#TBT: Rationalizing the Popularity of ETFs
"History doesn't repeat itself...but it does rhyme."
- Mark Twain
Just about every investor has an ETF of some kind in their portfolio going to work to make cash work on the side. However, it's kind of tricky when the concept of ETFs have turned into a derivative product in everything but name only. Many investors will claim that ETFs are liquid, safe, and efficient...but actually, they said the exact same thing about mortgage-backed securities (MBS) prior to the market meltdown in 2008.
In recent years, ETFs have been packaged in such a way that they are starting to resemble the financial engineering that caused the mortgage meltdown. An analyst from Piper Jaffray wrote in 2005 that "when you invest in MBS, you help lower the cost of financing a home and make housing more affordable for many Americans." This sounds oddly familiar to the ETF database's note that "the tremendous growth of the ETF lineup has democratized the business of investing...opening up investment strategies and entire asset classes that have historically been accessible only to the largest and most sophisticated of investors." While this is not wrong, the language is still a bit suspect.
ETFs have opened up the door to many average investors, it's true, but the overall growth is so rapid that it's hard for technology to avoid meltdowns that would scare the crap out of average investors. You may recall a few years back when the market had what is called a "flash crash" where the S&P 500's value dropped rapidly but then came back up again after an trader missed a few 0's at the end of a large trade. ETFs are far more susceptible to "systemic risk" than other investment since they possess derivative-like features. Flaws in the system could have major impact for ETFs in particular -- in 2015, approximately 42% of the overall value trading on U.S. exchanges was in ETFs.
Additionally, since they now mirror indexes, sometimes investors worry about the underlying value of the stocks when they shouldn't be. Analysts recently stated that:
"the underlying securities in broad indexes, and most especially in small capitalization or industry specific indexes, can be drowned in a tsunami of derivative arbitrage selling, very likely in a disorderly fashion, by the stampede away from the ETFs of hedge funds, portfolio insurance sellers (e.g. institutions), and retail investors. Put simply, the marketing strategies that sell ETFs as frictionless and unconstrained investment vehicles do not account for the inherent difficulty of trading the securities within these packages."
We've also seen a very broad scope of ETF packages from some large sources, but there are thousands more. I'm not advocating that you avoid ETFs at all, but just understand that ALL investments, even those that appear safe, carry a substantial amount of risk too.
(This post was originally published on GradMoney on August 23, 2017)