We recently published an article on three ASX shares to avoid. In many ways this was a simple exercise. Valuation is a driver of future returns. Shares that are trading at high valuation levels relative to their prospects should be avoided. This can happen as investors get too excited about a share and chase returns. We used our analyst opinions on the fair value as a basis to identify overvalued shares.

Finding ETFs to avoid is a more subjective exercise. Valuation can still play a role. An ETF is simply a basket of securities. That group of securities can be collectively overvalued whether they are part of a broad-based index like the ASX 200 or a narrow theme like robotics.

But rather than taking a valuation-based approach I’ve tried to identify ETFs that may be indicative of mistakes that investors commonly make. And this is where the subjectivity comes in. This is my opinion but I’ve tried to explain what I believe an investor is hoping to accomplish with an ETF and why I think this isn’t worth doing.

Betashares Australian Equities Bear Hedge Fund (ASX: BEAR)

I am picking on a single Betashares offering but I would suggest investors think carefully about buying any inverse ETF. An inverse ETF is one that moves in the opposite direction of something else. In this case the ASX 200.

If the ASX 200 goes up the ETF loses value. If the ASX 200 falls the ETF gains in value. The degree of change is not perfectly negatively correlated to the market. A perfectly negatively correlation means that if the market falls 1%, the ETF goes up 1%. But it is pretty close.

There are two reasons why an investor may want to add this ETF to a portfolio. The first is the idea that they are “hedging” their portfolio. An investor may want to include a negatively correlated asset in a portfolio to reduce the overall portfolio risk if we define risk as volatility. If the rest of the portfolio fell in price the overall drop would be less because the negatively correlated asset would go up in value.

As an example, we can compare two hypothetical portfolios. One is 100% invested in an ASX 200 ETF and one allocates 90% to the ASX 200 ETF and 10% to an inverse ASX 200 ETF. If the ASX 200 fell 10% the portfolio including the 10% allocation would only fall by 9%. You could change the percentage allocated to the inverse ETF to provide different levels of hedging.

Another reason an investor may use an inverse ETF is to make a directional bet on the market. If you think the market is about to fall – and are right – investing in an inverse ETF would allow you to profit.

There are a couple reasons that I think investors should avoid inverse ETFs.

If you are using this ETF to make a short-term bet on the direction of the market, all the best. It is going to be very hard to be successful. Short-term movements over days and weeks are essentially random. Not only does an investor have to get the timing right for when to buy the ETF before the market drops but also needs to know when to sell it.

If you are going to recklessly speculate on short-term market movements you might as well bet the market will rise. The odds are in your favour. Between 1926 and 2019 the S&P 500 went up 54% of all days.

I also don’t think you should buy this ETF if you are convinced the market will drop over a longer period – say the next year. This holds true if you have no basis for your prediction or if you’ve done your homework and have developed a thesis based on valuation levels and other signs of collective speculation.

There are two reasons why I think it is a bad idea. The first is that once again it is hard. Between 1926 and 2019 the S&P 500 went up 73% of all years. And again, you need to get the timing right on both the purchase and sale of the ETF.

The second reason is that if you are utterly convinced the market is headed for trouble I would suggest you have a higher probability of success by temporarily changing your portfolio to reflect that view. This is called a tactical asset allocation.

I don’t think most investors should make tactical changes to their asset allocation based on market conditions. I just think it is a better move than buying an inverse ETF because it accounts for the very real possibility that you are wrong.

For instance, if you thought the market was going to fall you could increase the amount of cash that you hold in your portfolio. The cash would not gain in value if the market dragged down the rest of your portfolio but the increased allocation would cushion the blow.

There are three scenarios we can explore to demonstrate why I think increasing the allocation to cash is a better option for most investors. The first scenario is if the market goes up. In this case you were wrong. Remember this has happened in 73% of all years between 1926 and 2019. More cash is obviously the better option here. You miss out on some returns but at least you earn some interest and the cash doesn’t fall in value.

The second scenario is that the market falls but not by that much. Cash is still the best option here. The breakeven point for an inverse ETF can be found by adding the interest rate on cash with the fee of the ETF.

I use ING for my cash savings. I haven’t put any effort into shopping around for the best interest rate but right now I can get a one-year term deposit through ING for 4.90%. The fee for the Betashares BEAR ETF is a ridiculously high 1.48%. That alone should disqualify this ETF from consideration by any investor. If we add the fee and the interest rate on the one-year term-deposit we get 6.38% as a breakeven point. The market would have to fall more than 6.38% in a year for the ETF to contribute positively to your portfolio.

To invest in this ETF you need to correctly predict an unpredictable market twice – once when you buy the ETF and once when you sell it. The market has to fall which has only happened 27% of the time in modern history. And the market has to fall more than 6.28%.

Despite the long-shot odds that buying this ETF results in a profit there is another use. Hedging. Most investors shouldn’t care about volatility but there is one specific time when volatility matters. That is when an investor is approaching a goal. One example is during the transition to retirement. For more about that see this article.

Even if you will probably lose money having this ETF in your portfolio is it worth it for downside protection? In other words, does it act as insurance. We buy insurance not because an event will probably happen but to protect us on the off chance that it does. Most people happily lose money on insurance. Is an inverse ETF insurance for your portfolio during this critical time?

Once again, I think there are better options with a higher probability that you will have a better outcomes. Personally, I think holding a higher percentage of cash during times when volatility is a risk is a better option. Some investors may prefer bonds. Some might go for the safety of an annuity. I believe that all these options provide just as much protection if markets happen to fall and much better outcomes if markets rise which is a more likely outcome.

Investing is a probabilistic exercise. Many market pundits talking confidently about what will happen in an unknowable future. This is all bluster. Nobody knows. We need to make decisions that give us the best chance of accomplishing our goals. Chances are if you buy this ETF you will lose money while paying a high fee. That makes it one to avoid.

Global X FANG+ ETF (ASX: FANG)

I know this one is going to raise some eyebrows. I have included an ETF on this list that had a return of just over 96% last year. That is not a typo. FANG went up 96.17% in 2023. And to be clear nothing in my portfolio went up 96% last year. Is this the delusional ranting of an old man mad at the kids for having fun? Maybe. But anyone can pick an ETF that has plunged in value and tell people to avoid it.

I don’t know how FANG will perform going forward although the chances of another 96% annual return are very slim. Given the performance last year and some other characteristics of the FANG ETF I believe it serves as a cautionary tale about some of the traps we fall into as investors.

The more time I’ve spent thinking about investing the more I’ve been drawn to why investors make the choices they do. Any cursory examination of the subject matter makes it abundantly clear that we are our own worst enemies.

I was listening to a podcast recently and heard an economist say that when investors make decisions, they are not calculators, but storytellers. I thought this was concise way of describing decades worth of academic research that have debunked the notion that we are rational economic actors assessing investment decisions based on their relative merit.

We are drawn to compelling narratives about investments and those we can tell ourselves and our mates about outcomes we've acheived. We explain away luck and randomness and find patterns where none exist. 

We make decisions based on the description of an investment rather than the investment itself. We overweight certain attributes of an investment while ignoring others. We chase performance which means we buy investments after the opportunity has passed us by.

Humans use rules of thumb to make complex decisions. In investing one rule of thumb is to seek investments that sound compelling to large groups of people. This is our evolutionary emotional need to protect ourselves by assuming there is safety in numbers.

FANG has a compelling narrative. According to Global X's website, FANG “seeks to invest in companies at the leading edge of next-generation technology that includes household names and newcomers.”

Who wouldn’t want to invest in ‘companies at the leading edge of next generation technology’? The alternative would be investing in companies with out-of-date technology from past generations. ‘Household names and newcomers’? That seems like a pretty wide list of criteria but presumably excludes companies we’ve never heard that have been around for a long-time.

I think this is a pretty poor description of the companies in FANG. These are all huge established companies with large market shares which are much more interested in preserving the status quo. I would argue those are all traits that are preferrable to what is being described. Investing in companies that truly are at the ‘leadng edge of next generation technology’ is hard because there is less predictability about outcomes.

The fact the description is written in such a way is telling. Our preconceived notions about what something is supposed to be influences the choices we make. We often just give in to our stereotypes when making decisions. And we’ve come to think that successful investing is about technology, high growth, and disruption. That is why we tend to overpay for companies that exhibit those qualities. None of those things are bad in isolation but the price we pay for them matters.

The index construction of the FANG ETF is unique. The ETF holds 10 companies with six permanent members consisting of Meta, Apple, Amazon, Netflix, Microsoft and Alphabet. The other four members are picked from 19 sub-industry classification groups that have high price to sales ratios, high sales growth and are large companies that are traded a lot. In other words, shares with lots of investor hype.

The strong recent performance of FANG also triggers some behavioural impediments to achieving investment goals. We put more weight on things that have happened recently which means if an ETF has strong returns we are more likely to think it will continue to do well. Mix in some fear of missing out and many investors churn their portfolios as they chase hot investments.

The issue is that when an investment has done well valuations rise. These higher valuations reflect higher expectations about the future. At some point those expectations defy reality and become impossible to meet.

Has FANG passed the point of reality? Maybe. Maybe not. That is what each investor needs to decide based on the valuation of each security in the ETF. That is a reason to invest in FANG or avoid it. Not the recent the performance. The fact that FANG went up 96% last year makes it a riskier investment even if our instincts are telling us the opposite. At the very least the investor hype imbeded in this ETF should give you pause before plunging in.

Final thoughts

This is an article on two ETFs to avoid. And personally I would avoid them. But this is also an article on investing. There are larger lessons that will do far more for your investing results than avoiding a couple ETFs.

  1. Investing is a probabilistic exercise. Despite the confidence with which people talk about the future nobody knows what is going to happen. As we become more confident about our views we stop imagining other scenarios and our portfolios become less resilient.
  2. We are predisposed to make poor decisions. And there are certain triggers that make it more likely we will make a poor decision. Those include a compelling narrative, strong recent performance and an investment that passes the superficial test of what we think a great investment should look like. When evaluating an investment opportunity that checks these boxes take extra time to examine if you are investing in a realistic assessment of future opportunities or unachievable hype.

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