A seismic shift of capital – from active to passive – has eviscerated financial markets. The trend is no more obvious than in a widespread uptake of Exchange Traded Funds (ETF). The topic for consideration is whether ETFs make financial markets more or less efficient. Do they improve our ability to access market returns, or encourage undue risky behaviour? Perhaps, even, a new financial bubble? To jump to the punch line, ETFs are less a cause of irrational exuberance, than a manifestation of it. Investors, however, must still be wary of certain risks that are inherent to niche ETFs (A PDF version of the entire four-part series may be found here).
After their conception in the early 90s, ETFs remained relatively dormant in the financial world until the late 2000s. Today, around $5 trillion is invested in these vehicles globally with about 70 per cent of them in the US. In Australia, ETF assets have grown to almost $30 billion or 15-fold over the last decade. Such robust demand has propelled the creation of increasingly esoteric indices and products. For instance, consider the $3m Obesity ETF, which invests in pharmaceutical companies, weight-loss products, and plus-size clothing retailers. Or the $38m Inspire Global Hope Large Cap ETF, aimed at Evangelical investors, which screens out companies involved in gambling, alcohol, pornography or that support LGBT rights. The US securities regulator has even granted approval of a quadruple leveraged ETF (the Force Shares Daily 4X US Market Futures Long Fund), which aims to produce four times the daily performance of the S&P 500 futures index. Industry leader Vanguard has also joined the party, recently seeking approval of a new Total Corporate Bond ETF, which would wrap up a number of their other passive debt funds into one convenient product (in other words, it would be an ETF of ETFs!) According to Strategas Research Partners, there are now more indexing products in the world than there are stocks themselves.
“Risk cannot be eliminated: it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky” – Howard Marks.
In 1952, future Noble prize winner, Harry Markowitz, had a celebrated insight. He discovered that the risk of investing in any type of financial security is not a function of its volatility, but the extent to which that volatility may be diversified away by holding a portfolio of securities. In other words, he discovered that investors could reduce risk by holding a diversified pool of assets. This seemingly obvious insight is just another way of saying: “don’t put all your eggs in one basket”. We take umbrage with Markowitz’s idea that risk is a function of asset price volatility, rather than the likelihood of suffering a permanent loss or impairment of capital (we are not alone in this regard). But even within our own definition of risk, the principle of diversification and its purported benefits still hold. An investor may reduce their risk by holding a portfolio of securities in which the economic drivers of asset performance are not perfectly correlated. The key point is that assets must be uncorrelated in an economic sense, rather than a volatility sense, in order to yield the intended benefits of diversification. In fact, believing that a portfolio is less risky because asset prices are uncorrelated has proven to be one of the greatest tragedies of modern finance.
Such false diversification was exemplified by the proliferation of Collateralised Debt Obligations (CDOs) prior to the global financial crisis. CDOs are a type of structured finance vehicle that seek to bundle up other debt products into a single income stream. During the US housing boom, investment banks used CDOs to repackage income or repayments from subprime mortgage bonds. They then marketed these “safe” products to institutional investors, along with a stamp of approval from the US ratings agencies. Such CDOs would pick out a certain tranche (or portion) of home loans from a large pool of mortgage bonds and then repackage those tranches into a new “diversified” pool of assets. The problem was that such tranches all had the same underlying risk profile, which meant that if one home loan went bad, it was likely that all the others would too. By bundling up subprime loans from Florida, California and Texas all into one product, CDOs didn’t make those loans any safer; they merely concentrated the risk. The situation is analogous to selling flood insurance to thousands of people living in the same flood plain. Although the insurer’s risk is spread across a number of households, each policyholder is likely to lodge a claim for damages at the exact same time. Both the CDO investor and the flood insurer have the illusion of safety because their risk is not truly diversified in an economic sense.
Exotic ETFs purvey the same false promise of diversification as the CDOs of subprime mortgages. Rather than alleviate risk, they concentrate it. Consider a typical high-yield corporate bond ETF, which is comprised of a large pool of low investment grade debt. Although the risk is spread across a large number of assets, in the event of a recession or rising interest rate environment, many of these underlying companies are likely to incur operating stress and potential default at the same time. The same thing may be said about an ETF of ETFs, (akin to the old “CDO squared”) which re-slices and repackages the same assets over and over again, but does not change their underlying risk profile. But the most startling and potentially dangerous innovation in this area is the leveraged ETF. A product akin to the infamous “synthetic CDO”. The key difference between a normal CDO and a synthetic CDO is that the latter bundles up derivative bets that resemble a pool of asset-backed securities (say mortgage bonds), rather than the underlying assets themselves (hence “synthetic”). In other words, leveraged ETFs don’t actually own the relevant assets, but merely a series of side contracts that seek to replicate their performance. The situation is analogous to an insurer that sells you flood insurance on your house, but then allows a hundred-other people to insure your house as well (because they want to bet on a storm). The insurer then bundles up those extra premiums into a new security and calls it diversified! Such synthetic or leveraged ETFs are nothing more than convoluted tools for outright speculation and gambling.
“The more risk we take because we believe the environment is low-risk in character, the less the environment continues to be low-risk in character” – Peter Bernstein.
The comparison of ETFs with CDOs is not to purvey either product as inherently evil. Every financial innovation serves a useful albeit limited purpose in the smooth functioning of financial markets (they are not the first to suffer at the hands of speculative and irrational investors). Rather, the proliferation of unconventional ETFs are an indication that financial markets have become riskier and that asset prices have diverged from the long-run average return on capital. In other words, the uptake of such speculative products is less a cause of irrational exuberance than a manifestation of it. Investors have become complacent and hungry for returns, which has led them into more complex products at higher prices. When investors are unworried and risk-tolerant, they buy assets with low yields and at high valuations. Such optimism and absence of caution is the true source of investment risk, not the underlying assets themselves. In other words, high quality assets can be risky, and low quality assets can be safe. Ultimately, it depends on the price paid. The current perception that ETFs are less risky, therefore, is also what makes them more risky. And the general shift toward index funds and ETFs, which allocate capital according to price rather than value, is what makes the current investing environment likely to deliver lower returns (not higher returns) over the long run.
An important lesson of financial history is that nothing lasts forever. Every investment cycle sows the seeds of it’s own destruction. The investor psychology that drives current market behaviour will eventually self-correct and drive investors with the same energy and momentum back in the opposite direction. The question, therefore, is how will those unconventional ETFs fare in an inevitable downturn? Such products have never been tested in challenging market conditions. And the presumption of liquidity may turn out to be illusory in a full-fledged bear market. This is especially true of the thinly traded and smaller ETFs in which the fund manager is obligated to create or redeem units at a price close to NAV. For instance, what happens when the share price strays too far below NAV, but there is no one willing to buy the underlying assets? Who is responsible for redeeming investors then? Is it the market maker, the authorised participant or the ETF manager itself? In such a downturn, a potential run on an illiquid asset class could leave an ETF manager with no other option but to redeem investors below NAV, or even put a complete freeze on all redemptions. Such an event could trigger a run on other ETFs and perhaps a wider panic. Either way, it’s clear that when the investment cycle does eventually turn, many ETFs will be exposed for their false promises of liquidity and diversification. The more interesting question is which underlying asset class will prompt the eventual turn of sentiment? Or in other words, what will be the US subprime loan of the next financial reckoning? If we had to put a bet on it, our money would be on long-term government bonds (off the back of rising inflation). But that’s a story for another day.
 Elio D’Amato, “ETF risks: Exchange traded funds are far from risk free”, AFR, September 12, 2017:
 Crystal Kim, “Beware of Niche ETFs”, Financial News, July 3, 2017. https://www.fnlondon.com/articles/beware-of-niche-etfs-20170703
 Nicole Bullock and Joe Rennison, “SEC approves 4X leveraged ETFs”, Financial Times, May 4, 2017.
 Rachel Evans, Carolina Wilson, and Julie Verhage, “Vanguard jumps on ETF-of-ETFs bandwagon, The Vanguard way”, Bloomberg Markets, August, 23, 2017: https://www.bloomberg.com/news/articles/2017-08-23/vanguard-jumps-aboard-etf-of-etfs-bandwagon-the-vanguard-way
 See supra note 3.
 Howard Marks, The Most Important Thing Illuminated, Columbia Business School, 2013, pg. 61.
 Stephen Penman, Accounting for Value, Columbia Business School, 2011, pg. 19
 Michael Lewis, The Big Short: Inside the Doomsday Machine, Norton, 2011, pg. 72-73.
 See Gillian Tett, Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, Brown Book Group, London, 2010, for a history of Credit Default Swaps and their evolution from rare and legitimate uses, just prior to the GFC, into systemic financial weapons of mass destruction.
 For a thorough analysis of the prevailing market dislocation, including the role played by index funds and ETFs, see: “Indexation: Capitalist Tool – Delivery Agent of the Great Bubble”, presentation by Steven Bergman of Horizon Kinetics, at the Grant’s Interest Rate Observer Conference, October 4, 2016, http://www.grantspub.com/files/presentations/Grant’s%20Conference_Oct%204%202016_Steven%20Bregman_Final.pdf
 See supra note 7, pg. 68
 Howard Marks has also pointed out that “It is not clear where ETFs and index mutual funds will find buyers for their holdings if they have to sell in a crunch”. See Chris Flood, “Record ETF inflows fuel price bubble fears”, AFR, August 14, 2017: http://www.afr.com/news/world/record-etf-inflows-fuel-price-bubble-fears-20170813-gxvgj5
 See supra note 6 of Part I, for a more complete discussion of the redemption/creation feature of ETFs. Also see Matthew Tucker and Stephen Laipply, Fixed Income ETFs and the Corporate Bond Liquidity Challenge, iShares, Black Rock, pg. 5: https://www.ishares.com/us/literature/brochure/fixed-income-etfs-and-corporate-bond-liquidity-challenge-en-us.pdf
 As noted by Raphael Dieterlen, head of ETFs and index investing at Lyxor, “Whether you have a conventional mutual fund or an ETF that invests in high-yield bonds, in a crisis you may face a challenge selling the fund’s assets,” …“ETFs are just tracker funds that provide exposure to an underlying asset class. You cannot assess the ETF without assessing the underlying.”
 Even Jack Bogle has said: “it is high time both the ETF industry and policymakers re-examine the entire ETF ecosystem. Why? Because of its sheer size and fragility in times of market stress.”https://www.ft.com/content/59739d3a-bd60-11e6-8b45-b8b81dd5d080