Not what it says on the tin

June 26, 2011 8:50 PM

"Any industry would be proud of an average annual growth rate of 34% over ten years and of a global reach from Austria to Taiwan. But the headlong expansion of exchange-traded funds (ETFs), which by May this year controlled almost $1.5 trillion of assets (not far short of the $2 trillion in hedge funds), has become a matter for concern among financial regulators. Could ETFs be the next source of financial scandal, or even of systemic risk?" Characterizing the Financial sector "like a hyperactive child" that "can never leave a good thing be", The Economist appears to be wishing for the ETFs to be better regulated because "it would be a shame if reckless expansion spoiled a good innovation".
posted by vidur (28 comments total)

The free market will handle it, if there is a crash of some kind it will just be because these regulators are causing all kinds of uncertainty.
posted by furiousxgeorge at 9:09 PM on June 26, 2011

What Does Exchange-Traded Fund - ETF Mean?

A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.

One of the most widely known ETFs is called the Spider (SPDR), which tracks the S&P 500 index and trades under the symbol SPY.

posted by KokuRyu at 9:10 PM on June 26, 2011 [1 favorite]

I'm reminded of the owners of sports teams who constantly whine for a salary cap or something similar because dammit, we just can't quit giving stupid contracts. Save us from ourselves!
posted by Ghostride The Whip at 10:33 PM on June 26, 2011

Seems like yet another "the sky is falling (and it's the evil banks' fault)" article from the Economist. Though it seems a lot of financial publications do this these days--let's consider all the vehicles that could cause the next crisis--if we're right, then we told you so. If we're wrong, then that means things are good and everyone is happy and doesn't care we cried wolf.

Indeed, like other risks, liquidity risk is indeed a risk, and by definition, risks can and do materialize into losses. And it should not be a surprise that illiquid collateral proves to be illiquid if/when you are forced to call it.

But the article gets a little irresponsible and even misleading in a number of places. For one, if a bank puts up assets as collateral, it's not like those assets disappear. They are still owned by the bank and of course included on its balance sheet. And the whole off-balance sheet thing is not quite accurate--sure, it's easy to spout off how evil they are--banks hiding bad stuff off there balance sheet. That is not really how it works though. If an entitiy does not have a direct financial interest in an asset, then it is not included on its balance sheet.

And so the solution to this problem (whatever it is) is better/more regulation? Please. For one, that is just not likely to occur, and it is a waste of time to pretend like it could. Secondly, the federal government rarely does a good job at regulating the market. Thirdly, regulating such a market could be done, but it would come with a faily high price tag--the costs in actually physically regulating would be quite high, and so would the loss/reduction of many of the great advantanges that ETFs do offer.
posted by stevenstevo at 11:11 PM on June 26, 2011

stevenstevo Secondly, the federal government rarely does a good job at regulating the market.

You're missing the wood for the trees. I agree that it is very difficult to keep the regulatory caps screwed down over the squirmy, wriggling, inventive little bastards, and anything a government does in that regard is always going to be too late and/or too little. However the main thing that a government does to regulate markets in its jurisdiction is to loom over them as the threatening prospect of Legal Trouble, primarily as the enforcement arm of remedy for breach of contract, ie the courts in which you get to sue the other bastard, and secondly, as the prosecutor of fraud.

Of course this is only true so long as government actually bothers to prosecute fraud, and to decide breach of contracts on the terms of the contracts, rather than by the amount of money shoved at politicians and judges by the disputing parties, or the relative sociopolitical power of the fraudsters and their victims. When it gives that up, ie gives up the basic Rule of Law, all kinds of unpleasant issues occur.
posted by aeschenkarnos at 11:34 PM on June 26, 2011 [6 favorites]

Mutual funds are a huge ripoff, and ETFs for things like the S&P or NASDAQ or whatever a good antidote to that.

I think the concern is overblown. An ETF is just like a stock, and like stocks, ETFs could in theory collapse. I suppose there could be a problem if, for example, lots of people bought an ETF that tracks the price of gold, and then there was some scandal where they couldn't back up their target. Something like that.
posted by delmoi at 11:55 PM on June 26, 2011

ETF are almost the same things as mutual funds, except they are rolled up as stocks and traded on the market. Generally the fees are low and often the EFT sells below the combined price of its holdings. Yet their is no special magic to them, other than the fact that traders can play mischievous games with them.
posted by Yakuman at 3:43 AM on June 27, 2011

I don't think the ETFs being discussed here are the one that look, feel, and behave like traditional long only mutual funds. The ETFs these people are worried about have a lot more complicated stuff going on inside them.

I have no idea if they create some sort of systemic risk, although history would tell you the banks will find a way to innovate themselves into that of they can, but I am absolutely positive that the fancy ETFs are constantly Mis-sold
posted by JPD at 3:53 AM on June 27, 2011

delmoi: What should be done? The greatest need is for transparency: it should be made as clear as possible to investors what they are buying. They ought to be able to tell the difference between a normal and a synthetic ETF just by looking at the fund’s name. The exact nature of the collateral should be disclosed on a regular basis, like the main investments in a mutual fund’s portfolio. Investors ought to be told that the market for ETFs may not always be as liquid as they would like. And the industry should look to its own self-interest: it would be a shame if reckless expansion spoiled a good innovation.

The concern is that these vehicles offer a new way for banks to obfuscate the real risk consumers are taking on, and that they'll eventually be abused and create a new bubble.

It's the Economist for god's sake. The Economist is now too left wing and pro regulation for some folks? Jesus.
posted by Grimgrin at 3:57 AM on June 27, 2011 [2 favorites]

Secondly, the federal government rarely does a good job at regulating the market.

Here here! The only people worse at regulating the market is the financial industry.

I am sorry, but you saw, with your own goddamn eyes, what happened after they repealed Glass-Steagall. The old trope about markets managing themselves has been proven to be a dangerous fraud.

Whenever someone says they want less government oversight of the financial markets, what they're really saying is they want large businesses to steal billions of dollars from consumers, ruin the economy of entire nations, and get away with it.
posted by Slap*Happy at 4:28 AM on June 27, 2011 [10 favorites]

The old trope about markets managing themselves has been proven to be a dangerous fraud.

And in some cases transparently disingenuous.
posted by goethean at 4:31 AM on June 27, 2011 [2 favorites]

Even long-only ETFs derive their value from their underlying assets. Ergo, there should be online reports for investors on their operations & assets.

Ideally, ETFs should be regulated much like Mutual Funds, given so many investors treat them identically. There might be some need for additional restrictions to protect pre-IPO companies, not sure.

Are there any "open source" ETFs or Mutual Funds that actually publish the trading algorithms they use for tracking the market?
posted by jeffburdges at 4:36 AM on June 27, 2011

There needs to be some Internet Rule about this kind of thing - if you can think of some kind of financial product, someone has already exploited it (to the detriment of the rest of society).
posted by backseatpilot at 4:55 AM on June 27, 2011

the risk of the manager taking unintended or outsize risks as they attempt to grow an ETF is much lower for more vanilla style products because the underlying market is so much deeper and cheaper.

Given the mechanics of how these things work tho, it isn't really possible to generate a statement of assets and operations - mostly because many of them don't actually directly own the underlying. That's actually sort of part of the issue. I mean the answer "Swap with Counterparty X" doesn't really tell you anything about Counterparty X's risk position. And many ETFs aren't backed by a swap, but rather are basically kept in-line with the underlying through an arbitrage process of third parties going to the manager and creating or redeeming shares.

Are there any "open source" ETFs or Mutual Funds that actually publish the trading algorithms they use for tracking the market?
Why would anyone who sells these things for money do that? Also its not as simple as one algorithm. There are a multitude of things you need to do to run an ETF or an index fund well and profitably at the market rate for fees.

(really its index funds/passive funds that are the relatives of ETFs - not all mutual funds)

There needs to be some Internet Rule about this kind of thing - if you can think of some kind of financial product, someone has already exploited it (to the detriment of the rest of society).

I'd slightly change that - eventually someone figures out how to abuse a good idea (ETFs, Asset Securitization, Credit Derivatives) and make them detrimental to rest of society. These things always start out as a useful solution to a problem, but the high profits attract lots of attention, and not all of it good.
posted by JPD at 5:03 AM on June 27, 2011

Did people here actually read the article? The problem is that for many funds the ETF's underlying asset isn't the same as the one it purports to track. For instance, an ETF whose return tracks the price of gold might actually have its assets invested in the share market. The ETF's investors think they've invested in something that insulates them from the risk of a share market crash, but in fact they are almost as exposed to that risk as if they had invested directly: if the share market crashes then the fund managers may not have enough money to pay people redeeming their units.

It gets scarier when you consider that the ETF managers might actually use the fund to get rid of badly performing assets. How likely is it that banks would have used home mortgage securities as assets, if they could? You might have bought units in a currency-based ETF, but it will turn out that its returns weren't based on currency swaps but on the ability of homeowners to pay their mortgages. This is potentially huge, but we'll never know unless and until there's a crash in an asset class backing a large ETF.
posted by Joe in Australia at 5:29 AM on June 27, 2011

Mutual funds are a huge ripoff, and ETFs for things like the S&P or NASDAQ or whatever a good antidote to that.

How so? Index based mutuals do the same thing. Yes, poorly run managed mutuals made some money in good times (but not as much as an index funds) but the few well run managed funds did something just as important -- they made or lost a little bit of money when the market as a whole was losing a great deal of it.

The problem isn't index based ETFs, it's synthetic ETFs. Just exactly what is being bought into, and sold from, the fund? That's easy to tell with a index ETF -- a replication index ETF is going to match the index as close as possible. Try that with other ETFs. Bring aspirin.

I dislike The Economist because they live and die by the freshwater economist kool-aid, but they *honestly* live and die by that, and the journalism is excellent. So, I should note that when The Economist is calling for more regulation, this is a big sign that the correct thing to do with an ETF is to run as far away as possible.
posted by eriko at 5:57 AM on June 27, 2011

How so? Index based mutuals do the same thing.

ETFs are generally cheaper than a retail index fund. Priced more like an institutional index fund.

The problem isn't index based ETFs, it's synthetic ETFs. Just exactly what is being bought into, and sold from, the fund? That's easy to tell with a index ETF -- a replication index ETF is going to match the index as close as possible. Try that with other ETFs. Bring aspirin.


a lot ETFs and index funds are not pure replication funds - indeed part of why they are so cheap is the different techinques used to mimic the index w/o having the costs associated with buying the entire index. But that's not really what the FT is talking about here - replication is not the oppposite of synthetic.

A synthetic ETF is one that has an equity return swap underlying it (see the example I gave above) the issue the Economist has is with the collateral the bank is pledging for the other side of that swap. The argument isn't that this collateral should be the underlying securities, but that rather it should be someting very similar to, if not exclusively, cash.
posted by JPD at 6:21 AM on June 27, 2011

Well I guess the economist is arguing it should be the underlying securites, but that sort of defeats the purpose of creating liquidity in illiquid markets. As long as the collateral pledged on the other side of the swap is secure the share owners should get their money back if the bank fails. That's really all you can ask for as an ETF owner.

I shudder to think that there is some muppet out there running an ETF business who hasn't figured out someway to hedge his exposures on the other side of the swap, but in the context of owning an ETF, that shouldn't really be your concern. Its something for the regulators and banks shareholders to care about. Which they probably don't care enough about.
posted by JPD at 6:29 AM on June 27, 2011

BTW - the reason to fund the collateral with someting other than cash (that is not the underlying) is to keep the cost of the swap itself down, and the ETF's costs lower.
posted by JPD at 6:39 AM on June 27, 2011

Marketcetera looks like the only open source automated trading platform.

If the ETF is backed by swaps, that's all well & good. Investors should however be able to look up the stakes in various counterparties, as well as the basic guidelines under which the ETF operates.

I'm personally more concerned that ETFs make IPOs less profitable.
posted by jeffburdges at 8:08 AM on June 27, 2011 [1 favorite]

These are not products. They are abstractions built on other abstractions. You have to dig two or three layers down to find the actual growth drivers - the enterprises that issue stock - and the profits taken at these meta-levels actively sap that capital from where it could be productive, diverting it to banks and other middle-men. Geez, didn't these people watch Inception? The more layers down you go, the more unstable the dream!
posted by 1adam12 at 8:15 AM on June 27, 2011

ETFs make IPOs less profitable

Wow, am I ever having a hard time building up much sympathy for this. From that link:

Had Microsoft been acquired by IBM, for example, would Bill Gates today be the richest man in America? Heck no. Lotus Development was acquired by IBM and the fortunes of those Lotus people haven’t fared any better than those of their colleagues at Big Blue. Yes, they got $3.3 billion, but today that’s not worth much more, maybe less.

IPOs are better if they work. IPOs make entrepreneurs big rich.

Boo hoo, poor entrepreneurs, having to make due with a paltry few billion instead of being Bill Gates. Sheesh.
posted by adamdschneider at 8:26 AM on June 27, 2011

Goethean : The old trope about markets managing themselves has been proven to be a dangerous fraud.

And in some cases transparently disingenuous.

I heard this key phrase at a conference recently: "self- regulation is no regulation".
posted by dr_dank at 9:01 AM on June 27, 2011 [1 favorite]

I heard this key phrase at a conference recently: "self- regulation is no regulation".


I like "self-regulation is to regulation what self-importance is to importance".
posted by A Thousand Baited Hooks at 10:24 AM on June 27, 2011 [3 favorites]

Do you prefer that the financial establishment slurp up all the capital that might otherwise be invested into new companies adamdschneider? Before you answer, please recall that said financial establishment has vastly more resources than pre-IPO companies for manipulating investors.

Or perhaps you'd prefer that all small companies are eventually acquired by other established companies in their industry? All our lives would be much improved by Google being a division of Microsoft, no doubt.

IPOs provides the financing for the major corporate growth spurts that keep our economy healthy and prevent us from perpetually bowing down to the same corporate masters. IPOs are a core function of our financial industry that we really should not fuck up.

There is however one major flaw with that article I linked, namely that Cringely isn't particularly knowledgable or trustworthy. <shrug>
posted by jeffburdges at 10:32 AM on June 27, 2011 [2 favorites]

IPOs are a core function of our financial industry that we really should not fuck up.

Possibly. I don't have the expertise to opine on this one way or the other, but when I read stuff like, "IPOs provides the financing for the major corporate growth spurts that keep our economy healthy and prevent us from perpetually bowing down to the same corporate masters," the first thing that comes to my head is, "meet the old boss, same as the old boss."
posted by adamdschneider at 11:31 AM on June 27, 2011

I'm less worried about whether bosses improve than whether an elite can ensure they remain the bosses, kill & control disruptive technology, etc.

I'd love an even more "dynamic" system that directly disrupted the giants, rather than just slipping around them unnoticed, but who knows how one achieves that.

There has been an awful lot of improvement in bosses in the tech sphere, right up until Facebook. Retail tells perhaps the opposite story though, but even Walmart lowered prices. <shrug>
posted by jeffburdges at 12:16 PM on June 27, 2011

stevenstevo: if a bank puts up assets as collateral, it's not like those assets disappear. They are still owned by the bank and of course included on its balance sheet.

Yeah, because when could that not be true?

WSJ did a recent piece on synthetic and commodity ETFs ("Extreme Tax Frustration"). Summary: they suck. Longer: obfuscated value metrics, uncertain cost basis, unknown internal costs, deranged potentially multi-State tax reporting obligations, ability to force tax reporting into tax-deferred accounts. And that's even without the difficult-to-ascertain-or-quantify internal systemic risks.
posted by meehawl at 1:23 PM on June 27, 2011 [1 favorite]