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Back in 2007/08, AIG faced large problems. I won't go into detail as most people are well aware of the financial crisis. Needless to say the company was more or less a concentrated pool of risk that blew apart when the CDS' they sold en masse turned out to be more correlated than they had previously envisaged.

I'm not suggesting that the next financial crisis is around the corner but I would like people to consider how dangerous ETFs are becoming because of their increasing concentration of retail assets into what is essentially a derivative product (you are not buying the companies in the markets, you are buying a product that attempts to track these companies. The ETF derives its value from its theoretical constituents.

In November, ETF World reported that global ETF assets had reached $2.4 TRILLION Dollars.

(click to enlarge)

ETFGI reports that US ETFs have total assets under management of $1.7 trillion which is larger than the entire S&P 500 Mkt cap of $1.6 trillion (growth shown in the above graph). Of course ETFs don't just hold equity but the general gist is pretty evident.

Why have these ETFs become so popular?

Mainly they are the most efficient method of deriving low cost equity returns. Before the advent of these products, you had to place your money with a money manager, who could charge as much as 2% of your total capital per year and 20% of any above watermark performance that he makes for you (this is the top end).

Of course not all funds are led by big name FMs. A quick look at Invesco Perpetual's high income fund, shows no performance fee but the existence of a 1.5% management fee. As a corollary, the SPDR S&P500 estimates operating expense fees of 0.09% of Assets Under Management. Furthermore, as the ETF grows, expenses become a smaller and smaller percentage of assets under management.

Another reason why ETFs may be preferred is that investors don't want to bear the risk of investing in a bad fund manager. They simply want to match the equity index as it's "always going up" and there is always a fear that a maverick fund manager may decide to bulk up the fund with some great value AIG. Although fund managers can act around a tight remit, the fact that general funds are smaller in size means they may not be able to diversify all of the non-systematic risk, while an ETF that holds every stock in the universe may well be able to.

After the crisis, blame was heaped upon financial professionals whether or not they played a role in the crisis (a family friend of mine was insulted by an old lady because he was an intern at a UK investment bank!). Since then a huge mistrust of banks and the financial system has grown and I believe that investors have shunned a variety of these active and passive funds because they don't want to enrich the pockets of these bankers. They see ETFs as a collective where the manager cannot buy a yacht every year for his hard work.

If we take other funds out of the equation, ETFs may also be preferred to good old fashion self-investment because some people may simply not have the time, resources or know how to scour through financial statements and pick those winners. If you are trying to beat the paltry bank returns with a similar amount of effort, and ETF can offer you the way to go.

All these positives, where're the negatives?

The big risk I can envisage with ETFs lies in the simple fact that most retail investors have put their money into a derivative (you know, what Buffett called financial weapons of mass destruction). The ETF creators have taken your money bought and expanded the pool of equity to a phenomenally large amount have given investors a ticket BASED ON THE NET ASSET VALUE OF THE FUND.

If the share price drops, investors are actually playing pass the parcel with their ETF as a look at most ETF prospectus indicate that redemption of units (you sell your units back to the fund and they sell the relevant equities in the pool) can only occur in blocks of 50,000 units ($9m for SPDR S&P) and only by institutional clients.

Why could this be terrible? ETF holders will tend to be more retail clients and pension funds. Usually, when a crisis of any kind occurs, households will pull money from speculative investments and deposit them into safer savings accounts. However, now that most people have concentrated all of their assets into one product rather than the 500 offered in the S&P 500, a record number of retail investors will be trying to grab their money from the same bag!

A Quick Example

The S&P500 ETF is trading at 1000 and the NAV is 1000 (the ETF price reflects the actual price of the basket). A crisis occurs and John is the first to hear about it. He goes to the markets and sells his ETF.

The market moves from 1000 to 990 - 995, suddenly Kelly gets worried and sells her ETFs, we are now at 980 -990.....as the crisis unfolds a HUGE amount of money ($2.4 TRILLION) begins running to the door, the same door, continually hitting the bids on the ETF yet leaving the actually underlying shares alone!!

Of course in a crisis most of the single stock prices will drop too, but because of the huge increase in ETF volumes, the stock holders are the ETF guardians themselves and they cannot sell their holdings until an institutional investor decides to sell the units back in large blocks. I can quite easily envisage that the next crisis will see a wave of significant losses as ETFs get panic, sell below their NAVs as all retail investors sell this one single product while the actual shares remain held by the ETF fund which cannot easily sell!

Conclusion

The ETF industry no doubt has brought a wave of efficiency to the market. Lock-up periods have drastically shortened and fund management fees have dropped. Despite this, a huge amount of money is flowing into a single product which will concentrate a huge amount of risk into a derivative product which has the potential to destroy the value of those who hold them EVEN IF THE SHARES THEY INDIRECTLY HOLD DON'T MOVE.

The morale of the story? Keep a diversified portfolio and look at funds which are nicely diversified and actually hold the stocks. There are plenty of products that give you direct equity exposure and many of them advertise right here on Seeking Alpha! Better yet, do the work and try and invest yourself. A Wal-Mart bond isn't as dangerous as most people think!

Happy investing!!

Source: ETFs Concentrating Risk In Time For The Next Crisis