Are Derivative-Based ETFs Sowing The Seeds Of The Next Financial Crisis?

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By Christopher OLeary :

What is an ETF? Traditionally, exchange traded funds have been like 'index tracker funds', replicating 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. ETFs are traditionally passive investments; this means that with few exceptions 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 vs. mutual funds. Combine this with the benefits of diversification and additional tax benefits in many cases you can see why ETFs have grown exponentially over the last few years.

To put this phenomenal growth into perspective, ETFs 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 globally. The number of globally listed ETFs has swelled to over 2,700; there is now an ETF to track virtually every single market and index 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, more recently launched ETFs are leaving behind the 'index tracker' model and are quickly mutating into more complex instruments like collateralized debt obligations, which nearly brought down the entire financial system.

While ETFs have made building a diversified portfolio much easier and cheaper for the average investor, 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 fueling short-term speculation and leading to a market driven by short-term sentiment rather than the fundamentals of supply and demand. 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 in a matter of minutes. The now notorious '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 ETF's Net asset value (the value of the underlying holding). Because they use a derivative contract, their price doesn't necessarily mirror the underlying asset and these types of ETFs could potentially trade at a premium or discount to their Net Asset Value (( NAV )). The size of the discount or premium will depend on the liquidity of the fund. 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 are advertised to do.

An example of this is an exchange traded note (( ETN )) called [[GAZ]] which tracks the performance of near-month NYMEX natural gas futures contracts. Towards the end of April shares of GAZ traded at a 15% premium to NAV. Investors should especially be careful to stear clear of ETFs trading above their NAV, as in the event that 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 argues that 'using index funds as trading vehicles can only be described as short term speculation.' I tend to agree with Bogle, though it's interesting to note that Vanguard, the fund company Bogle founded, has whole-heartedly embraced ETFs and is the 3rd largest ETF issuer in the U.S. marketplace.

ETF involvement in the $2.3 billion "rogue trader" scandal at UBS is only a harbinger of worse to come. Ultimately it is their success, rapid growth and increasing complexity which should concern investors considering ETFs and I do not believe the more comple of these products are fully understood by many market participants. I would therefore advise 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 their portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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