The other day at the park, my three-year-old son (a very active little chap) helped a couple of older kids build a sandcastle. They all worked pretty hard and the result looked great—the castle had a moat, a drawbridge and even a little flag on top (a leaf stuck on a juice box straw). And then, inexplicably, my son stuck is foot right in the middle of it—bang. It was gone. He thought it was pretty funny – the other kids? Not so much.
What have my son’s antics got to do with ETFs? A lot actually according to a recent article in the Economist. It argues that ETFs are in danger of being damaged by an overzealous group of finance professionals eager to exploit and overdo a good thing:
“Fund managers’ fees have always eaten into investors’ returns; ETFs were a splendid way of letting investors keep more of their money. But like a hyperactive child, the finance sector can never leave a good thing be.”
Of course they’re referring to the proliferation of new kinds of products like exchange-traded notes (ETNs) and commodity ETFs. These newer types of ETFs offer indirect exposure to underlying assets. And therein lies potential for big problems in future.
As new types of exchange traded products begin to engage in swap arrangements, counterparty risk is emerging quickly – and given the rapid speed at which new products are being pushed onto the market, it’s hard to keep a handle on the level of exposures out there.
Something’s got to give—and soon according to the Economist, which argues we are headed quickly for an ETF blowup. Driven of course by a hyperactive finance sector eager to push this new product to its eventual limits.
An ETF blowup would be a black mark on an otherwise excellent financial innovation. It’s a risk to investors for sure—but it’s also a threat to the industry as a whole.
Here’s hoping investors are getting better at understanding and asking about counterparty risk in the wake of the financial crisis.
If not, there could be a lot of them left crying in the sandbox.