How ETFs Came Under Fire

ETFs are on the hot seat these days. On Wednesday, a US Senate subcommittee held a hearing to consider the idea that ETFs are contributing to volatility and instability in the financial markets. This is pretty serious stuff. How did the humble ETF, once hailed as the most investor-friendly innovation in decades, become the target of such suspicion?

The brouhaha can be traced back to September 2010, when a little-known investment firm called Bogan Associates wrote a white paper called Can An ETF Collapse?, which got enormous media attention. One CNBC stock-picking guru reviewed the report and referred to ETFs as “a monster that will wreak havoc.” But almost immediately, the Bogan report was criticized as “wildly off the mark and highly irresponsible.” Credit Suisse exposed the report as specious.

Two months later came another alarmist report from the Kauffman Foundation, which argued that ETFs are distorting financial markets and presenting dire systemic risks. Within a day of its release the report was called out for its conflicts of interest and its “serious misunderstanding of how ETFs work.” Media outlets such as IndexUniverse and Forbes wrote scathing rebuttals, and a couple of weeks later the foundation released a revised version with most of the inflammatory claims watered down.

Yet despite their shoddy arguments, both the Bogan and Kauffman reports were highly influential. I received several emails from readers who wondered if they should be worried. Earlier this year, iShares Canada told me they were still getting phone calls every day from investors who were concerned that ETFs were going to trigger the next financial crisis.

Should you be concerned?

Although these two reports were thoroughly debunked, some of the concerns about the growing ETF industry do have merit. Several other reports released this year have raised the possibility that certain complex ETFs might potentially contribute to instability in the financial markets. Unlike the sloppy Bogan and Kauffman documents, these were prepared by people who actually understand how ETFs work:

The concerns raised in these reports—and in the heated discussions that have followed them—can be boiled down to three important issues:

  • the growing complexity of synthetic ETFs (which use derivatives called swaps rather than holding assets directly) and the risk that the swap counterparty could default
  • increased volatility and market instability caused by ETFs that use leverage
  • the potential dangers of excessive securities lending, whereby ETF providers earn additional revenue by lending the portfolio’s stocks to investors who sell them short

Next week, I’ll look at each of these concerns one by one, and I’ll do my best to explain how relevant they are for Canadian ETF investors.

15 Responses to How ETFs Came Under Fire

  1. Chris in Edmonton October 21, 2011 at 10:29 am #

    The Economist has a particularly good article on ETFs at http://www.economist.com/node/18864254. The article distinguishes between plain-vanilla ETFs and synthetic ETFs, and notes the inherent risks an investor is taking with some of the more exotic ETFs.

  2. Canadian Couch Potato October 21, 2011 at 11:08 am #

    @Chris: The Economist is an excellent source, but (like the Financial Times) it tells the story from a European point of view. And in Europe the situation is much different: about 50% of all ETFs use synthetic structures, and many of the ETF providers are banks, which can create conflicts of interest. The regulatory regimes are also different in Europe. So Canadians do have to sort out some of these differences when they read these reports.

  3. DM October 21, 2011 at 11:17 am #

    Looking forward to the series Dan. My concern is that the reputation of plain vanilla ETFs could get unfairly dragged down during the intense period of regulatory scrutiny that is surely facing leveraged ETFs and synthetic ETFs in the future.

  4. Charles Chase October 21, 2011 at 12:25 pm #

    Thanks Dan for providing the Canadian perspective on these issues. It’s quite valuable to me and many others, I’m sure.

  5. Michel October 22, 2011 at 7:08 am #

    Thanks Dan. Looking forward to your articles on this subject. Is the bad rap about stock ETFs only or does it include bond ETFs and REITS ETFs?

  6. My Own Advisor October 22, 2011 at 7:57 am #

    Good post Dan and should be a great series!

    Surely plain vanilla ETFs are not coming under fire, but I’m assuming this is another (financial) case where folks like to paint everything with the same brush.

  7. Canadian Couch Potato October 22, 2011 at 10:10 am #

    @MOA and Michel: In most cases, plain vanilla ETFs are not the focus of the reports listed above, but in the media and among the general public, the lines are often blurred. The fact that people are calling iShares with concerns is evidence of this. iShares offer the most traditional ETFs in the country, but they are feeling the heat, too.

  8. Jon Evan October 22, 2011 at 12:54 pm #

    When the financial community is confused regarding etfs and their impact on markets going forward then the ordinary investor needs to pause! Focus is shifting to talking about bad etfs versus good etfs, but this dichotomy may not be helpful if the complex etfs fail and distort the market for everyone. The difference now in this era of many etfs as compared to the previous era dominated by mutual funds is the impact of the short traders who buy and sell etfs as if they were stocks. Surely, this adds to market volatility and disruption?

  9. Canadian Couch Potato October 22, 2011 at 1:03 pm #

    @Jon Evan: “…if the complex etfs fail and distort the market for everyone.” Absolutely. I think everyone agrees that regulators need to deal with these issues, because they are real. But the point here is that some investors worry about buying ETFs because they think they may be contributing to the problem, or because they think owning an ETF will make them more vulnerable. This is not true. It’s like saying you should not get a mortgage because you’re worried about another subprime crisis.

    RE: “Surely, this adds to market volatility and disruption.” That is the issue being debated, most recently at the Senate hearing last week. But it is not at all clear that leveraged or swap-based ETFs are in fact guilty as charged. There are many potential issues, but scant evidence that any of these are actually causing problems today. And it is certainly the case that traditional ETFs play absolutely no role in market disruption or instability.

  10. Jon Evan October 22, 2011 at 3:32 pm #

    Until regulators sort out what real/potential impact traditional/complex etfs have on present market volatility or more sinister future disruption I think it prudent for investors to pause with new investments into etfs and hold cash for now. Discount brokerages taking away etf trading fees is even more worrisome since this just encourages the short traders and buy/hold investors should be outraged I think!

  11. Amir October 22, 2011 at 8:55 pm #

    Who gets the revenue when an ETF lends securities? The ETF administrator or the holders of the ETF or is the revenue shared?

  12. Canadian Couch Potato October 22, 2011 at 9:06 pm #

    @Amir: In most cases, the revenue from securities lending is shared between the ETF sponsor and the fund’s investors. I’ll be dealing with securities lending in detail in one of my posts next week.

  13. Idiot Stock Investor January 7, 2012 at 11:44 am #

    What concerns me are the physical metal ETFs because how do we know they are fully allocated as they claim?

    The only one that allows you to withdraw physical metal is PBU.UN with conditions.
    I believe a case in the US was uncovered where a fund was found not to have the allocated bullion!

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