Will the ETF be Viewed as Another Financial Innovation Disaster?

Financial Innovation is usually both a blessing and a curse.  In the vast majority of circumstances, an idea borne of market efficiency, lower risk, lower costs and more utility to investors ends up in complete disaster.  Consider the following example.

Recent Financial Innovation Example – Derivatives and Securitized Debt

What started off as a great idea to both diversify risk and monetize debt into a non-correlated steady income stream for investors turned into complete ruin with the culmination of the housing collapse in 2008-2009.  People generally view these instruments as dangerous and reckless.  The reality is that the instruments themselves, while poorly understood by many, were actually a pretty good financial innovation.  What broke down was lending standards, politicians pushing agendas to have “every American in a house” and the complete fraud and falsification of loan documents and underwriting standards that were driven by greed on Wall street and in the Housing Industry that was certainly facilitated by the creation of these instruments.  In reality, if there were adequate lending standards and underwriting in place, then derivatives, credit default swaps, mortgage backed securities and the like would not have been problematic.  Congress, bankers, homeowners, loan officers and many others share the blame – yet the only one taking the fall in the court of public opinion has been the instruments themselves.

Additionally problematic was the set of poor assumptions that went into the formulas that comprised these instruments.  The best and brightest statisticians, physicists and engineers from top schools in America descended upon Wall Street to become the Quants (see how Wall Street Violated the Most Basic Laws of Physics).  In their infinite wisdom, they made some very stupid assumptions in their models – namely that housing prices would continue to appreciate indefinitely (this is not an exaggeration – this actually what was in their models), and it doesn’t stop there – they assumed that home prices would continue to appreciate at the 5-8% that we’d seen earlier in the decade, even though hundreds of years of housing data in Western societies demonstrates that aggregate home prices tend to appreciate with wide guages of inflation, usually in the 2-4% range in the US.  Major deviations from the mean are met with corrections, but this minor detail was overlooked in these assumptions.  In short, what started off as a very sound and useful financial innovation ended in disaster.

Will ETFs be the Next Financial Innovation to End in Disaster?

This begs the question as to whether ETFs will be the next financial innovation to end with a black mark on their name.  ETFs are widely viewed as much better investments than stocks and mutual funds given their lower fee structure and optimized tax efficiency over their counterparts.  However, note that I used the term “investments”.  What started off as an alternative to mutual funds has turned into an instrument to quickly trade sectors and in many cases, employ leverage – which many investors don’t fully understand.  Leveraged ETFs rely on daily rebalancing, not amplified weekly or monthly returns, so it is a mathematical certainty (demonstrated here visually in this ETF Risk article) that over time, volatility erodes the value of both long and short leveraged ETFs ferociously no matter what the underlying index does (unless it is a straight up uninterrupted rocket like post-March 2009, which is extremely rare).

Besides these weapons of mass destruction, even mundane sector ETFs are being traded with increasing volume (for sheer enjoyment, check out the 10 Worst ETFs of 2009).  When sector funds were first envisioned by the likes of Vanguard and Fidelity, they were mutual funds that weren’t prone to rapid trading.  What’s happening now is that many retail investors that would normally have their funds in a broad US-based mutual fund paying perhaps a .75% or lower expense ratio are now trading the SPY ETF on a daily basis trying to time market movements, generating annual commissions in the thousands of dollars with no incremental benefit to show for it (evidence suggests the vast majority of retail traders cannot meet or exceed index returns).

While there’s no rational argument to say that ETFs are “bad” or shouldn’t exist, an argument can certainly be made as to whether they have facilitated bad behavior on the part of people who would otherwise have been protected from themselves.  While this logic doesn’t sit well with responsible people, we’ve demonstrated with ample evidence this year alone that Americans at least, are not a responsible people.

With inverse ETFs, leveraged ETFs, rapidly traded index and country ETFs, currency ETFs and the other myriad types (here’s an 800-strong ETF List if you must) out there, it begs the question as to whether the retail public at large would have a higher net worth right now having left their money in mutual funds and avoided millions of trades over the past few years as these instruments have grown.  A decade from now when people look back and question – “on the whole, were ETFs actually good for investors?”, I’ll be curious to see what the financial historians say.

What are Your Thoughts on ETFs and Their Net Impact on Investors?

Tagged as: ETF, Financial Innovation