The Cloud of ETFs Looms Large

The mystery of the reason why ETFs were such a large proportion of the stock market free-fall on Thursday May 6, 2010 should come as no surprise to readers of this site. In 2009, we published a series of articles on ETF investments that didn’t paint a favorable picture.

The first article, titled “ETF: Mediocrity with No Pretense of Value,” referenced a very important section of the Federal Register which described the way in which ETFs are supposed to work. We offered up our own explanation of how we interpreted the description of the Federal Register text. Our closing remark to that article was the following:

“The blowback from something like this is on par with the unwinding of a derivative contract gone bad.”

The next article that we followed up with was titled “ETF: Indiscriminant Risk.” Our closing comment in that article was:

“As I hinted at before, ETFs pose a tremendous risk to the stock market and the portfolios of the respective ETF will be remembered for the fact that due to a liquidity drain all the stocks held will collapse regardless of value. With little cash on hand and an "automated" form of management there will be a crash on the most liquid stocks because the relatively illiquid stocks won't be able register a bid.”

In a SeekingAlpha.com article titled “U.S. Natural Gas Fund: The Beginning of the ETF Unwinding?”, we asked, “Are we on the cusp of seeing this situation with EFTs unravel?” In the same article we said, with considerable forethought:

“In their zeal to create hedging and leveraging opportunities to the retail investors, leveraged ETF distributors didn't emphasis enough the fact that the risk of loss was far beyond known market risk. Unfortunately, like the FIRREA rule change we could see painful unintended consequences.”

It is our assertion that all of the matters that we’ve raised are salient issues that need to be addressed. It is our view that instruments like ETFs should be left to the professionals exclusively or unwound altogether. The continued belief that retail investors need to invest in an ETF fund that issues “creation units” as described in the Federal Register is a definite recipe for disaster, if not now then at some point down the road.

The source citations from our “ETF: Mediocrity with No Pretense of Value” article and SeekingAlpha’s “U.S. Natural Gas Fund: The Beginning of the ETF Unwinding?” are well worth reviewing. Only after reviewing all the sources mentioned will it be possible to come to the conclusions that we have regarding ETFs.

Disclosure: No Positions