The Dark Side of ETFs

ETFs, one of the most notable methods of passive investing, have exploded in popularity over the last few years. Now with close to 5,000 products listed globally, you can literally express pretty much any trading view with an ETF.

ETFs, one of the most notable methods of passive investing, have exploded in popularity over the last few years. Now with close to 5,000 products listed globally, you can literally express pretty much any trading view with an ETF.

Extremely efficient, with very low costs, the capability to go long – or short – an index, sector or trading strategy via an Exchange Traded Fund has attracted millions of investors. They are and incredibly convenient and easy way to gain market exposure.

A major part of the attraction – and what has really caught the imagination of the investing public, is how they provide the ability to gain access to a diversified portfolio of shares, with the ease of buying a single stock. An ETF tracks an index or a basket of assets so it mirrors their overall  performance. This provides investors with the gains of the assets that do well, balanced by any losses in the portfolio. And all at a much lower cost with the active management fees stripped out.

There are real fears, however, that investors don’t fully understand the risks present in these instruments, with liquidity and the extensive leverage in some ETFs uppermost in mind.

For many observers, the concerns center around the fact that the ETF phenomenon has never been properly tested in a downturn. Everything can appear fine when markets are going up and there is always a bid for any investor wanting to sell, even if it is at a level that is not especially attractive. In volatile market conditions, however, when assets are sliding fast, that bid may not be there and when a large number of retail investors are trying to exit ETFs at the same time, a potential liquidity freeze could emerge, exacerbating a market downturn.

This was the focus of a presentation by Grant Williams, entitled Passive Regression, where he charts the rise of the ETF industry and the trouble that could be in store for financial markets from the proliferation of passive investing.

The growth in the ETF complex  has seen assets grow to just under $3 trillion, with the top ten ETFs alone containing total assets of $826 billion. Amidst all this growth, some of the ETFs that have been launched have been much more speculative, which has raised more than a few eyebrows, as the market looks to create ever more options for investors in an extended bull run.

Commentators have remarked on the fringe element ETFs, which include ETFs of dubious credit quality, high leverage and the creation of bespoke indexes, which track niche areas of the market. Potentially the most alarming to date was a quadruple leveraged ETF that was recently licensed by the Securities and Exchange Commission. By giving unsuspecting retail investors access to products that don’t just amplify returns by four times – but also magnify risks by the same measure – there could well be trouble in store for the ETF industry and wider markets.

Steven Bregman, co-founder of Horizon Kinetics, articulated the hidden dangers in ETFs in a three-part interview with Grant Williams on Real Vision.

Steven demonstrates that investors are getting something diametrically opposed to what they expect with certain ETFs and identified the magic trick that ETF providers employ to reduce PE ratios where they need to and influence sector diversification. This interview will go down as the definitive account of the trouble with ETFs and the dangers that everyone investing in these instruments needs to understand.