such a good idea? What sounds like a long-term no-brainer, carries significant risks that hardly anyone talks about. But today, we put our finger on the wound!
The selling pitch behind passive investing into ETFs sounds too good to be true. By putting your savings into these vehicles, you get access to broadly diversified equity portfolios. Individual risks are spread out among hundreds or even thousands of different stocks. At the same time, you are just paying a small yearly commission, because these funds only replicate indexes (hence the term “passive investing”).
But what sounds too good to be true, indeed most often is too good to be true.
For example, they don’t tell you that this is a business yearly generating billions of USD in fees for the ETF providers like BlackRock, Vanguard and peers. By the end of 2021 – when the markets peaked – total assets under management were approaching 10 trillion USD for the first time. This was around 40% of the US economy in size.
The points above are not inherently false per se. Unfortunately, ETFs carry around the narrative of being the ultimate long-term investing vehicle where nothing can go wrong. You are told “not to put all your eggs in one basket” and to “spread your bets”. This is how diversification is explained and these products are pitched.
But what if I took away this illusion and told you that diversification is not only overrated but also misunderstood? Both claims from above are dangerous simplifications that make many ETF investors believe that their investments are infallible. Should their “bets” lag any performance expectations, they say “we invest for the long run”.
“Long-term” or “long run” with a rather week performance over a longer strech can be very unnerving, though…
Today, we are continuing where last week’s article ended. We will go into more detail about ETF basics as well as the risks of ETF investing that you are not told. At the end of the day, you will know where stock diversification through ETFs has its limits and why it is overrated.
Plus, I am going to tell you how to avoid these dangers and how to invest instead in a sneak peak.
ETF investing 101 – what you are told
Most ETFs are so called passive investment vehicles. Passive, because these funds only replicate (or track) certain baskets of stocks without actively picking new equity investments. Only from time to time when for example the constituents of an index change, this change is replicated in the passive fund, too.
The most known and tracked index by far is the S&P 500 which contains the 500 biggest US companies by market capitalization. ETFs are also replicating whole sectors like technology or green energy as well as certain geographies like Europe or emerging markets. There are also such funds that invest into Bonds, Bitcoins or gold and silver.
One strategy to invest is through ETF savings plans. This way, you have an automated system in your investing process avoiding market timing. Plus, you can take advantage of the effect of so called dollar cost averaging where you lower your average cost basis by buying more shares during market corrections for the same money. With rising markets over time, you buy into the markets at favorable average prices.
These passive funds are preferred due to their low costs, especially compared to often underperforming actively managed funds with high costs.
When searching for terms like “investing for beginners”, earlier than later many people stumble across ETF investing. Sounds like a clever way to invest with little time-effort, at low costs and without taking the risks of individual, concentrated investments for your retirement, doesn’t it? Only picking some topics with a birds-eye’s view and spreading among these ideas seems like the way to go.
This is also the strategy of many people in the FIRE community, I wrote last week about. After cutting their biggest everyday costs and living a less stressful, more calm and enjoyable lifestyle, they preferably put what is left over as savings into stock market ETFs.
The most prominent and most often mentioned ETFs are those that track the:
- MSCI World Index (most recent factsheet as of writing this article here, more information here)
- MSCI Emerging Markets Index (most recent factsheet as of writing this article here, more information here)
Keep in mind, that you cannot invest directly into these indexes listed above. You need a provider that replicates one of those with a passive fund. Known providers are Vanguard, BlackRock, etc. (without advertising them).
The idea behind investing in those indexes is straightforward. With the MSCI World index you are buying shares in the biggest companies in the developed world. This shall give stability and average growth (s. below).
To boost the returns “for the long-term”, the MSCI Emerging Markets index is a mentioned addition to the portfolio, because Asia (>70% of the index) is the place where the bigger growth is expected.
Sounds logical, doesn’t it?
Here and there in the FIRE community, there are also mentioned “less risky” ETFs that invest into bonds. However, for the purpose of this article, we are focussing on the both mentioned indexes. And yes, I don’t think that it is a good idea to invest in bonds during a period of rising interest rates, especially not ones with a long duration… when interest rates rise, bonds with their most often fixed coupons get less attractive and their price drops.
Here is a rough shot on what investments into ETFs replicating these indexes have approximately performed in the past:
- MSCI World Index had an average performance of 7.9% from 31 December 1987 – 31 August 2022
- MSCI World Index had an average performance of 10.1% over the last ten years until 31 August 2022
- MSCI Emerging Markets Index had an average performance of 9.7% from 31 December 1987 – 31 August 2022
- MSCI Emerging Markets Index had an average performance of 3.3% over the last ten years until 31 August 2022
For the Dow Jones or S&P 500 indexes you can somewhat expect similar figures over longer timeframes.
The result of looking at different long-term intervals is that stock market ETFs average an annual performance of around 8–9%. This is what you can expect over a very long timeframe.
However, this is not a figure you should expect gradually every single year.
After one year with say +20% and another with a zero, there will inevitably come a down year or two. Drawdowns (falling prices) tend to be shorter, but more intensive. Don’t be surprised to see some years with –20% or –30%.
But on average, you could have expected in the past solid 8–9% p.a. with ETF investments. It is also in line with what ETF providers advertise.
However, here is where the stress-free part ends, because theory works only in theory, not in practice.
All ETFs have in common, that you buy into baskets of securities and thus ideally spread your money over many hundreds or even thousands of different investments.
But do you exactly know:
- in what geographies
- in what currencies
- in what companies
- in what bonds (who are the debtors and how solvent are they?)
- with which weightings
you are exactly investing with your ETFs?
Or could it be more likely, that most ETF investors do not even know what they are doing? Is the safe feeling masked by assumptions and a strong belief that everything will go its way?
Before putting a single penny into an ETF, you should find out how your ETF of choice is build and what the constituents are. Not only that, but also in which weightings – that’s why I marked the last point on the list above in bold.
In the past, it had big implications on the returns of the following periods when there was a too big imbalance in certain sectors. Maybe you will be surprised, that history doesn’t repeat, but it is said to rhyme.
Let’s explore in the next section what I exactly mean.
The dangers of ETF investing you are not told
Due to the loss-averse nature of humans, these offerings are a welcome psychologically compatible, user-friendly and cost-effective way to invest primarily in stocks where the investor himself has no active management duties and responsibilities.
ETFs are supposed to bring fearful investors a good balance between acceptable long-term returns on the one hand and safety on the other.
Loss-averse means that people are way more afraid of a potential loss than they feel pleasure about a potential gain.
Because of psychologically weighing losses higher than gains, the motto is, “before producing any losses myself, better let someone else do the work safely”. This is the reason why many people are afraid of investing into individual stocks or even stocks in general.
But be careful, loss-averse is not the same as risk-averse!
Interestingly, many people are loss-averse, but not risk-averse. They:
- prefer a sure gain over a speculative and unsure gamble to the upside, hence prefer cutting winners and taking money of the table prematurely
- but seek to avoid sure losses (or limiting losses) in favor of gambling in the loss frame, hence are risk seeking and hope to flip the loss into at least a zero
Think through it for a second: When facing risks, humans are rather risk seeking. When taking risks, people tend to be risk-averse.
This is why many prefer to put money into a savings account where they get “safe” 0.5% p.a. without fluctuating daily prices instead of earning historically 8% p.a. with a stock portfolio. One step further, the argument is the same when it gets to investing into ETFs vs. individual stocks.
This of course is depending on what timeframe you look, for example, over the last ten years, the S&P 500 earned an above-average 12.99% p.a (total return with dividends reinvested). Generally, the average long-term return is somewhere in the range of 7–9% p.a. This is what you need to keep in mind.
Approaching the above with common sense and logic, you would say that it should be expected the other way around. Especially when it gets to investing money in the stock market.
Indeed, it should be. But this is not the way most people approach investing.
Instead, when investing many prefer to limit their upside (sure gains before potential gains) while at the same time avoid cutting and limiting their losses (hoping to reverse a loss into the green instead of freeing up capital for better opportunities).
Why stick with the rotten apples?
Because many are afraid of taking losses.
The danger of refusing to realize losses is even amplified by silly claims like “only a realized loss is a real loss” or “as long as I don’t sell, I don’t have a loss”.
Why is this a problem?
You would need to admit that you made a mistake!
But what is being portrayed as an alleged sign of weakness and attached with a loser-attitude, in fact is the best way to:
- clean up your mind (you will have forgotten about the loss in the near future)
- focus on your winners and let them run (a stock that goes up 3x can make up the losses of 4x –50%! – of course you should not fish for so many losers…)
- learn from your mistakes (and please take this lesson!)
I fully support proper risk management and practice it myself. But you have to distinguish between calculated and uncalculated risks. I need a much higher optionality than I have downside. This creates an attractive risk/reward ratio.
The potential gains have to be way higher than the potential losses (at least 3 to 1).
Should a loss nonetheless occur (this happens to everyone) and my original investment thesis lose its foundation, then it is time to cut losses and move on.
What has this in common with ETF investing and why is it important for today’s article?
The problem is that ETFs are sold as being safe, having limited losses due to spreading the bets and supposed to be sure gains over the long-term.
But is this the reality? Are ETFs without risks?
To examine this, let’s look at the compositions of the favored indexes, the MSCI World and the MSCI Emerging Markets.
MSCI World Index
You will not be surprised to see all the Big Tech stocks taking most of the top ten positions of the index, because they are by far the biggest companies by market capitalization:
|Company||ISIN||Market Capitalization||Index Weight||Sector|
|Apple||US0378331005||2.6 tr. USD||5.1%||Inf. Tech.|
|Microsoft||US5949181045||1.9 tr. USD||3.7%||Inf. Tech.|
|Amazon||US0231351067||1.2 tr. USD||2.3%||Cons. Disc.|
|Tesla||US88160R1014||0.7 tr. USD||1.4%||Cons. Disc.|
|Alphabet A||US02079K3059||0.7 tr. USD||1.3%||Communic.|
|Alphabet C||US02079K1079||0.6 tr. USD||1.2%||Communic.|
|United Health||US91324P1021||0.5 tr. USD||1.0%||Health C.|
|Johnson&Johnson||US4781601046||0.4 tr. USD||0.8%||Health C.|
|Exxon Mobil||US30231G1022||0.4 tr. USD||0.8%||Energy|
|Nvidia||US67066G1040||0.4 tr. USD||0.7%||Inf. Tech.|
|Total||9.3 tr. USD||18.3%|
What might surprise you, however, is that the ten biggest positions have a weight of nearly 20% of the whole index. For an index that is said to “diversify” across the developed Western economies, this is misleading.
Especially, when you understand that the index has a total of 1.516 individual positions.
When 0.66% of the positions make 18.3% of the whole index, we have an imbalance. You might not be as diversified, as you thought.
It is not uncommon to have bigger and smaller companies. This is not the point. We are not talking about rather exotic equal-weight indexes that can be found on the market, too.
The biggest official sector of the MSCI World Index – as of 31 August 2022 – is clearly information technology with nearly 22%. It is already 50% bigger than the second biggest sector, financials.
You will also notice that the “diversification” efforts have placed their bets 70% in USD (which by the way I think is rather a good thing in todays political and economic environment, but we stop looking at currencies here, just to mention this point, too).
Up until here, the MSCI World Index is approximately a tech-heavy and US-concentrated basket.
Unfortunately, the sector categorization is somewhat discussable, to say the least.
Hence, it gets more concentrated as you will see.
Whereas Apple, Microsoft and Nvidia are grouped into the IT sector, Amazon, Alphabet and Tesla are not. I would rather see them in at least a very similar category.
It would not be too far-fetched to count into the basket of technology companies several others from the sector of communication services (Alphabet, and outside of the top ten, a.o. Netflix, ISIN: US64110L1061 or Meta / Facebook, ISIN: US30303M1027, see factsheet of this sector here) and at least partially consumer descretionaries with a technology-link (Amazon, Tesla).
These are all multi-hundred billion USD companies by market capitalization (Netflix currently jumps around this mark after being down nearly 70% from its high). This means, they all have just one voice (one position each of the 1.516 in total), but very high relative weightings.
Taking the IT sector plus the biggest companies with technology-like businesses from the communications and consumer descretionary sectors mentioned above, we get closer to a total weighting in the range of at least 25%. Maybe even closer to 30% for the technology sector as a whole in a supposed to be broadly diversified index.
This is the advertised “diversification” of the MSCI World Index. Less than 1% of the positions dominate the index with 25–30% of the weighting, whereas there are hundreds of positions you wouldn’t notice if they doubled or tripled in price.
You would rather expect such weightings in a technology index like the NASDAQ (which has an even more stark imbalance).
One could argue, “these are the best companies we ever had” and “they are so dominant and cash generating”…
Or one of the evergreens: “This time is different…” Better forget this last sentence, because it is very costly…
True, but let’s not forget to look at history.
It will let your jaw drop to hear that this index imbalance is one of the highest we had, at least for the last 50 years. These imbalances always correct sooner or later and new sector weightings emerge.
Partially, this correction has already happened since the end of last year, at the latest. But expect more rebalancing.
When everyone knows which stocks will go up, then it is time to leave the party…
All imbalances historically ended with a rotation from the big sectors and companies to smaller ones, that itself got bigger. Thus new sector imbalances arise with time.
Here is a brilliant graphic from visualcapitalist.com that shows different sector weightings from 1800 up until around 2018. The last 3–4 years are more or less the same, but even more to the extreme, because this was when stocks like Tesla and Nvidia really took of. And of course the first-row Big Techs rose, too, but less so.
Let’s have a look and search for parallels to the current situation. Jut have a first look at the following graphics. I am going to explain the main findings:
Here is another graphic from a different source with the shorter timeframe of around 50 years and with a slightly different order, but the same results:
This is a lot of material and data at first sight.
Not all periods are exactly comparable with each other, because some sectors and industries just did emerge way later than others while others declined. For example, there was no technology and no health care sector 200 years ago. The REIT sector was only created in 2016 as a “spin-off” of the financial sector.
What you will see immediately, is that the curves fluctuate. This showcases the rotation of the weightings of the different sectors. That’s the first and most important thing to notice.
I’ll break down the important details for you.
Let’s look at the most prominent and eye-catching points in time of the last hundred years to get the big picture (all figures roughly per eye):
- at the beginning of the 1920’s post-WWI, the energy sector had a weighting of around 25%. Then the economic and stock market boom (speculation) started until the bust of 1929. The weighting of energy nearly got cut in half while other sectors got bigger in relative terms.
- during the frenzy of the roaring twenties up until the bust in 1929, financials (stock market speculation) had weightings of around nearly 20%. This weighting was reached again only 50 years later, partially due to many financial institutions going bankrupt.
- after WWII for about 10–15 years, energy and materials combined had a rising weighting, peaking at more than 40% before the 1960’s.
- during the 1970’s and at the beginning of the 1980’s again energy and materials had a combined weighting of around 25–30% at the peak.
- then of course the dotcom bubble of 1999/2000: technology and telecommunications had a share of 50% of the whole stock universe (tech 30%, telecom 20%) – you know how that ended.
- around 2007/2008 before the global financial crisis, the financials sector rose to more than 20% again (the housing sector or REITS these days was part of the financials and just split in 2016, as I wrote above).
- currently: the new tech stocks with 25–30% index weighting.
I don’t know how you feel, reading this, but the odds seem not to be in favor of those betting on a continuation of the rise of the tech stocks.
However, there is one more thing we have to look at to complete this review.
How did these current darlings grow in the past decade? Let’s look again at two very useful graphics:
You see that the sectors with the highest growth rates over the last decade by far have been:
- IT (9th column with the green fields) have grown 20% per year (!) in the MSCI World Index (second row)
- consumer descretionaries (second column), including companies like Amazon and Tesla, with above average growth rates of around 15% p.a.
- health care also had high growth rates (6th column). This is explained by the fact, that in that time many biotechnology stocks (non-traditional health care) grew rapidly
The same with the second graphic (it is interactive, you can click on the link below; in this screenshot I marked the IT sector for a better overview):
Most of the time during the last decade – or after the global financial crisis, respectively – technology stocks were among the fastest growing sector. Self-explanatory, this sector had by far the greatest annual growth rate with nearly 17% p.a. in this timeframe.
By the way, the S&P 500 itself also had a respectable above average return of 12–13% p.a. The main reason here was also the outperformance of the technology sector that has a great weighting and thus impact on the S&P 500.
But, as you know, the bulk of this growth was driven by the Big Tech stocks. Otherwise, they would not have such high weightings in the indexes.
Great, you might say. Why shouldn’t companies with strong businesses have exceptional growth rates? And what’s the catch with ETFs?
Didn’t they tell you that you are going to earn 8–9% p.a. with ETFs? And what about historical sector rotation?
In the current situation, almost everything depends on the fate of the big tech stocks which have grown with nearly double the average historical annual rate of return.
Diversification has lost its original meaning in this sense, because the concentration is rather high. All ETFs that track such indexes are sitting in the same boat.
In order to revert to the mean (come back to the average 8–9% p.a.), the tech sector has to either stagnate for a very long time while the other sectors stage a strong comeback and the economy as a whole will get a boost. I don’t think this is very likely.
Or, the other option, the tech stocks will have to come down rather hard and grow way below the historical average to rebalance the outperformance of the last decade.
You shouldn’t be surprised to see many tech stocks only grow with low to mid dingle digit figures, especially as the economy slows and interest rates continue to rise. Many of these stocks are not immune to economic contractions.
You should not expect the underperformers (with low weights) of the last decade to be able to offset the probable underperformance of the highly weighted tech stocks.
Next, let’s just look briefly at the situation in the MSCI Emerging Markets Index.
MSCI Emerging Markets Index
To rush forward with the results, this index has an even more krass imbalance.
But we are only looking briefly at it, because first it is a rather exotic non-core ETF investment for many. And secondly, historical long-term data is not so available, like in the case above.
The top ten positions in this index have a total weighting of 23% alone as the following table shows:
|Company||ISIN||Market Capitalization||Index Weight||Sector|
|TSMC||409 bn. USD||6.3%||Inf. Tech.|
|Tencent||260 bn. USD||4.0%||Communic.|
|Samsung Electronics||213 bn. USD||3.3%||Inf. Tech.|
|Alibaba||182 bn. USD||2.8%||Cons. Disc.|
|Reliance Industries||101 bn. USD||1.6%||Energy|
|Meituan||99 bn. USD||1.5%||Cons. Disc.|
|Infosys||63 bn. USD||1.0%||Inf. Tech.|
|JD.com||63 bn. USD||1.0%||Cons. Disc.|
|China Constr. Bank||60 bn. USD||0.9%||Financials|
|ICICI Bank||57 bn. USD||0.9%||Financials|
|Total||1.508 bn. USD||23.3%|
The top ten of 1.382 companies (0.72%) have a weighting of 23.3% of the whole index.
Do you feel diversified?
To complete, here are the sector and country weightings:
The sectors are somewhat differently weighted. Financials is the biggest one, closely followed by IT and consumer descretionary. Here too, we have some mixed categorizations, as Alibaba for example is not counted as a tech company (like Amazon in the MSCI World Index).
Whereas we had around 70% of USD exposure in the MSCI World Index, here we have a full 50% China-Taiwan risk. I would not feel safe (loss- and risk-aversion?) to have such a high exposure into this conflicted region…
Plus, more than 70% of the investments are in Asia only.
To sum it up, ETFs had a great run over the last decade with falling interest rates. But now, the tide seems to shift. From a historical standpoint, a sector rotation is very likely and necessary.
In the last section, as promised, I am going to show you what will be obviously the better strategy for the next years, maybe even decade.
What you should look for instead
I have found more interesting visualizations to show the different current weightings. 😉
Here we have a so-called “heat map” of the S&P 500 index, which is not so dissimilar compared to the MSCI World Index. Especially the big positions are most often the same. The following pictures show you how big each sector is and how big individual companies are.
Note: The numbers are irrelevant here, they show relative trading volume. I just picked them to have a better overview in one color family. Just focus on the relative size of the single fields.
First, I highlighted the technology, communication services and consumer descretionary (or “cyclical”) sectors for you:
You will notice the big chunk these sectors have. Not all companies fit into the same basket, but at least the biggest individual fields are members of the big tech firms.
The next picture shows the energy and materials sectors in comparison:
Not so big… Maybe 10% together, at best. Energy and materials are cyclical sectors, though. That is for sure. But I am expecting higher prices over the next years. Here are two strong reasons why.
First, to assess the direction of the prices of resources – and that’s what energy and basic materials are – it is useful to look at supply and demand. The less supply and the more demand in relation, the higher the prices and vice versa.
I cannot say – wether from the news nor from the direct reportings of the companies involved – that there is an abundance of supply to be expected. It is nearly everywhere the same, be it oil, gas, coal, copper, lithium, lead, silver, even water or sand, etc… (see several links here, here, here, here, here and here)
Demand is expected to slow down due the recessionary environment we have worldwide. This may be true.
But demand is way harder to forecast than supply. You have way more variables / customers that determine demand. Plus, while demand can come back (or fall down) relatively quickly and cannot be predicted sufficiently over a longer term, supply can!
Due to all the regulations, political interventions, regulatory uncertainties, permitting processes, ESG and financing hurdles and of course plain time it takes to dig holes before you pull out resources from the ground, supply is way more slow-moving.
Plus, many companies held their investing budgets rather tight over the last decade, because prices (and their earnings) were low.
Now, one should expect them to pro-cyclically curb investments up to increase supply with way higher (even oftentimes record) earnings. But many companies favor paying out surplus cash to their shareholders! Here is a graphic that shows the trend is already long in the making and no sudden surprise!
The graphic above goes only until the end of 2020. But the clear trend has intensified.
It seems as if we are in a position to face a structural deficit in many resources. Because the mills grind slowly, it is often easier to forecast structural supply changes than demand changes!
The odds stand likely in favor of not falling, but rather rising prices of energy and materials.
Second, again it is history. We have a graphic that shows us the historical valuations of financial assets (stocks) and real assets (among others: resources).
As of the publication of the chart, we had all-time lows. Now, the bottom should be in and the graph will stand higher as most stocks nosedived this year and stocks of especially energy-related companies rose.
The last thing – but not detached from the last point – is inflation.
The only comparable period of modern history from what I know, though not perfect, is the 1970’s with their low-growth and high-inflation environment. This was a decade with stagnating stock markets (sector rotation?) and high inflation, but also high interest rates.
Here you see the S&P 500 moving in a broad band sideways for more than 15 years:
Nevertheless, the crucial question is: What were the winners of the 1970’s, as not everything was falling?
You guessed it:
Housing (REITs) did okay, because of inflation adjusted rents. The winning sector was clearly the one of commodities.
To be more precise, it was oil in the 1970’s:
And a quote from capital.com to round it up:
According to research by the World Gold Council, historically, the winners during periods of stagflation between 1973 and 2021 have been “defensive assets and real assets, in particular gold, while equities have suffered the most followed by a mixed performance from fixed income.”https://capital.com/investing-during-stagflation
“Real assets do well during stagflation, with commodities both fuelling and feeding off inflation, while gold has tended to benefit from the elevated risk environment, rising inflation, and a lowering of real interest rates,” analysts said.
Add to the resources also agricultural commodities like grains, sugar, etc. as well as farmland. Not so surprisingly, farmland had its biggest price increases during the 1970’s:
The 1970’s showed the largest percentage increase in agricultural land values.https://www.nass.usda.gov/Publications/Trends_in_U.S._Agriculture/Land_Values/index.php
If you think that you can just buy any ETF, sit around and do nothing, because money takes care of itself, you might be in for a surprise over the next years.
It would be wiser to leave the boat of groupthink when it comes to investing.
Active investing and thinking will become more important again, and rightfully so!
ETFs are not the easy-going investment vehicles they are sold to the public. Buy and hold and pray is not an investment strategy, but a foolish and dangerous herd-mentality! You are not investing, but hoping for the best. This is why I don’t like ETFs as an all-for-one solution.
Differently with sector-specific ETFs, where you don’t want to pick individual stocks, but decouple from the whole market. It could be wise to own for example ETFs that track resources companies to participate in this specific sector. But look under the hood what you are buying!
With ETFs you not only pick up all sorts of stocks you don’t want to have (because you buy whole baskets). Even worse, you are falling victim to the loss- and risk-aversion phenomenon. While you limit your upside (ETFs can only perform like the market they track), you fully participate to the downside (like the market does).
From time to time, there do arise sector imbalances within indexes and thus ETFs that just track and replicate them. During history, these imbalances have always corrected. Sooner or later.
Why should it be different this time?
But, where there is a crisis, there is a chance. Where there is an imbalance, something else must be underweight.
This is what I am researching on this blog for my readers.