Thu. Jan 20th, 2022

In Steven Spielberg’s original Jurassic Park, the chaos theorist played by Jeff Goldblum, chastises the amusement park father’s foolishness in resurrecting dinosaurs by remarking: “Your scientists were so busy with whether they could or not, they did not stop to think whether they should . ” The exchange traded fund industry must take note.

This is an exciting time for the ETF world. The total inflow last year exceeded $ 1 billion for the first time. Together with the driving force of financial markets, this means that the ETF industry is on the verge of exceeding the $ 10tn assets under management brand.

The industry is also expanding. Bond ETFs raised about $ 244 billion in 2021 – a new record and the third $ 200 billion plus year in a row. Many traditional investment groups also embrace the ETF structure for active strategies, which emphasizes how it surpassed its origin as a passive vehicle.

But as so often before in the annals of financial innovation, a brilliant idea can be taken to extremes. To stretch the Jurassic Park metaphor, the ETF industry has gone much further than cloning triceratops, and has been producing tyrannosaurs for some time now.

Bar graph of assets under management ($ tn) showing the rise of ETFs

This is not a new phenomenon. The first “leverage” and “reverse” ETFs – which uses derivatives to saponify yields of an underlying index, or to deliver the opposite performance – was first introduced in 2006. “Thematic” ETFs dedicated to niche areas such as pet care or cybersecurity have been growing for more than a decade. But it is a phenomenon that is now growing and evolving rapidly as the industry to the extreme test that can be squeezed into the ETF structure and sold to investors.

Many of the more risky or gimmicks are very popular in the recent retail frenzy. Assets under leveraged and reverse ETFs have more than doubled in the past two years to $ 180 billion, according to Morningstar. The assets of thematic ETFs have almost doubled to $ 227 billion.

However, even the existing range of leveraged, reverse and or merely foreign thematic funds is surpassed by some newer entrants and their increasingly esoteric approaches. The number of ETFs worldwide jumped a record 710 last year, according to Morningstar data, and, frankly, many are rude.

There are now leveraged and reverse versions of Ark Invest’s ETFs or the stock of Warren Buffett’s Berkshire Hathaway; five-fold leverage of ETFs that follow the Nasdaq and the S&P 500 – and even bitcoin futures and non-swingable token ETFs, despite the unregulated nature of the underlying markets.

Leverage Shares, one of the suppliers that ship these products, said in a statement that it was “committed to educating investors”, but argued that they met a need. “Modern investors are very different from those of the past; instability for them is not exactly a source of fear, but an opportunity, ”it said.

Bar graph of assets under management ($ billion) showing trading and thematic ETFs since the start of pandemic

Some of these products are strictly speaking exchange traded notes, in other words synthetic debt securities rather than traditional funds. ETFs, ETNs and exchange traded commodities (ETCs) are collectively known as exchange traded products (ETPs). But the confusing jumble of similar acronyms means many investors are calling everything an ETF.

The problem is that many of these funds are mostly useless vices designed primarily to extract fees from investors, not to serve a real need. Often they are potentially dangerous to the financial health of those who buy them, and in the worst case probably to the health of broader financial markets.

Some give ordinary investors easy access to derivatives and complicated trading strategies that they may not be equipped to understand. In some cases, retail investors will be prevented by regulators from using the strategies directly without an ETF.

Take the range of ETFs that are Vix Volatility Index that contributed to a violent stock market correction in 2018. Over the past decade, 19 such vehicles currently tracked by Morningstar have taken in a net $ 11 billion in investor money. Currently, only $ 2.4 billion is left.

This means that investors would have gotten more of their money back by investing in Bernard Madoff’s Ponzi scheme than in the Vix-linked ETF ecosystem.

For years, ETF critics have ruined the industry’s fixed income products, arguing that they were dangerous because of the mismatch between their immediate tradability and the often only occasional buying and selling of the underlying securities. Yet the real dangers probably lie in complex, expensive, derivative-based ETFs that are thinly disguised fee withdrawals sold to retail investors or day traders looking for excitement.

Twitter: @robinwigg

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