Are exchange traded funds (ETFs) sowing the seeds of the next financial crisis?

Tuesday, Aug 16 2011 by
6
Are exchange traded funds ETFs sowing the seeds of the next financial crisis

What is an ETF? An exchange traded funds is like a tracker fund, they replicate the performance of a particular market or index. They are traded like shares on a stock exchange and can be bought and sold throughout the day. They are passive investments; this means they are not actively managed by a fund manager. Because ETFs do not require ongoing management, they can charge much lower fees, typically around 0.5% per annum which is one of their main attractions. Combine this with the benefits of diversification and you can see why ETFs have grown exponentially over the last few years.

Their growth has been phenomenal, they have managed an average annual growth rate of above 30% over ten years and this year they are expected to control over $1.5 trillion of assets. Their numbers have swelled to over 2,700; there is now an ETF to track virtually every single market and indices imaginable. Perhaps the most disturbing development is the proliferation of leveraged ETFs which offer geared returns on a given index or market. This is where I see disturbing parallels with subprime mortgage securities where financial innovation got out of control. Whilst their scale and complexity doesn’t yet match subprime mortgages, they are quickly mutating into more complex instruments like collateralised debt obligations which nearly brought down the entire financial system.

Whilst they have made investments much easier and cheaper, they are turning millions of retail investors into mini-hedge fund managers allowing them to speculate on the markets throughout the day.  With millions of retail investors now trading ETFs on exchanges, they are fuelling short-term speculation and leading to a market driven by short-term sentiment rather than the fundamentals of demand and supply. The market for ETFs has exploded with such speed that in some cases it has become bigger than the underlying market which they intend to track; this will inevitably increase volatility and the likelihood of bubbles developing. An example of such volatility was on May 6th 2010 when the Dow Jones Industrial Average fell by almost 1,000 points, this ‘flash crash’ was primarily caused by ETFs.

Many ETFs are not backed by physical assets but instead use a derivative position with the investment bank as the counterparty. Under the EU's Undertakings for Collective Investments in Transferable Securities (UCITS) rules, an ETF investing in a derivative contract can face counterparty exposure of up to 10% of the ETFs Net asset value (the value of the underlying holding). Because they use a derivative contract their price doesn’t necessarily mirror the underlying asset, they could potentially trade at a premium or discount to its Net Asset Value. The size of the discount or premium will depend on the liquidity, this is the ease at which the investment product can be bought or sold without incurring large trading cost. A lack of liquidity will cause the bid-offer spread to widen; a wider spread will take a bigger slice out of an investor’s return. If ETFs are diverging from the market on which they are suppose to track, they are not doing what they it says on the tin. An example of this is an exchange traded note (a type of ETF) called GAZ which tracks the performance of near-month NYMEX natural gas futures contracts. Towards the end of April they traded at a 15% premium to its NAV. Investors should stay clear of ETFs trading above their NAV, should the premium collapse investors will face hefty losses. Once these hidden costs are taken into account, ETFs are not quite the low cost and efficient investment products that investors are made to believe.

Jack Bogle, the inventor of the index fund calls ETFs ‘a traitor to the cause of classic index investing’, he argued that ‘using index funds as trading vehicles can only be described as short term speculation’, I agree. Ultimately it is their success, rapid growth and increasing complexity which should concern investors considering ETFs and I do not believe they are fully understood by market participants. I would therefore advice any investor to avoid investing in ETFs unless they are backed by the physical asset, and even then I would recommend that ETFs make up no more than 5% of your portfolio.


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12 Comments on this Article show/hide all

nigelpm 16th Aug '11 1 of 12
1

I would therefore advice any investor to avoid investing in ETFs unless they are backed by the physical asset, and even then I would recommend that ETFs make up no more than 5% of your portfolio.

Totally irrelevant!

It's all about the levels of gearing you are employing i.e. ETF's could be 100% of your portfolio but pose little risk.

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xigris 16th Aug '11 2 of 12
1

I'm sorry Christopher, but I think your logic is distinctly flawed.

Many ETFs today are turning millions of retail investors into mini hedge fund managers allowing them to speculate on the markets throughout the day. Many ETFs are not backed by physical assets but instead use a derivative position with the investment bank as the counterparty. Because they use a derivative contract their price doesn’t necessarily mirror the underlying asset, they could potentially trade at a premium or discount to the underlying asset.

What's wrong with being a mini-hedge fund manager? Why is it a problem that some ETFs are not backed by physical assets? So there's a counterparty; so what? ETFs could trade at a premium or a discount - well sounds like the Investment Trust sector to me, and how is that a problem?

I think I see where you're coming from, but I don't think your arguments are properly developed yet.

I look forward to  fuller, more detailed analysis to back up the rather sweeping comments you make,

Best,

Xig

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marben100 16th Aug '11 3 of 12
8

Hi Nigel, xig,

As it happens, I think Christopher has highlighted an important issue. It is not just Chrisopher that is highlighting the risks, but also the UK's FSB. See this FT article:

 


A “powerful source of contagion and systemic risk” could be created if banks that are most active in derivative-based “synthetic” exchange traded funds run into problems, according to the Financial Stability Board, the body that co-ordinates financial regulators...

 

...A provider of a synthetic S&P 500 ETF will use investors’ cash to buy a basket of assets to be held as collateral for the swap, rather than buying the constituent stocks of the benchmark index. But the collateral basket could be made up from less liquid equities or unrated corporate bonds from an entirely different market. If investors later decided to withdraw from the synthetic S&P 500 ETF, the provider might face difficulties liquidating the collateral to pay them back. This could force the bank to suspend redemptions from the ETF or it could face a liquidity shortfall if it decided to let investors continue to sell their synthetic ETF holdings...

 

I have so far only used iShares "vanilla" ETFs within my portfolio (specifically ISXF, IBZL - though I don't have holdings in any at present). I have studied the legals as best I can, and as far as I can tell they do not use that type of structure - i.e. they DO invest directly in the underlying assets they  purport to invest in. However, there are plenty of weasel words and I am not entirely certain. I certainly see merit in there being a very clear label on ETFs so that investors can be sure that they are the "real thing" and not composed of synthetic instruments that are more vulnerable to systemic/counterparty risk, and for there to be tight regulation and auditing of "vanilla" ETFs.

There is good reason to be wary of the geared or short products.

Cheers,

Mark

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emptyend 25th Aug '11 4 of 12
2

In reply to marben100, post #3

I happen to agree with Marben and Christopher O'Leary - and I've indicated as much recently with my comments on gold (ie hold the physical if you want to express a view). One important point is this one:

The market for ETFs has exploded with such speed that in some cases it has become bigger than the underlying market which they intend to track; this will inevitably increase volatility

I have seen the destabilising impact of this sort of situation many times in my career.  Outstanding positions that exceed the size of the underlying market (or even which get anywhere near it!) are, by definition, highly dangerous!

And I would also add that there is a stack of recent evidence to show that new products which grow exponentially quickly are doing so because people have drastically under-estimated the risks! (eg MBS, ABS etc).

The evident complacency of some holders is also a key warning sign......

ee (in haste)

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marben100 25th Aug '11 5 of 12
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In reply to emptyend, post #4

Yes, that warning re "paper gold" could be rather apt, given this:

 

..The gold market experienced a surge in demand last week, which lifted the assets of the world’s largest bullion-backed exchange-traded fund, the SPDR Gold Shares ETF, to a record of nearly $77bn. The surge catapulted SPDR Gold Shares to the top of the world ETF league, above a peer that replicates the S&P 500...

 

Must admit, my own preference is to hold shares in gold miners, rather than the physical. At least they earn something.

Cheers,

Mark

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Christopher OLeary 26th Aug '11 6 of 12
6

In reply to xigris, post #2

‘Synthetic’ ETFs which gain exposure to the underlying asset via a derivative contact with an investment bank face counterparty risk. Under the EU's Undertakings for Collective Investments in Transferable Securities (UCITS) rules, should the counterpart default the holder of an ETF will face losses of up to 10%. The most famous counterparty default was Lehman Brothers.

Trading at a premium or discount means an ETF doesn’t do what it says on the tin which is mirror the underlying asset. Investors will face substantial losses if they buy an ETF trading at a premium which then collapses. An illiquid ETF will face wide bid-offer spreads, this will further add to an investors cost.

ETFs using a derivative contact to track the price of the underlying asset will be subject to tracking error. Without going into detail, an example is the US Oil ETI which from 2006 to the end of June 2011 had fallen by 46%; whereas the price of light sweet crude which it had meant to track actually rose by 32%.

Add these factors together and an ETF isn’t quite the low cost, low risk and efficient products investors are made to believe.

Finally if millions of retail investors are behaving like mini-hedge fund managers, then this will inevitable fuel a market driven by speculation and short term sentiment rather than the fundamentals.

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emptyend 27th Aug '11 7 of 12
3

In reply to Christopher OLeary, post #6

Quite so - described in more detail than I had time to attempt yesterday!

Finally if millions of retail investors are behaving like mini-hedge fund managers, then this will inevitable fuel a market driven by speculation and short term sentiment rather than the fundamentals.

This is perhaps the most important aspect, especially with a market that is as narrow as gold. We are in (or very close indeed to) the sort of situation that pertained in 1929 in respect of the stock market.....

....every man in every street is aware that the economy isn't great and that the gold price has been going up. Gold is perceived (not quite correctly) to be the only asset that has performed in recent times......and that is IMO fuelling a widespread fear trade. I've heard radio phone-ins with people of quite modest means who are looking to buy Kruggerands, Sovereigns or small gold bars. The topic is all over the press....and even this week's record 3 session plummet seems to have been viewed as a buying opportunity.

My take is that there may be one more leg up - but then the market is set up for an almighty crash. This was a particularly good piece in yesterday's FT, which correctly concludes:

A house can be lived in. Corporate stocks generate dividends. Gold generates nothing and therefore cannot be valued in its own right, only as a measure of revulsion towards other assets. Rather than being a store of value, it is doomed to obey bubble dynamics. When bubbles burst, they usually return to pre-bubble valuations. In 2001, gold was no higher in real terms than in 1972. A repeat would reduce gold bulls, like the third servant, to "weeping and gnashing of teeth".

...which is a point I have made previously, if not as lyrically!

It is time to review one's gold investments to ensure that one is as directly connected to the gold price as possible and hold the exposure in a form without much counterparty risk and in a way that can be sold without delay. Next time the three day fall may be somewhat larger than the 10% observed this week, IMO....and the "smart money" out there is going to want to be very liquid indeed - and you won't want to be far behind!

ee

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marben100 27th Aug '11 8 of 12

In reply to emptyend, post #7

In 2001, gold was no higher in real terms than in 1972.

Hmmmm.... a very carefully chosen time period. 1972 was not a low point, whereas 2001 marked a 21 year low.

In the long-run, and assuming supply and demand can be balanced, there is no reason to expect anything other than "real terms" stability. You derided me a few years back when I suggested that the gold bull market had some way to go, due to supply/demand dynamics. So far, my assessment has been right.

To justify building new mines (to replace production declines from old ones) prices ITRO $1,200 - $1,500 are likely to be required, IMO. This article shows that average total costs of production were $857/oz in 2010 (and will have risen further since). Whilst real interest rates remain negative there is no (apparent ;0)) disadvantage to holding gold vs cash.

ISTM that the very strong run over the last couple of months is overdone, with the gold price having overshot, so there is certainly a risk of a fall back to below $1,500 in the short -term. However, where we disagree, is that no way do I think that the secular bull market in gold is nearing its end. That won't come until interest rates rise and currency stability is restored. There is no sign of those two things happening yet. When they do, there will be little reason to hold gold any more and at that point sellers will outnumber buyers...

Mark

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emptyend 27th Aug '11 9 of 12
4

In reply to marben100, post #8

Please don't reply to a post of mine and then highlight a quote that isn't from me, without qualification or attribution!

And if you want to say that I "derided" you some years ago, please do me the courtesy of providing a link to the evidence (so that people can make up their own minds). I may well have disagreed and suggested that oil may do as well - but that is another matter!

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snaj 30th Aug '11 10 of 12
1

In reply to emptyend, post #9

Hang on a moment ee, you did write immediately on either side of the quote:

"This was a particularly good piece in yesterday's FT, which correctly concludes:"

"...which is a point I have made previously, if not as lyrically!"

...without qualification, so why does marben need to qualify it?

p.s. Congratulations on the grandchild

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emptyend 30th Aug '11 11 of 12
1

In reply to snaj, post #10

Hang on a moment ee, you did write immediately on either side of the quote:

Well I would have hoped that it would at least be recognised that I quoted an entire para from the FT which made a general point (which I agreed with), whilst Marben chose to take issue with some dates buried in the middle of it as if the dates concerned had been selected by me, rather than the FT's correspondent.

He then went on to allege that I had "derided" him a few years ago but  a) that certainly isn't my recollection (though I may very well have strongly disagreed with an idea or the contents of a post) and b) he provided no link to the alleged derision so that people could make up their own minds

I may have been slightly more irritated than usual because I had just come straight from reading a post on ADVFN in which (again without any link) he implied that I had indicated that a close period would soon be ending - which I most certainly hadn't (all I did was to give a link to an RNS with a results date).

Anyway - it doesn't bear a long discussion. But I'm not going to stand for people apparently putting words into my mouth, whether through deliberate intent or (as I suspect in these cases) inadvertence, especially when they relate to other duties.

rgds

ee

ps...thanks for the congrats.

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marben100 21st Sep '11 12 of 12

Seems that the Adoboli case is shining the spotlight on this murky world:

Financial regulators across the world are racing to step up supervision and impose limits on the little known but rapidly growing world of exchange-traded funds, the investments that allegedly enabled junior trader Kweku Adoboli to rack up $2.3bn in losses at UBS.

Concerns about mis-selling and systemic risk connected with ETFs have been mounting in recent months and the International Organisation of Securities Commissions recently launched a global study of the threats they pose to financial stability...

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About Christopher OLeary

Christopher OLeary

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Financial blogger, market contributor and private investor. Author and creator of ‘The Astute Investor’, an investment blog designed to help investors preserve and accumulate wealth. This blog also voices my thoughts and ideas to help my development and progression as a private investor. Furthermore, I  contribute investment ideas and analysis through 'Seeking Alpha' and 'The Motley Fool',  global financial media sites. http://seekingalpha.com/author/christopher-o-leary http://www.fool.co.uk/news/investing/company-comment/2012/05/30/why-you-might-buy-pearson.aspx more »


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