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ETF’s – Virtues or Vices for Investors?

By Mandeep K Bhandal, on 10 September 2012

ISRS Senior Research Fellow, Chris Cook,  discusses the  virtues and vices of Exchange Traded Funds in the FT on the 10 September 2012.

Dear Sir

I was interested to read John Gapper’s article today re the virtues of ETF’s for investors.

Now, the virtues of ETFs for their originators is quite evident. A stampede of risk averse ‘passive’ investors has, particularly post QE, been convinced by investment banks of the virtues of ‘inflation hedging’. Since market risk is taken by the investor, and not by the banks, excellent returns on minimal capital requirements may be made by banks through strategies such as High Frequency Trading and Delta One proprietary trading incorporating asymmetric information.

Unfortunately, the virtues of ETFs for the originators comes at a price both for the underlying markets and for ETF investors.

Firstly, the presence of generally ‘long only’ passive and risk averse investors in markets –  whose motivation is to avoid loss rather than to make speculative transaction profit – has largely destroyed the price formation mechanism and has thereby financialised those markets where they have become predominant.

The result has been correlated bubbles in equities, energy and commodities and, to use a term coined by the FT’s Izabella Kaminska, a ‘Dark Inventory’ of encumbered shares and commodities. We therefore see a two tier physical market where a privileged few profit from asymmetric knowledge of the encumbered assets.

Secondly, and as a result, we have seen bemused value investors departing equity markets which have lost almost all connection with the underlying reality of assets and dividends, and market participants in commodity markets who are at a loss to understand how market prices are connected to the reality of production and consumption.

In summary, ETFs have killed our present generation of markets and constitute the next great regulatory accident waiting to happen when, not if, the current correlated bubbles collapse and risk averse ‘muppets’ realise that they have been mis-sold market risk on a cosmic scale.

I think that we shall soon find that the unseen vices of ETFs far outweigh any apparent virtues.

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