ETFs: The Next Meltdown

My latest rant along time back - Sept. - bashed the U.S. as I endeavored to create a globalized diversified investment strategy to play countries, rather than companies as investments. Trouble was, I focused on using the crazy-popular ETF (exchange traded fund) as my primary investment vehicle. If anyone doesn't believe that ETFs are the only game in town, read this:

US ETF Assets Hit $1 Trillion Milestone

Now, the first rule of investing - and an idol of mine Warren Buffet's favorite piece of advice - is invest in what you know. Wall Street has made that much more difficult since they decided to turn away from hiring finance majors, and instead put MIT wizzes to work as "quants" on black box investing strategies. So, being the dutiful investor, I decided to look into exactly how an ETF works. Yes, the industry has done a marvelous job marketing these products and every day there is news about another ETF opening to investors. But how exactly do they work and are ALL my family's assets safe in them?

The more and more I looked into them, the more fearful I became. Here is a product that essentially is an index fund operated by a trustee that purchases shares of equity in that index for its shareholders. Investment banks create initial share of these ETFs as creation units, which are then traded to hedge funds, other institutions and you and I - the retail crowd. What branches off from reality, however, is the fact that these banks can create an UNLIMITED number of these shares to satisfy market demand.

Now, I don't know about you, but in my opinion there can be no market when there exists an infinite amount of anything. This becomes a concern because short sellers - mostly hedge funds - can borrow ETF shares from those that own them and sell them, realizing a profit if they drop in value, but promising to pay them back to the owner if the ETF rises in value. Indeed, the amount of short interest on some of these ETFs is staggering - well in excess of the value of the underlying long holders.

Check this out

This introduces a HUGE counterparty risk to the holders of the ETF. Counterparty risk is the risk that the other player on the trade - in this case the hedge fund - will not be able to make good on their promise to give you the shares back when the ETF rises. Advocates for ETFs say these short players have to post collateral on such trades, but somehow I'm not assuaged by that argument given the recent financial subprime metldown and the fact that not even the smartest brains on Wall Street on in Washington had any idea what a CDO (collateralized mortgaged-backed security) was.

I'm not advocating that there will be a failure of an ETF. That might be the case. What I do know if the "Flash Crash" that occurred 2:45 p.m. May 10, 2010 causing the biggest one-day decline in Dow Jones Industrial Average history was linked to ETFs. By the way, regulators still don't know the exact cause.

There is a general disconnect in basic trade theory that you need a supply and demand for a properly functioning market. The demand is clearly there - $1 trillion in ETFs - the high correlation between ETFs and the overall market, etc. Investment banks and wealth managers are pushing these things are tax-advantaged investments with no more risk than the average index fund. Yet, that is not the case. These are derivative instruments - what Buffet has called "weapons of mass destruction." When you buy an ETF share, you don't own the actual shares of the companies in the index as you would in a traditional mutual fund. You own the right to a creation unit - that remember has an unlimited supply. So skyrocketing demand - unlimited supply. Do you see a problem ahead? I do.