Maybe you didn't know that the rogue trader at UBS AG (NYSE: UBS) who lost $2.3 billion last year was trading exchange-traded funds (ETFs)... or that Jerome Kerviel, another rogue trader at Société Générale SA (PINK ADR: SCGLY) who lost $7.2 billion in 2008, was trading ETFs.
Maybe you didn't know that ETF trading accounts for 35% to 40% of all exchange volume, according to Morningstar Inc. (Nasdaq: MORN).
Maybe you didn't know that the US Securities and Exchange Commission (SEC), the US Commodity Futures Trading Commission (CFTC), the Financial Stability Board (FSB) and the Bank of England (BOE) are each concerned that ETFs pose potential systemic risks.
Maybe what you don't know can actually hurt you.
ETFs: Growing Popularity a Growing Danger?
Just when you thought that exchange-traded funds were a simple, smart and safe way to diversify out of underperforming stock-and-bond mutual funds, along comes reality.
What these regulators and financial- stability oversight agencies are increasingly worried about is whether Wall Street's presumed good intention in creating these hugely popular investment vehicles is being undermined by unintended consequences.
But, let's not forget, we're talking about Wall Street, where "unintended" consequences are a rarity. The reality is that ETFs were originally conceived – and are increasingly being engineered – to ratchet up trading for the Street's own benefit.
And while you may not think that affects your investing or trading of ETFs, or your portfolio-diversification plans, you'll be surprised – and maybe even alarmed – to learn that you're wrong.
Let me explain ...
Instruments of Diversification... or Disaster?
ETFs started out as tradable alternatives to mutual funds. Initially, product portfolios consisted of stocks, or baskets of stocks, that replicated such key indexes as the Dow Jones Industrial Average, the Standard & Poor's 500, or the Nasdaq Composite Index.
The idea was to offer products that mirrored benchmarks – and that traded all day, like stocks. The tradability of these instruments offers effective liquidity that conventional mutual funds lack, with the added benefit that ETFs would also be easy to short.
Product offerings multiplied quickly. In addition to exchange-traded funds based on stocks, product sponsors created ETFs that replicated oil-and-gas, gold-and-silver and diversified-commodities portfolios – all of which were based on futures contracts.
In fact, a lot of ETFs started out as a cheaper alternative to futures trading. Futures traders must cover high initial-margin deposits. And positions are marked-to-market daily, which requires immediate additional margin coverage when losses arise. The upshot: Futures trading is too expensive and too volatile for investors who are used to traditional stock market investing.
Today investors can find exchange-traded funds that offer exposure to all kinds of risk instruments - from currencies and bonds, to thin slices of the yield curve and volatility. And there are even "leveraged" and "inverse" ETFs that multiply risk exposure and allow traders to make all kinds of directional bets.
ETF volume has been growing at a rate of 40% a year for the past decade. According to BlackRock Inc. (NYSE: BLK), which bought the successful ETF product manufacturer, iShares, exchange-traded-fund assets exceed $1 trillion in the US market and $321 billion in Europe.
On the surface, it all looks good. But behind this vast array of exchange-traded funds that retail investors rely on for diversification are thousands of traders – most of them institutional players. And those professionals trade these same ETFs. Then they turn around and trade all the underlying securities, futures and derivative instruments that make up those funds.
And that's a problem – on several levels.
From Rogues to Riches – Wall Street's, That Is
In order to create baskets of stocks, bonds, futures and other financial instruments that become ETFs, sponsors employ "authorized participants" to package and essentially manufacture them. Authorized participants, typically big trading shops, are constantly buying component instruments to create ETF shares – only to sell them when ETFs shrink (because net sales diminish their size). But not only are these "insiders" buying and selling ETF-component securities to create and retire ETF shares, they are also constantly arbitraging and speculating against the actual exchange prices for the underlying components.
High-frequency trading (HFT) has become standardized practice across all major trading houses. And what are these outfits trading so frequently? That's right – ETFs and all their underlying stocks and other component instruments. These are the building blocks of most HFT trading programs.
Not only has growth spawned more trading, more trading has exponentially elevated market volatility.
The frightening irony is that traditional retail investors are diversifying into ETFs to protect themselves from the stock-market volatility that's eroding long-term-investing horizons. And instead of getting protection, they're becoming multiple-asset-class speculators.
And they don't even know it.
On Wall Street, ETF trading has become such a big business that significant space on Delta One trading desks goes to teams of ETF traders. Delta One, which is an options trading term that refers to how much an option price moves relative to its underlying instrument (a delta of 1 means the option moves on a 1-to-1 basis with the underlying) is the name big banks give their trading desks that aren't supposed to be proprietary trading with the bank's money.
Rogue traders Kerviel from Société Générale and Kweku Adoboli from UBS both were Delta One desk ETF traders.
That should tell you something.
The massive losses they incurred resulted from a failure to hedge out the risk of their positions properly; in other words, they weren't "delta neutral" – as they fraudulently pretended to be.
But the larger point is that these desks are flat out taking huge positions in ETFs. And if they are speculating in underlying futures, they are using ETFs to hedge.
The Delta One desks are actually a ruse. Their role is supposed to be one of facilitating customer order flow on big trades by taking the other side of institutional positions. They do this in their capacity as "market-makers" on behalf of their customers. But while they can hedge the positions they take with offsetting trades – hence the "Delta One" designation – they aren't actually doing that as often as they are supposed to.
These desks are nothing more than proprietary trading desks posing as market makers – while they're actually wagering the house's money to make big profits and bonuses. And they are increasingly using ETFs to make those giant wagers.
Most frighteningly, many exchange-traded funds and approximately 40% of European over-the-counter funds are based on "synthetic" portfolios. The underlying instruments in theses ETFs can be swaps, derivatives, and "referenced" securities (meaning they aren't even in the portfolio). Not only are these ETFs leveraged by the nature of their derivative-portfolio construction, they pose huge counterparty risk based on who is on the other side of the underlying instruments that have to pay up if their bets go wrong.
And we're now discovering that the huge increase in volatility that ETF trading has helped create isn't even the most serious problem we face.
Market Overseers Taking a Close Look
In a June report on systemic risk and ETFs, the Bank of England pointed to the expansion of ETF trading and risks "characterized by increasing complexity, opacity and interconnectedness."
The Financial Stability Board, an international oversight committee hosted by the Bank for International Settlements (BIS), recently warned that "intensive recourse to securities lending by ETFs provides new challenges in terms of counterparty and collateral risk."
Here in the United States, the CFTC is taking a hard look at ETFs. The CFTC's chief concern is how, by concentrating instruments or assets in certain futures markets, ETFs exceed position limits – which has forced some funds to turn to derivatives and swaps to supplement commodity holdings.
And now the SEC is looking into whether ETF trading contributed to the unprecedented volatility we saw last August – when the Dow lost or gained more than 400 points nearly every trading day for two weeks.
Given the evidence already presented here, I feel I don't even need to offer a comment on that.
The bottom line for ETF investors is that they need to be aware that these diversification tools are far more volatile and speculative than they realize. The interconnectedness of huge traders placing bets on all these products and their underlying securities and derivatives makes them prone to systemic risk, which somehow almost always goes against ordinary investors.
Don't ever buy an ETF without knowing exactly what it is, what makes up its portfolio, whether it's leveraged, who is behind it, and how volatile it has been historically. And, even then, don't lose sight of your positions, and use stop-loss orders for safety.