Even the best financial innovations have a nasty habit of spinning out of control. No surprise, then, that regulatory antennae are twitching at the rapid growth of exchange-traded funds (ETFs), investment pools that are listed on stockmarkets. ETFs have plenty of attractions, giving retail investors a relatively cheap way to diversify their holdings. But their dangers are also becoming more apparent.
The sheer size of the industry is one cause of concern. At the end of May ETFs in America held around $792.6 billion (Dh2.91 trillion) in assets, according to Morningstar, a research firm. The worldwide total passed $1 trillion at the end of 2009. Morgan Stanley predicts the industry will grow by 20 per cent to 30 per cent in 2010. The market has rapidly evolved to meet demand for more exotic products, particularly in commodities, where many worry about the impact of the appetite for ETFs on prices.
ETFs also gained popularity because investors can trade them all day long, whereas a mutual fund can be liquidated only at the beginning and end of the trading day. Retail investors, who are thought to make up half the American ETF market, are probably better off holding on to investments rather than day-trading them. And the "flash crash" on May 6 demonstrated that it is not always easy to exit from ETFs. As liquidity disappeared that day, many ETFs traded down nearly to zero.
The events of May 6 may have been exceptional but a period of market volatility is not. That spells danger for investors in leveraged ETFs, which use debt to magnify the returns of the index they follow.
Because these ETFs "reset" on a daily basis, they can easily stray from their targets. If an index worth $100 drops 10 per cent one day and gains 10 per cent the next, it is worth $99, a loss of $1. You might assume that a fund leveraged to deliver twice the returns of this index would be worth $98, a loss of $2. In fact, an ETF of this sort would be worth $80 on the first day and $96 on the second day, for a loss of $4. Whether retail investors understand this is not clear.
