Is Timing with ETFs a Good Idea?

By Mark Hebner

This is a question I get more and more frequently these days. On the one hand, I am pleased to see that people are making the move to indexing, but it's a bit frustrating to see that investors cannot free themselves from their prediction addiction--emphasis on addiction.

In no small part, this ferocious addiction is well-fed by a boon of market-timers who entice you to believe, for a handsome price, they can lead you to wealth without risk. The increase in their popularity, however, is not rationalized by their lackluster performance. Dig deep and you will likely find the only way to profit from market-timing with ETFs is to sell a newsletter about it.

The list of problems that occur with timing ETFs is a long one, but here are a few:

One problem is it follows the belief that somehow the ETF is priced wrong. This of course is a problem that plagues all kinds of stock picking and market timing "strategies." All the current news and the probability of future news are built into the ETF's price already.

Another huge problem with the trading of ETFs is investors aren't exposing their assets to a consistent risk exposure over time if they are pulling their assets in and out of the market. Just how reckless is this behavior? The Dalbar Investor Behavior Studies have been tracking these practices for a long time. Not so surprisingly, they found the investor was only getting about 25% of the fund's potential return over these periods because of their stubbornness on trading in and out of these funds.

In his Little Book of Common Sense Investing, Vanguard founder John Bogle weighs in mightily on the subject of ETF trading, He states:

• "If long-term investing was the original paradigm for the classic index fund designed 31 (now 34) years ago, surely using index funds as trading vehicles can only be described as short-term speculation."
• "If the broadest possible diversification was the original paradigm, surely holding discrete — even widely diversified — sectors of the market offers less diversification and commensurately more risk."
• "If the original paradigm was minimal cost, then holding market-sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them, nor the tax burdens incurred if one has the good fortune to do so successfully."
• "Typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market."

...and Bogle's parting shot on trading ETFs provides an ominous warning:

• "I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting."

These observations go a long way in explaining why the average mutual fund investor only sees 25% of the returns. The moral is best explained by Brad Barber, finance professor, who tells us "Trading is Hazardous to Your Wealth." Indeed.

Why do investors fall prey to charlatans who tell them they can predict the market? The main reason is no one wants to settle for “average.” But average returns are really the superior returns. If investors had bought and held a globally diversified IFA Index Portfolio 100 for the last 20 years, they would have an average annualized return of 9.55% per year, and they would have had about as much risk as the S&P 500 Index which delivered 8.06% over the last 20 years (ifacalc.com). Buy and hold works best, but don’t forget the hold.

The landmark and definitive study of market timers was conducted by John Graham at the University of Utah and Campbell Harvey at Duke University. The professors painstakingly tracked and analyzed over 15,000 predictions by 237 market timing investment newsletters from June, 1980 through December, 1992. The conclusion of this 51 page analysis could not have been stated more clearly. "There is no evidence that newsletters can time the market.

In "The Elements of Investing" by Burton Malkiel and Charles Ellis, the authors discuss a psychologist from Berkeley named Philip Tetlock, who studied over 82,000 varied predictions by 300 experts from different fields over 25 years, and concluded that expert predictions barely beat random guesses. Ironically, the more famous the expert, the less accurate his or her prediction tended to be.

William Bernstein once said, "There are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know. Then again, there is a third type of investor - the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know."

As Charlie Ellis said, "Market timing is a wicked idea—don't try it ever."

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