You need to be afraid of ETFs. They are, most likely, the soil in which the seeds of the next financial crisis (there’s always another one) are being planted. How do I know this? I don’t for sure; but they look very like other financial innovations that started out (and, in fairness, after convulsion came back) as jolly good ideas.
The path is a well trodden one. First, somebody innovates to address a problem. The idea proves a hit. It’s developed. A suite of products emerges. The industry gets bigger. Charlatans begin operation. The industry becomes enormous after years of success. The black-swan tips up; Ka-boom!
We do this over and over. In my short career I’ve witnessed the above life cycle with high yield; Milken, Boesky, Ka-boom!, no more Drexel Burnahm Lambert. Derivatives; Kobe earthquake, Nick Leeson, Ka-boom!, no more Barings and most recently of course securitization; Ka-boom!, no more Bear Sterns, Lehman Brothers or Merrill Lynch (to name just a small handful from the total casualty list) and don’t get me started on craptocurrencies.
The paper highlighted this week, on the subject of ETFs, is from our very own market regulator in Hong Kong the Securities and Futures Commission (SFC). It’s a useful read if you need a quick primer on industry development and certain trading trends specific to Hong Kong. In fairness they point out some of the risks and some of the current potential problems in terms of poor capital allocation decision making, risk mispricing and etcetera.
They also go on to discuss the notion of allowing ‘active’ ETFs to list; and this is where I first get the willies. An active ETF is one which doesn’t blindly follow an index. Instead, just like a mutual fund, there’s a manager jockeying a portfolio; but here’s the mischief, the SFC is proposing that holdings only need be reported with a one month lag. Investors will therefore be buying highly liquid black boxes. Not a good idea on so many levels.
What also concerns me is the authors breezily note they’ve talked to the industry; but by this I presume they mean the creators, traders and largest holders of ETFs? Unsurprisingly then the tone of the note is progressive, upbeat and looks forward to the market becoming bigger and more diverse. Given nothing has gone wrong in their sample period what other conclusion could there be?
Turkeys, asked to self-assess health, will report feeling just fine on 364-days of the year. The poor turkeys though can be forgiven for not knowing what’s around bend. Highly intelligent partisan operators don’t get the same pass. If they’re not being more frank about the risk inherent in these instruments, especially that which would be amplified at a time of intense market stress, they’re being disingenuous.
You can read the paper in full via the following link HK SFC ETF Paper.
Happy Sunday; consider yourself warned.