ETFs – The Next Accident Waiting to Happen?

How many of those holding ETF’s know what the ETF stands for? How many know how they work? How many understand the leveraged ETF’s and their risks? How many understand the hedging procedures? How many have actually created, priced, and hedged ETFs? The answer to all the above is probably very few. Despite being  a relatively complex field within the creative finance industry, especially the exotic and leveraged versions, few people actually understand what they trade, and even less the risks involved with these products.

A few weeks ago we saw many novice investors get crushed in their TVIX holdings. Below is a good summary, by a non banker, explaining in plain english about some of the risks associated with ETFs. Don’t forget, 80% of the issued ETFs, are done by 6 players. Most of those had to be bailed out by the taxpayers. Those are some risks to think about….From Golem.

Where will the next point of instability be? Not what will trigger the next liquidity and credit crunch and cause the next landslide of panic selling and losses. We can already see many candidates for the trigger. But what will be the mechanism by which it is amplified and spread?

I think that in a couple of years, unless something alters the current trends in money flows, we will come to know ETFs the way we already know the securitization and packaging of  sub-prime mortgages into CDOs. I think the signs are already there to suggest ETFs are where the instability and risk is accumulating. If I am in any way correct then ETFs will be to the next stage in our on-going state of siege-mentality crisis what CDOs were to the last.

To substantiate this claim I have to tell you in simplified terms what an ETF is. And then explain how, despite all the differences between mortgage backed CDOs and ETFs, the latter generally being based on stocks, bonds and commodities rather than mortgages, they are undergoing the same evolution from simple to opaque, stable to unstable, are being seen as the provider of liquidity and risk-controlled ‘exposure to risk’, just as CDOs were, when in fact they are concentrating risk and will, in a moment of panic, cause liquidity and lending to collapse.

In any ecosystem there are certain niches: large carnivore, carrion eater, arboreal fruit eater etc. These niches can persist even as the particular species that fill them go extinct. What you find is that another species, from a different family, will evolve into the niche because it is ‘empty’ and therefore there is ‘a job’ going free. So it is in the present ecosystem of global finance. In many ways the ETF is evolving, or being bred, to fill the same niche that Securitized debts (CDOs) filled only a few years ago.

Here is how a paper for the Bank for International Settlements (BIS) describes the rise of the ETF.

…in the low global interest rate environment in 2002–03, structured credit products [CDOs] were marketed to gear up investment returns for institutional investors …as they offered higher returns to comparably rated plain vanilla assets.

The financial crisis experience, however, dampened investors’ appetite for structured credit products. Yet the low global interest rates that supported growth in structured credit products have returned, with institutional investors facing similar problems to those back in 2002–03. This time, financial intermediaries have responded by adding some innovative features to existing plain vanilla investment funds.   (P.1)

Full must read article here.

Flash Crash reminder