" We'll leave the greater issues of systemic risk - derivatives, HFT and ETFs - for another day. "
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Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs) - Acrobat file from BIS Financial Stability Board (FSB)
Extreme Perils of Exchange Traded Funds (ETFs), Derivatives and Unlimited Black Swans (UBS) - Link
'Financial Stability Threatened
Regulators around the world have expressed concern that ETFs might be a new source of market instability for nearly a year now.
1. America's Securities and Exchange Commission (SEC) has launched a probe this week into whether ETFs are contributing to market volatility by offering investors a way to quickly lift and reduce their exposure to the financial markets. This, in turn, forces large entries and exits from the underlying securities, or derivatives, that mirror the assets or asset class that the ETFs seek to track.
2. The Bank of England warned in June 2011 that ETFs are potentially dangerous for unsophisticated investors. The rogue trading event that hit Societe Generale in 2008 also originated on a desk that was buying on the market to compile portfolios that underpinned ETFs. The UK's new Financial Policy Committee (FPC) has warned that ETFs are shrouded in "opacity and complexity". It said it was concerned that ETFs "could become a source of risk to the system as the market evolves".
3. The Financial Stability Board (FSB), an international super-regulator based at the Bank for International Settlements in Basel, Switzerland, wrote a prescient paper "Potential financial stability issues arising from recent trends in Exchange Traded Funds (ETFs)" in April 2011. Its central warning was that ETFs are neither cheap nor transparent.
Volatility, De-Coupling and High Risk
Extreme volatility makes ETFs behave unpredictably. ETFs do NOT always match the underlying asset or asset class in the way investors expect. Given the daily rebalancing and compounding, an investor can own a leveraged long ETF and end up losing money over a period when the market goes up but during which there are some sharp falls. Equally, an investor can own an inverse ETF -- which provides a short exposure -- during a period when the market goes down but if there are some sharp rallies, the investor ends up losing money. This actually occurred with some inverse ETFs in 2008, for example. ETF investors would not normally expect to be leveraged long and lose money if the market goes up or be leveraged short and lose money when it goes down. Yet, this is entirely possible with ETFs and is not known as an outcome to most investors.
Massive Short and Long Positions: High Frequency Trading (HFTs)
A big unrecognised risk with ETFs is related to the ease with which traders -- hedge funds and High Frequency Traders (HFTs) in particular -- are able to use such funds to short markets or go long. It is technically possible for the number of shares sold short or long in an ETF to exceed the actual number of shares available massively! It has been suggested that the "Flash Crash" of May 2010, in which US shares fell 1,000 points before bouncing back in a matter of minutes, was a consequence of this: around 70 percent of cancelled trades at the time were reported to be for ETFs by High Frequency Traders (HFTs). Given that hedge funds and financial institutions can apparently rely upon creating the units to deliver on their short, some market participants are short 1,000% or 10 times the amount of the ETF available. The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear. Yet, purveyors of ETFs claim that there is no such risk in shorting ETFs. Do they not understand the product they are offering, and if they can't, what chance has the retail investor got?
Camouflage and Subterfuge: Insider Trading
ETF stripping allows virtually untraceable insider trading. The way this works is that rather than take a position in a security where someone has inside information, The trader buys or sells the ETF and does the opposite on all the stocks that make-up the ETF, except the one for which they have insider knowledge.
Liquidity Out Of Thin Air
The problem of liquidity is an increasing issue with ETFs because of the way in which the funds have branched out into other asset classes such as fixed income and commodities including gold and oil. In these markets, liquidity is typically thinner than in big equity markets such as those measured by global indices like the S&P 500 or the Dow Jones. Liquidity is only ever a problem at times of market stress. Unfortunately, that is precisely the time when it matters, as Mortgage-Backed-Asset (MBA) investors discovered a few years back when the property market turned down and their managers were unable to sell enough properties to pay back redeeming unit holders. Investors were locked in. If the ETF is in an illiquid sector, can one really rely upon creating the units as one may not be able to buy (or sell) the underlying assets in a sector with limited liquidity?
Undisclosed Profitability
Although ETFs are billed as low cost they are also the most profitable asset management product for a number of providers. How can this apparent contradiction exist? The answer is that the charge for managing the ETF is only one part of the cost. There are also hidden cost benefits in the synthetic and derivative trades which the provider undertakes for the ETF. '
Jim |
