Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary (H/T paver). Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.
As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures like futures.
But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:
Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.
Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.
They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.
The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:
Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?
And the risk (and fees) just kept getting greater:
The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.
The biggest problem facing ETF investors now, according to the asset manager, is being able to discern the good funds from the bad — which ETFs have given into temptations to add revenues by lending assets out or buying derivatives instead of assets and which have not. In short, discerning which funds own what they say they own.
While Bedlam doesn’t expect the ETF industry or investors to discover the proverbial 10,000lb “gorilla in the room” any time soon, they themselves will be staying away from ETF investments for their own clients until they do. As Bedlam concludes:
Yet we have been here before. As investors know to their cost, doing nothing when you have good grounds to be suspicious of financial strength, say of a Northern Rock, AIG, UBS or Mr Madoff may not be entirely wise. For when the dyke breaks, many listed equity prices will suffer. Consider gold for the last time. It is the 10,000 lb. gorilla in the ETF market. If one of the many minnows explodes, it is likely to be covered up quickly or rescued by the local treasury or a competitor. When the first two Bear Stearns hedge funds blew up in June 2007, it was headline news for a couple of days only, yet within weeks small banks and funds were going off like fireworks.
The same pattern is likely with ETFs. One or more of the smaller exotics will expire. Little notice will initially be taken. After a couple more, especially if in different sectors, there will be a rush to dump them all. The good and the bad will be forced sellers alike to meet redemptions. This will lead to an avalanche of physical gold, live hogs and cocoa being heavily sold into often thin markets, causing sharp price declines. The share prices of related equities are sure to follow those of the commodities they produce.
It becomes a spiral. The key investment trick will be to avoid denial. There will be no bell, merely perhaps a couple of small stories or occasional hints from Dubai, London or Rio. The headlines will be a call for calm; the consensus that these problems represent a fraction of the industry. When that happens, run, including from related equities. Meanwhile be paranoid; most rich people are.You can view the whole note in the usual place.
Related links:
The problem with commodity ETFs - FT Alphaville
The ETF blowup begins – FT Alphaville