Fair exchanges?

On first examination, exchange-traded funds (ETFs) are a good thing, and the reason for their popularity is obvious: they not only offer instant liquidity, but also lower costs.

In a study conducted two years ago, Kenneth French, professor of finance at Dartmouth College’s Tuck School of Business, estimated that mutual funds’ active money managers ‘cost US investors no less than $80 bn a year – with no commensurate return over ETFs.’ Since then investors’ money has flooded toward ETFs that guarantee to meet indexed expectations, without the high charges. BlackRock estimates inflows of $67.2 bn into the funds in 2011, and most analysts expect the growth to continue.

It is typical of the finance sector that what started off as such an eminently sensible product should begin to get the iridescent tinge of a bubble, as financial institutions work out how to make money from it.

ETFs’ original assurance of representing direct holdings of the stocks in an index has been diluted, particularly in Europe. A recent report from the Financial Stability Board (FSB) has rung a warning bell about the rapidly evolving sector. The FSB, estimating $1.2 tn in ETF holdings in 2010 Q3, warns that even at this early stage ‘the speed and breadth of financial innovation in the ETF market has been remarkable… and has brought new elements of complexity and opacity into this standardized market.’

It also points out that ‘synthetic ETFs obtain the desired return through entering into an asset swap – such as an over-the-counter derivative – with a counterparty instead of replicating the index physically’ and adds that ‘some ETF providers are said to generate more fee income from securities lending than from their traditional management fees. Since securities lending is a bilateral collateralized operation, it may create similar counterparty and collateral risks to synthetic ETFs.’

Nor is the FSB alone in sounding a note of caution. On the macroeconomic scale, corporate governance activist Bob Monks suggests that, apart from other risks associated with ETFs, the funds represent a potentially dangerous extension of indexation into the markets. Estimating that ‘ETFs, indexes and ‘closet indexers’ among mutual funds already make up about 40 per cent of the market, I’m told that if you get up to about 60 per cent, there really is no market anymore,’ he points out.

While French is sure ‘we have a long way to go before there are not enough active investors’, Dr Konstantina Kappou of the ICMA Centre Henley Business School in the UK concurs with Monks. ‘There is definitely an issue with the increase of passive management in capital markets over the last decade,’ she says.

‘In simple terms, if all active traders who are responsible for eliminating market inefficiencies in stock pricing disappear from the market and all we are left with is a considerable amount of indexed money handled by purely passive portfolio managers, one could argue about an increase in market volatility and misleading stock valuations.’

Kappou notes approvingly that ‘the FSB report covers all the major concerns about the recent increase in the variety of ETFs and the complexity of some exchange-traded vehicles. The regulation process needs to progress along with the market developments to protect the average investor, especially in the case of less liquid ETFs.’

Click here for the rest of the story >>

[Article by Ian Williams, IR magazine]

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.