Exchanged traded funds (ETFs) are 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. An investment manager will instead purchase a basket of securities to reflect the movements in the market, the goal of the fund manager will be to replicate the performance of the market or index as close as possible. 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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