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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.