Are Exotic Exchange Traded Funds (ETFs) an Investment Time Bomb?
Exchange Traded Funds have morphed from their origins as more liquid versions of broad-based stock index mutual funds into more extreme varieties that mimic high-risk hedge funds. Edward Robinson described them as “ETFs Gone Wild” in his recent Bloomberg article, and wonders whether they are a financial disaster in the making.
Hedge funds are generally high-risk, high-reward investment vehicles that are largely unregulated and are unsuitable for most investors. Extreme exchange traded funds, which pack high-octane derivatives under the hood, are being marketed to anyone with $50, which includes many who cannot afford to lose their investment. Regulators are concerned.
One such hedge fund replicator is called The IShares Diversified Alternatives Trust ETF. According to the article, it contains the complex bets favored by hedge fund managers, packaged into one security. The fund is managed by a computer program.
Other extreme exchange traded funds trade volatile commodities futures. Even more extreme exchange traded funds are leveraged and inverse, whose net asset values move in multiples of a given basket of securities, or in the opposite direction.
While these funds are sometimes marketed as hedges or “insurance” against adverse market moves, the danger lies in the way they are really used, and that is to speculate in the hope of above-market returns.
John Bogle, the founder of Vanguard and the creator of the first index mutual fund in 1975, is one of those who believe that extreme exchange traded funds may blow up in investors’ faces.
“It’s insanity,” Bogle was quoted as saying. “This is a classic case of Wall Street trying to capitalize on the worst instincts of investors.”
“I couldn’t possibly justify putting clients’ money into those because they’re brand new, not tested, and I don’t know what’s in them,” one investment advisor was quoted as saying. “It looks like just another way for investors to get plucked.”
The Securities and Exchange Commission recently announced it was deferring approval of new ETFs that use derivatives, and the SEC and the Financial Industry Regulatory Authority Inc. (FINRA) issued a joint alert warning investors that returns in leveraged and inverse ETFs could deviate widely from their underlying indexes when held longer than a day.
In addition, FINRA is investigating several of its member broker-dealers for selling products that investors do not understand and that are too risky for their needs. FINRA is reportedly concerned about the “retailization” of leverage, derivatives and other hedge fund-style investing techniques.
Unfortunately, the result of “retailization” by Wall Street is that extreme exchange traded funds are wildly popular. As happened in the dot.com craze, too many brokers have persuaded trusting investors that they should abandon more disciplined and conservative investment strategies to avoid “missing the boat.”
Consequently, exchange traded fund assets worldwide have more than doubled to $1.1 trillion since 2005, and with 833 new funds, are expected to increase another 20 to 30 percent this year, according to BlackRock’s global head of ETF research.
Incredibly, on some days, over 40 per cent of trades on U.S. stock exchanges involve exchange traded funds, and over 70 percent of the trades canceled due to excessive declines in the May 6 “flash crash” were exchange traded funds, according to the SEC and Commodity Futures Trading Commission.
The bottom line, as Eleanor Laise put it in her May 29 WSJ article, “Danger: Falling ETFs,” is: “The mechanics of ETFs are more complicated than most investors and financial advisers ever realized. If you aren’t willing or able to keep up with the swings in the market or [a] technical discussion [of ETFs], it is a good sign that you should stick to ordinary mutual funds.”
By the same token, while exchange traded funds have morphed, brokers’ duties have not: Brokers must understand the risks of the investment they are selling, and, at a minimum, must not recommend an investment without a reasonable basis to believe that it is suitable for the investor.
Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in ETFs. For further information, please contact us.
