Skip to main content
Publish date:

Cramer's Got It Wrong on ETFs

He says they're a scam. Not so.

Jim Cramer has an interesting video called "Cramer Says ETFs Don't Make Any Sense."

Jim makes a couple of points I agree with and a couple I don't. One big issue for him is that ETFs simply represent the creation of product by Wall Street to be sold to an unsuspecting public. That new product is a big source of revenue. While new products do bring revenue to firms like Merrill Lynch and Morgan Stanley, ETFs are not part of that game.

Big investment banks are not part of the process of listing an ETF


The revenue comes from delivering a successful product that draws investor interest and assets. Revenue comes from ongoing management fees, not the mere listing, as is the case with closed-end funds or common stocks. From the fund provider's viewpoint, more revenue comes from a product that draws ever-more assets that pay the expense fee in perpetuity.

In Jim's video, he talks about ETFs as being anti-diversification and draws a parallel to owning tech stocks from different subsectors and thinking you're diversified. I watched that part of the video three times, and I still am not clear on what he meant. That part of his argument seemed to focus more on investor behavior as opposed to the structural elements of ETFs.

Jim believes that you end up clustered. If you are clustered, it has nothing to do with the product. The

S&P 500

has 10 sectors. The way I build portfolios (and I doubt this is unique) is to look at the weight of each of the 10 sectors, decide how true to the current weights I want to be and, finally, find the best way to build each sector.

Using the industrials as an example, I want to be equal weight compared to the S&P 500, and for me, the best mix is four common stocks and the

PowerShares Water ETF

(PHO) - Get Invesco Water Resources ETF Report

. In the financial sector, I prefer five stocks and no ETFs and for telecom, one stock and one ETF.

You can be poorly diversified with any mix of products just as you can be well diversified with any mix of products.

A consistent theme in my coverage of new and existing ETFs is exploring whether a given fund could be a better way to access a certain part of the market. Most times, in my opinion, an ETF is not the single best way to capture a sector or country, but sometimes it is. Idly dismissing every fund that exists is probably a mistake for most do-it-yourselfers.

However an investor builds his portfolio, it is logical to consider multiple products to build the result. In general, ETFs are cheaper and much more transparent than traditional mutual funds. ETFs also offer a way to avoid single-stock risk in those market segments in which it might be difficult to take single-stock risk. A couple of examples that come to mind are biotech and Malaysia.

Jim also likes to pick on the

Oil Services HOLDR

TheStreet Recommends

(OIH) - Get VanEck Vectors Oil Services ETF Report

as being manipulated. Although I suppose this could be true, I don't believe it matters if it really is or not. If


think it is, then you should stay away; other ETFs provide energy sector exposure after all.

Assuming Jim is right about OIH being manipulated, that would, obviously, be a negative. All funds have positives and negatives, and if a fund has too many negatives, regardless of what they are, you should not buy it.

I will readily concede that some funds seem gimmicky and questionable. But just because they seem so does not mean they are. Last April, First Trust listed its

IPOX-100 Index Fund

(FPX) - Get First Trust US Equity Opportunities ETF Report

. An IPO ETF has all the makings of a gimmick, but as I

pointed out last April, it looks to me like it has a high correlation to the

iShares Russell 2000 Growth Fund

(IWO) - Get iShares Russell 2000 Growth ETF Report

with the potential to outperform IWO.

That is, in fact, what the fund has done. Any investor who would buy a small-cap growth fund should probably spend time studying FPX as part of his investment selection process. This sort of secondary effect is present in many funds that some might dismiss as gimmicky, and although you won't need most of them, you should consider some of them.

At the time of publication, Nusbaum and his clients were long PowerShares Water ETF, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

click here

to send him an email.