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Can you trust ETFs?

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by Peter Switzer

Wall Street drifted lower on no big news and after the US stock market hit a two-year high last week, it makes sense that the bulls are taking a breather. But there is a building controversy around the issue of just how safe an exchange-traded fund (ETF) is.

Let me reveal my hand: I hold ETFs and I want to be balanced about the concerns that have been raised. And, as I always argue, without controversy there is no progress.

Ever since I talked to experts on ETFs on my Sky News Business Channel program, I have always tried to work out what could go wrong with these great-sounding products. Remember, I have invested in them but I won’t let complacency take root when I invest.

Before I look at a US research paper, which raised some questions over ETFs, I have to say there are two groups who might not like the progress of ETFs. Stockbrokers could be losing business as investors go for the index, for example, rather than punting on individual stocks or a created portfolio. Also, fund managers are losing business to ETFs, which can approximate the index in terms of returns. And, they are cheaper.

History says one-third of good managers can beat the index but two-thirds don’t. But herein lies an irony if this paper is right: people who don’t want too much risk buy ETFs, however, they could have a blow-up potential, if this paper is right.

(Remember I don’t know if this paper is right but the facts need to be considered. This piece is meant to get the wise guys and gals talking so we eventually know what we need to know.)

The paper I refer to comes from the Kauffman Foundation and industry experts say the report has made some real mistakes.

The authors, Harold Bradley and Robert Litan, reject criticism of their work. They think ETFs could create a big market sell-off. The Yanks had a flash crash and, to date, no one can explain how it happened. The authors say that ETFs work against IPOs as an IPO will never be in an ETF and it could be argued this creates enemies for ETFs. They also compare the growth of ETFs to financial engineering and could be a sub-prime loan-style problem waiting to happen.

Here is one of the arguments put forward by the paper: “… Because the underlying securities are in short supply, mounting obligations of ETF sponsors to purchase them exposes the sponsors to the risk that the cash they have on hand will be insufficient, at the sharply higher prices of the underlying securities, to cover those purchases and thus track the index”.

They also believe a short squeeze could expose an ETF business and if one ETF operator failed there could be a big rush for the door creating a panic-driven rush for the door! And when ETFs sell out big time, the market would nosedive big time!

We are going through a massive boom in ETFs but the industry now has to take this challenge head-on to answer these criticisms before the next crash is on the horizon. Of course at the moment, ETFs could help a boom take place but if it does, I want to sell my ETFs before everyone starts to panic.

By the way, I won’t be a seller now but as I am kicking off this debate in Australia, I will be watching and listening with great interest to what the industry has to say about the safety of ETFs.

Finally, if you reject ETFs and, say, take up our top 20 stocks, you could still be caught up in an ETF sell-off as these ETFs are the biggest buyers of our top 20 stocks.

Let the debate begin!

For advice you can trust, contact Switzer Financial Services.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Wednesday, November 10, 2010