How ETFs Came Under Fire

ETFs are on the hot seat these days. On Wednesday, a US Senate subcommittee held a hearing to consider the idea that ETFs are contributing to volatility and instability in the financial markets. This is pretty serious stuff. How did the humble ETF, once hailed as the most investor-friendly innovation in decades, become the target of such suspicion?

The brouhaha can be traced back to September 2010, when a little-known investment firm called Bogan Associates wrote a white paper called Can An ETF Collapse?, which got enormous media attention. One CNBC stock-picking guru reviewed the report and referred to ETFs as “a monster that will wreak havoc.” But almost immediately, the Bogan report was criticized as “wildly off the mark and highly irresponsible.” Credit Suisse exposed the report as specious.

Two months later came another alarmist report from the Kauffman Foundation, which argued that ETFs are distorting financial markets and presenting dire systemic risks. Within a day of its release the report was called out for its conflicts of interest and its “serious misunderstanding of how ETFs work.” Media outlets such as IndexUniverse and Forbes wrote scathing rebuttals, and a couple of weeks later the foundation released a revised version with most of the inflammatory claims watered down.

Yet despite their shoddy arguments, both the Bogan and Kauffman reports were highly influential. I received several emails from readers who wondered if they should be worried. Earlier this year, iShares Canada told me they were still getting phone calls every day from investors who were concerned that ETFs were going to trigger the next financial crisis.

Should you be concerned?

Although these two reports were thoroughly debunked, some of the concerns about the growing ETF industry do have merit. Several other reports released this year have raised the possibility that certain complex ETFs might potentially contribute to instability in the financial markets. Unlike the sloppy Bogan and Kauffman documents, these were prepared by people who actually understand how ETFs work:

• Global Financial Stability Report: April 2011, International Monetary Fund (see page 68)

• Market structures and systemic risks of ETFs, Bank for International Settlements

• Potential financial stability issues arising from recent trends in ETFs, Financial Stability Board

• ESMA’s policy orientations on guidelines for UCITS Exchange-Traded Funds and Structured UCITS, European Securities and Markets Authority

The concerns raised in these reports—and in the heated discussions that have followed them—can be boiled down to three important issues:

• the growing complexity of synthetic ETFs (which use derivatives called swaps rather than holding assets directly) and the risk that the swap counterparty could default

• increased volatility and market instability caused by ETFs that use leverage

• the potential dangers of excessive securities lending, whereby ETF providers earn additional revenue by lending the portfolio’s stocks to investors who sell them short

Next week, I’ll look at each of these concerns one by one, and I’ll do my best to explain how relevant they are for Canadian ETF investors.