Couch Potatoes: Not the Next Financial Time Bomb

I would have been kicked out of journalism school for writing this: “The culprit behind the epidemic of death on our roads is clear: drunk drivers. There are more than 21 million of these in Canada today.” The problem, of course, is that the 22 million figure refers to all drivers, but the context suggest it applies only to the drunk ones.

Now consider these sentences from a recent article by Andrew Ross Sorkin of The New York Times. The article discusses the extreme market volatility we’ve recently experienced and quotes a Wall Street money manager with a theory about its cause: “He says he knows the culprit behind the late-day market swings: leveraged exchange-traded funds or ETFs. These funds, which allow investors to bet on a certain basket of stocks, commodities or an index, are perhaps the hottest rage in investing, with some $1 trillion invested.”

Is it clear that the $1 trillion figure relates to all ETFs in the United States, the overwhelming majority of which are plain vanilla index funds? Probably not. It’s likely that most readers will lump in the Sunday drivers with the drunks. That helps explain why so many investors are worried about the coming ETF meltdown.

To confuse matters even further, Sorkin’s article tosses in the line: “You might consider the ETF the new derivative.” What does that even mean? Which ETFs is he referring to? And for that matter, which derivatives, since most of these are plain vanilla, too? It’s an irresponsible statement that plays on the fears of investors who don’t understand complex financial instruments. All they know is that they’re scary, and they should be avoided. CDO, CDS, ETF—they’re all the same. If it has three letters, apparently it must be a financial time bomb.

A few bad apples

For more than a year now, people have been concerned that certain ETF structures could eventually lead to global financial instability. The concerns are legitimate. But they are confined to some very specific products: namely leveraged ETFs, which magnify the possibility of gains and losses, and synthetic ETFs, which use derivatives rather than holding assets directly. These products make up a very small proportion of the ETF industry in North America (although synthetic ETFs are extremely common in Europe).

Let’s be clear: no one is raising these red flags about boring old ETFs that simply buy all of the stocks or bonds in a transparent index. Your Couch Potato portfolio is not going to usher in the next financial Armageddon.

In future posts, I’ll review the concerns about the ETF industry and try to offer Canadian investors some perspective on these issues.