ETF Industry Red Flag – IMPORTANT!! |

ETF Industry Red Flag – IMPORTANT!!

I use ETF’s all the time. I use them to gain exposure on the long and short side. I have been both surprised and impressed by the speed and breadth of development. I have also voiced a gut concern that such rapid development and asset flows may be harbingers of danger, but at the time, the plain vanilla ETF structures seemed pretty stable, and while not without flaws, represented a better alternative than mutual funds for many investors.

Over the past few days, the Financial Stability Board published a report of recent trends in the ETF industry. While I haven’t heard about the report in most major news outlets nor financial blogs, at least FT.com published it. Here are a couple of highlights:

…the nature of the product structures themselves and the huge conflicts of interest that arise from the providers’ synthetic, vertically integrated models. It is here that the FSB report really stands out, since it is the only regulatory note to date which really focuses on the innate conflicts of interest. It also hints pretty overtly at the real motivation for the creation of many of these products. Namely; cheap access to collateral and funding — although we’d add that at many banks ‘position recycling’ also plays a large part.

But overall, it’s true — you plain vanilla ETF investors, who naively take these products at face value, are more than likely funding banks. (Hint, they tend to trade on margin while you’re giving up 100 per cent of your cash to let them hedge on your behalf. Unless you’re shorting the ETFs, of course — which is what the smart-money, namely hedge funds, almost exclusively use ETFs for.)

These articles are a must read:

The last one is especially critical of new synthetic replication techniques.

These warning are likely to go unheeded both because of limited alternatives, liquidity needs, and false sense of security, however, investors in these products and their advisors should understand the underlying risk in the implementation vehicles, and make the appropriate considerations.

Last 5 posts by Yaron Sadan

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