The Perils of Exchange Traded Funds

Despite their retail-friendly image today, ETFs were originally designed as a product for professional fund managers and institutional investors, and their involvement is still high

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October is the month for ghouls and goblins and, therefore, makes a fitting time to examine the perils and frights that may or may not lay in wait for unsuspecting ETF investors.

Like the costume-clad candy collectors, many of the perceived threats facing ETF holders are merely phantoms that look scary but pose no real danger. That doesn’t mean, however, that there is no risk at all: There are important risks currently facing ETF investors, and new ones potentially coming in the future.

Several recent developments gave ETF investors cause for concern. Kweku Adoboli, who worked for the Swiss bank UBS in London, became the latest “rogue trader” to be arrested after allegedly losing $2.3 billion through unauthorized trades made through his position as director of exchange traded funds.

This development precipitated several articles in the financial press warning of “the perils of ETFs” (Forbes) and finding “uncanny echoes of what took place with collateralized debt products last decade,” (Financial Times). To make matters worse, it soon came to light that Adoboli’s most recent role model – Society General’s Jerome Kerviel – was also an ETF trader.

Apparently, Adoboli’s job entailed working with institutional investors to create custom ETFs similar to what are known to U.S. investors as exchange traded notes, i.e. securities that do not represent ownership of physical assets but are instead the obligation of the issuer and thus confer counter-party risk.

The fact that his trading involved what in Europe are called “synthetic” ETFs backed by swaps and other derivatives was trumpeted loudly in media reports as it fed into an existing theme among ETF critics that they are, or can be, empty “shells” that are bound to implode sooner or later.

While it is always useful to remind investors of the real risks involved in exchange traded funds, it is of no use to anyone to simple declare that because the losses involved ETFs, ETFs are to blame.

From what little information UBS has disclosed regarding Adoboli’s trading, it appears that he claimed to have offsetting positions to hedge his trading activities that did not actually exist, something a trader of any financial instrument could conceivably do.

Still, the revelation of another massive trading loss provides occasion to delve into the lesser-understood aspects of ETF trading, particularly their use by institutional traders.

Despite their retail-friendly image today, ETFs were originally designed as a product for professional fund managers and institutional investors, and their involvement is still high.

According to a study done by ETF sponsor Invesco PowerShares, about half of the assets held in U.S. exchange traded funds are owned by institutional investors. Institutional participation in daily trading activity is probably higher.

And with ETFs now accounting for somewhere near 40% of all exchange trading volume, institutional ETF traders occupy a very important position in the daily functioning of financial markets.

ETF sponsors are aware of the heavy institutional ownership of ETFs, and even cater to it. When BlackRock’s iShares unit launched the Emerging Markets Small Cap ETF in August, the NYSE/Euronext called the move “a direct response to the growing trend among institutional investors” to use ETFs.

The periodic reports warning of the inherent dangers of ETFs have failed to put much of a dent into their popularity, but there are real risks that investors probably should be more aware of. The Securities and Exchange Commission is investigating multiple issues surrounding ETFs.

One issue SEC regulators want to look at is whether ETFs, and particularly leveraged ETFs, have added to the recent stock market volatility, according to a Wall Street Journal report.

ETFs also lend themselves to some unsavory activities. The SEC is charging a former trader from Goldman Sachs with using his knowledge of the firms trading activities surrounding the SPDR S&P Retail ETF to buy or sell the underlying securities when large orders for the ETF came.

Insider trading can also be accomplished through ETF “stripping,” in which a phantom position can be created by simultaneously buying an ETF and selling all the underlying securities but one.

As a result of the May 2010 “flash crash,” in which ETFs suffered a disproportionate number of trades that were later broken, it has come to light that ETFs are at increased risk for wild price fluctuations because there is only a thin market for them. The SEC’s final report on the flash crash stated that “anecdotally, market makers in ETFs reported that ETFs trade distinctly from individual securities, which often results in more concentrated liquidity on exchange order books.

Specifically, they considered ETFs a “professional’s market,” in which depth of book is more limited compared to individual stocks, and there are little, if any, resting retail orders far from the mid-quote. Sell pressure that overwhelms immediately available near-inside liquidity is less likely to be “caught” by resting orders farther from the mid-quote in an ETF versus an individual stock, according to the SEC report.

Of even more concern is the increasing complexity of the investment strategies ETFs use. New leveraged ETFs are being launched every month, as are hedge fund replication ETFs, volatility and Beta ETFs, as well as active ETFs whose strategies are not disclosed at all.

Also, as sponsors rush to grab any unfilled market niches, ETFs are pushing into less-liquid markets, which may create problems during periods of high market volatility. Furthermore, there appears to be significant pressure from prospective managers of active ETFs to relax disclosure requirements so as to avoid revealing their daily activities.

How investors will benefit from less disclosure will be a difficult, but interesting, argument for ETF sponsors to make.

The ETFs listed in the accompanying table are thinly traded, suggesting that do not attract the attention of institutional investors, yet all garnered a top “overweight” ranking from S&P Capital IQ’s proprietary ETF ranking methodology, as of October 6. (S&P Capital IQ ETF rankings are subject to change at any time.)

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S&P Senior Editorial Manager Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF and mutual fund stories.

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