For years, SMI was slow to embrace ETFs (short for exchange-traded funds) primarily due to the fact that we felt their very structure encouraged investors to trade more. Research has long shown that individual investors who trade more tend to perform worse, so we thought ETFs would likely be a double-edged sword (at best) for individual investors. It appears we were right.

MarketWatch columnist Chuck Jaffe reports today on The Growing Case Against ETFs, helping to explain "why ETFs may be a superior investment option that is delivering inferior results." Jaffe's report is based on research done by Mark Hulbert, which shows that "the typical investment advisor makes more money for his clients with [traditional funds] than with exchange-traded funds (ETFs)." Hulbert examined advisors and newsletter editors who offer portfolios comprised solely of traditional mutual funds as well as other portfolios comprised solely of ETFs. He was shocked to find the traditional mutual fund portfolios have had significantly better performance.

Presumably, any given advisor would be able to capitalize on the better investment vehicle using their best investment ideas. And ETFs have been widely lauded as being superior to traditional mutual funds. So imagine the surprise when the traditional fund portfolios outperformed their ETF counterparts by three full percentage points over the past year, and two full percentage points per year over the past 10 years. To what does Hulbert attribute this surprising result? Basically, he says advisors are guilty of what SMI suspected all along would happen when investors embraced ETFs:

Note carefully that these results emerge from just those advisers on the HFD’s monitored list who maintain model portfolios of both types of funds. That is, these advisers have one or more model portfolios that only invest in ETFs, and in addition have one or more other model portfolios investing only in open-end mutual funds. By focusing on just these advisers’ portfolios, I can zero in on the unique impact of ETFs. That’s because the same market timing judgments, industry and sector bets, and so forth, are behind these various portfolios. So exchange-traded funds’ many advantages ought to be showing up in superior performance in these advisers’ portfolios of ETFs. But they’re not. Why? I can only speculate, but my best guess is that ETFs’ advantages are encouraging counterproductive behavior. Their low cost, coupled with the ability to get into and out of them at any time during the day, as well as the ability to sell them short, have seduced advisers into trading too often.

Investment vehicles change, market environments change...everything in investing changes except one thing — investors themselves don't change. We're still subject to the same human emotions and beliefs as investors 10, 50, or 100 years ago. Because of that behavioral aspect, certain things about investing will never change.

So what to make of SMI's evolving position regarding ETFs over the years? Well, we're still lukewarm on them in most contexts. You don't find them popping up very often in our flagship Upgrading strategy, though we'll include them on the recommended list when the rankings warrant it. We did switch part of our Upgrading bond holdings over to ETFs, specifically because they (1) allow new readers to simplify the getting started process by virtually eliminating the minimum investment amount required by traditional funds and (2) provide lower expenses than some investors can get otherwise. And, of course, we've embraced ETFs wholeheartedly within the confines of our new DAA strategy, where the required ability to trade in and out of a vehicle in as little as a single month's time would not be allowed by most traditional mutual funds.

The main thing to understand about SMI's use of ETFs is it occurs within the tightly restricted confines of our mechanical strategies. There's little risk an SMI investor is going to trade more often because they bought the ETF version of Vanguard Short-Term Bond Index rather than the traditional mutual fund version. That's not the case in more active portfolios, where the ability to easily trade seems to be making more trading happen (based on the results of the Hulbert study). It appears that the old research about more trading being counterproductive to long-term performance can be added to the list of things that haven't changed in investing.