Riding exchange traded funds up

Million Dollar Journey set off a small fire-storm in the summer when he wrote about the disadvantages of index investing through exchange traded funds (ETF’s). One of the disadvantages cited for investing in a board based equity-based ETF is that there is no down-side protection (I am talking about the plain vanilla ETF’s not the fancy one’s with hedging features).

Its hard to refute the assertion that there is no downside protection when the equity markets fall but let’s examine what happens historically once equities crash since 1974 (returns are on a board based equities market; stats courtesy of RBC Capital Markets):

1. 1974 crash wipes out 35% off equities in 11 months. From 1976 to 1982, markets return 81%.
2. 1987 crash wipes out 25% off equities in 4 months. From 1988 to 1990, markets return 44%
3. 1991 crash wipes out 20% off equities in 10 months. From 1993 to 1998, markets return 203%
4. 2001 crash wipes out 38% off equities in 13 months. From 2003-2007, markets return 149%.
5. 2007-2008 crash wipes out 43% off equities in 15 months….

To state the patently obvious, losses are short and painful but recoveries have, historically, cancelled out losses and more- it just takes time and patience.

If one where to purchase board based equities ETF’s tracking the major exchanges (NYSE, LSE, Tokyo, TSX, Hong Kong etc.), one could ride up the recovery and if you were in ETF’s while the markets went down, it may not be prudent to bail out given that the recovery will make up for the loss. Obviously, the past is not indicative of the future and if the market and economy keeps going down, well, you probably have larger concerns at that point than how your stock portfolio is doing..

Why an ETF rather than a specific stock? Could any of us predicted the fall of storied investment houses like Bear Stearns and Lehman Brothers? GE being in trouble?  Iceland about to go bankrupt? You can’t bet on one stock. At least with a board based ETF, you can ride the entire markets up without trying to pick and chose among thousands of stocks.