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%…