Are Fears About an ETF Bubble Warranted?

We have a problem in this country. We aren’t suffering like the rest of the world. At least that seems to be the way the rest of the world views us…

They are waiting for us to slide into the same kind of doldrums they’re experiencing.

A number of financial commentators are talking about the coming stock market crisis in the U.S. Gillian Tett, the editor of the U.S. edition of the Financial Times for example, says “The next crash is hiding in plain sight”.

Tett points out that SIV’s (structured investment vehicles) offered by the big investment banks with full-page spreads in newspapers like the Wall Street Journal in the mid-2000’s contained toxic mortgage bundles that caused investors to panic.

In previous recessions, other types of great new financial inventions triggered our problems: portfolio insurance strategies in 1987, interest rate swaps in 1994 and finally CDOs (collateralized debt obligations)such as mortgage-backed securities (MBSs) and CDSs (credit default swaps). 

Not that these are products that I and probably most of you had ever heard of before the financial shocks they caused hit the headlines of the major  newspapers.

I don’t know about you, but I had to take an online course in money in banking in order to understand what these things were. And watch a lot of movies about the financial crisis and financial scammers…

But now Tett brings up a new-fangled money invention to worry about that is something most of us in the middle class will have heard of — ETFs (Exchange Traded Funds).

Back in 2010 I pointed out that ETFs were a “poor man’s” type of derivatives. ETFs are the kind of fancy investments that rich people were snapping up that caused the “Financial Crisis” of 2007.

Now Gillian Tett is warning us to:

Consider the world of exchange traded funds. This sector has recently exploded in size with more than $4tn in asses under management globally and about $3tn in the US, it eclipses hedge funds. ETFs do not usually attract much attention, since the sector — yet again — seems geeky and dull.

In particular, Tett cites “inverse ETFs,” ETFs that bet the stock market with drop dramatically, as the ticking time bomb waiting to go off.

Inverse ETFs, also called “short ETFs” or “bear ETFs” yield a profit when there are declines in broad market index funds (themselves a secondary derivative financial product based on a bundle of companies underlying that index).

In other words we have a derivative (an index ETF) based on another kind of  derivative (a stock index or a stock sector index, e.g. tech sector, consumer sector, etc.) which in turn is based on an underlying pool of financial assets called stocks.

Consider then that these “stocks” for sale at brokerages are a secondary market product based on virtual prices created by after-market sales of IPOs (initial public offerings of original stock shares of the company).

Does this sound like a house of cards to you?  Yes…and no.

Why ETFs are so popular

Recently I went to the MoneyShow conference in San Francisco. There were lots of ordinary-looking middle class people attending this three-day event, ones I talked with staying at less expensive nearby hotels than the one the show was held at.

Many of the lectures were about options trading, in particular, how to trade options using stock index ETFs or stock-sector ETFs.

Whether inverse or direct, stock index and stock sector ETFs are popular because they enable middle class people to trade in the stock market at very low prices, without trading “naked” assets, i.e., extremely risky assets, on the margin (i.e., using money borrowed from their brokers).

Yes, this kind of financial investing using ETFs for options is very “geeky,” but it is not leveraged the way trading is by richer investors who use hedge fund companies or investment banks like Goldman Sachs. Many investors use options to hedge against losses in the stock market.

The risk of a bubble with ETFs, however, is that they are issued by hedge funds, such as the famed BlackRock as well as giant mutual fund companies such as Vanguard. The creators of ETFs are some of same types of players who helped bring us the last financial crisis.

As Vanguard mutual funds head, Bill McNabb, warned in an interview dismissing ETF bubble fears, there are esoteric ETF products out there that contain a lot of “leverage,” i.e. risk of losing a lot of money.

Until some noble soul funded by academia examines the differences between retail “mom and pop” investors buying ETFs and the so-called “sophisticated” investors who could be fooled again by brokers who come bearing highly-leveraged investments, we aren’t likely to know how likely the trillions of dollars ETF market is to implode.

Meanswhile, those of us depending on IRAs, 401Ks, 403bs, pensions and/or savings accounts can only keep a close eye on the stock market, the VIX (the stock market volatility index), and CNN Money’s Fear & Greed index, along with monitoring the ‘Trump effect’ on the American economy this year and next.



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