How ETFs Are Like Mortgage-Backed Securities
Via FT Alphaville:
Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary. Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.
As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures like futures.
But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:
Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.
Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.
They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.
The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:
Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?
And the risk (and fees) just kept getting greater:
The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.
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