In These New Times

25 Aug 2009

David Stevenson

ifaonline

Bubbles are a wondrous affair, and, according to the aficionados, easy to spot from afar.
The ever insightful US economist Nouriel Roubini reminds us of the sadly predictable cycle of euphoria and despair (first described by Hyman Minsky) with a simple set of stages that starts with investors meeting their investments out of cashflow, which then moves on to speculative borrowers, and finally crashes with Ponzi borrowers who can’t service either the interest or the principal.

This multi-stage evolution mimics many economic/product cycles that start with a good idea, then move on to a more risky version that usually involves some form of charged up return using debt. Then there is the final denouement that involves ruin, as the product is destroyed from within by people who shouldn’t be using the stuff.
ETF alarm bells
These words echo through my mind when I start to survey the frenzy breaking out in the world of exchange-traded funds (ETFs). Now, I am a huge fan of ETFs and I absolutely do think they are the way forward for any sensible asset allocator. But my alarm bells have been ringing in recent months as more and more funds are closed while ever more wondrous index-based mutations are unleashed on the world from fund providers keen to differentiate themselves from the pack.

The next stage of this cycle of doom involves leveraged versions which, in the wrong hands, are a disaster waiting to happen (more on that in a mo) and is then completed by the enormous investment banks muscling in with products that could be toxic, most certainly enormously expensive, and spiced up with all sorts of clever structured nonsense built into them. At which point the whole thing blows up and we nod our heads and say, “Told you so… it was the Minsky moment where all our pensions went up in smoke.”

OK, I am dramatising for effect, but we do have a problem. ETFs are becoming too clever and too popular with the wrong people. I’ll start this journey to despair with a cracking online blog called the Psi Fi blog, at http://www.psyfitec.com. Back in June, the author, a psychologist by training with an interest in value investing (the masthead is: In The Short Term The Market is a Voting Machine, In The Long Term it’s a Weighing Machine) wrote an entry entitled: Exotic ETFs Are Toxic ETFs: Beware of Enticing Charms.

Now the author – with whom I am in regular contact – knew that his attack on the ever more exotic forms of ETFs would elicit my response, and if you read the blog I think you’ll agree that he frowns too much on innovation in favour of the boring. The author’s view on exotic ETFs is summed up thus: “As usual, the investment industry has worked its magic and turned a really useful investment tool into a method for speculating in snake oil”.

More and more complex variants of index-tracking funds are being developed. Many concerns have emerged in particular over leveraged ETFs, offered in the UK by ETF Securities. For the record, I like these funds, but they are deadly in the wrong hands because they need lots of explaining. I would even go so far as to say that the next generation of these products – three or even four times leveraged – could have a place in a very adventurous, sophisticated investor’s portfolio, but the dangers are immense. Needless to say the Psy Fi blog is not impressed with all this quant-based wizardry and leveraged madness.

The next port of call in my journey through a potential bubble starts with the increasingly complex strategy-based ETFs offered by the big investment banks. Source – a joint venture between Morgan Stanley and Goldman Sachs – has just launched a STOXX 600 optimised super-sector index family that uses data on stock lending to inform weighting. At the same time, DBX trackers has launched a DB Commodity Booster index that optimises the Deutsche Bank commodity index. In themselves these are good ideas for the right kind of investor, but I can feel myself growing more worried by the day. Would any ordinary investor or adviser really use these funds? Should they? Frankly, I would be a bit worried at anyone below a senior fund manager at a very big institution dipping into this stuff, although to be fair Source is aimed largely at institutions.
Too clever by half
Then comes the news that the big wealth managers and investment banks are now selling portfolios built around ETFs but with structured returns and all sorts of cleverness built in. Not surprisingly, the expense ratios of these multi-asset, multi-structured ETF portfolios is shooting up close to 2% per annum (compared with the underlying building blocks that cost less than 50 basis points). These big boys realise that charging 50 or even 100 basis points for an ‘asset allocation’ overlay on its own won’t wash, so they have to add complexity by structuring the returns. Don’t they ever listen? I love the idea of simple multi-ETF portfolios precisely because the concept is: a) cheap and b) uncomplicated. Extra cost and complexity is the exact opposite of what I want out of an ETF-led approach.

All of this clever wizardry with ETFs will end in ruin as the sector will overreach. Hundreds more funds will close, and ETF portfolios will blow up the next time there is a crash because of this clever structuring and, sadly, the ETF sector will be tarnished as a result.