[Infowarrior] - Economist on the dangers of ETFs, ETNs, and more

[Richard Forno]

(Some ETFs I feel are fine -- but the more exotic ones, or the ones back by 'funny math' certainly deserve more scrutiny, I think.  -- rick)

Exchange-traded funds

A fast-growing industry is attracting more regulatory attention

Jun 24th 2010 | New york | from the print edition

http://www.economist.com/node/16438622/print

EVEN the best financial innovations have a nasty habit of spinning out of control. No surprise, then, that regulatory antennae are twitching at the rapid growth of exchange-traded funds (ETFs), investment pools that are listed on stockmarkets. ETFs have plenty of attractions, giving retail investors a relatively cheap way to diversify their holdings. But their dangers are also becoming more apparent.

The sheer size of the industry is one cause of concern. At the end of May ETFs in America held around $792.6 billion in assets, according to Morningstar, a research firm. The worldwide total passed $1 trillion at the end of 2009. Morgan Stanley predicts the industry will grow by 20-30% in 2010. The market has rapidly evolved to meet demand for more exotic products, particularly in commodities, where many worry about the impact of the appetite for ETFs on prices (see Buttonwood).

ETFs also gained popularity because investors can trade them all day long, whereas a mutual fund can be liquidated only at the beginning and end of the trading day. Retail investors, who are thought to make up half the American ETF market, are probably better off holding on to investments rather than day-trading them. And the “flash crash” on May 6th demonstrated that it is not always easy to exit from ETFs. As liquidity disappeared that day, many ETFs traded down nearly to zero.

The events of May 6th may have been exceptional but a period of market volatility is not. That spells danger for investors in leveraged ETFs, which use debt to magnify the returns of the index they follow. Because these ETFs “reset” on a daily basis, they can easily stray from their targets. If an index worth $100 drops 10% one day and gains 10% the next, it is worth $99, a loss of $1. You might assume that a fund leveraged to deliver twice the returns of this index would be worth $98, a loss of $2. In fact, an ETF of this sort would be worth $80 on the first day and $96 on the second day, for a loss of $4. Whether retail investors understand this is not clear.

Similar concerns dog other types of ETFs which use derivatives to achieve their results. An ETF tracking the price of oil, for instance, might not buy oil itself, but may make a “swap” deal with another financial firm guaranteeing a payout if the price of oil goes up. These “synthetic” funds entail hidden counterparty risks. If the firm guaranteeing the results of this oil ETF goes bankrupt, for instance, investors might lose their money regardless of the oil price.

In late March the Securities and Exchange Commission (SEC) issued a moratorium on the creation of new ETFs that use derivatives. Among other things, the government says it wants to assess whether a fund’s prospectus clearly conveys how it uses derivatives. Pressure is also mounting in Europe, where some have suggested banning retail investors from buying inverse funds, which are designed to benefit from falling prices, or leveraged products. The SEC hopes to finish its review by the end of summer and says its goal is to craft a policy that will permit ETFs only limited use of derivatives. Otherwise the industry’s explosive rise may end badly.