The last two Sunday papers jabbed obliquely at the perils of ETF investing with one highlighting the dangers of following an index and the other on why ETFs lead smart people to dumb decisions.
This one though goes straight for the gut. The authors, Mr. Si Cheng, Mr. Massimo Massa and Mr. Hong Zhang of the Queen’s University, Insead and Tsinghua Universities respectively, delve into the seedier side of ETFs; videlicet, what happens when they’re run by large financial conglomerates, which 75% of them are.
The proofs are complicated but the conclusions intuitive and simple. The researchers begin by noting ‘..the global ETF industry is much more complicated than a simple offering of index trackers might otherwise indicate.’ How so?
Operators of ETFs rarely set out to mimic exactly underlying indices; and this is where problems begin.
Where banks have superior knowledge of stocks, say, by being a lender to the company they regularly overweight these positions. That’d be fine if the advantage went to the ETF holders but as they’re only obliged to pay an index return it may not.
If they’re using some kind of synthetic instrument, issued by another bank, there’s systemic risk building up. What happens when/if the counter-party goes bust?
An ETF operator may lend stocks out. This is one way fees are kept low but again, the full benefit of this activity may not be passed on fully to the ETF investors and, as above, what happens if a counter-party fails?
The most important point is a banking crisis, when it next occurs, will spill over to equity markets, via ETF operations, and thence back to credit producing the kind of confidence-failure vortex at the heart of all financial calamities. Today’s painful raising of capital buffers will prove for naught in such an event and governments will find themselves at the same moral hazard crossroads they dithered at during the GFC. You have been warned.
My own final two-pennyworth which, if it weren’t so scary would be funny, is the root cause of this potential future calamity is visible today. Again, asleep-at-the-wheel regulators allowing a good-in-theory idea to get out of hand while doubtless being assured by the architects they have risk under control.
Risk-under-control of course being, like British cuisine, an oxymoron.
The paper in full can be accessed at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2224424
Happy Sunday