The Trouble With Exchange Traded Notes

Innovation in the ETF space going too far?

July 11, 2011

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1092504_thin_iceExchange Traded Funds are enjoying a huge boom in popularity. It would seem the idea of simplicity has caught on: buy the index and hold it, in as cheap a fashion as possible.

But the reality is more complex. There are index construction issues. There are the costs of frequent trading. And there’s the danger of a flash crash – another May 6 event  which mostly affected ETFs.

Now the august Economist is weighing in on ETF innovation. And it doesn’t like what it sees. Primarily the concern is with ETNs – exchange traded notes – and commodity ETFs. Normally, an ETF holds all or the bulk of the market capitalization of an index directly. That doesn’t mean it is immune to market disruptions – but at least you’ll get the market price, since arbitrageurs will close any difference between the price of the ETF’s underlying constituents and the price of the ETF itself.

That’s about as simple as it gets. But with newer ETFs, The Economist writes:

“For some, this is a worrying trend, with echoes of the subprime housing crisis, in which financial innovation went out of control. That crisis, too, had its origins in invention with a benign aim: the packaging of mortgages for use as securities for bonds was intended to reduce borrowing costs and disperse risk. Eventually, however, that simple idea transmuted into complex collateralised debt obligations and lower lending standards.”

Many in the ETF space insist that can’t happen here. But it could, because many of the newer ETFs are no longer direct investments in the underlying assets, but swap arrangements between an ETF provider and investment bank. It’s an indirect investment, to which is added another factor: the credit quality of the investment bank. Sometimes, investment banks go bankrupt, and seemingly safe, GIC-like investments collapse. That’s what happened with Lehman structured notes bought by retail investors in Europe. They were sold by Citibank, Deutsche Bank and UniCredit among others, but they were Lehman Brothers obligations, not obligations of the banks that sold them. So investors who thought they were buying a safe product have to stand in like with the rest of Lehman’s creditors.

Again, The Economist notes:

“Similarly, the new types of ETF no longer offer the cheapness and diversification of the early varieties. Instead they have become a means for hedge funds to speculate on the market throughout the trading day, allowing them to make complex bets on illiquid asset classes. And the portfolios of some ETFs consist not of a broad range of stocks but of a derivative position with an investment bank as a counterparty.”

Will a counterparty blow up? Almost certainly at some point, The Economist argues.

We’ve covered this before.

What’s interesting is that voices in the ETF industry are expressing doubt, The Economist finds.

“A failure might diminish the appeal of ETFs as a whole. ‘There are products that are not even funds which are being called ETFs,’ reports Deborah Fuhr of BlackRock. ‘The risk of confusion, disappointment and disillusionment among investors would be very negative for the ETF industry.’

“That would be a shame. Fund managers’ fees have always eaten into investors returns; ETFs were a splendid way of letting investors keep more of their money. But like a hyperactive child, the finance sector can never leave a good thing be.”

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