The Clear and Present Regulatory Danger Facing ETFs

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 |  Includes: DBC, EWZ, PBR, VALE
by: Martin Fluck

We may not have long to wait for the collapse in the exchange-traded fund bubble. The ETF industry ran out of control long ago, but regulators can no longer ignore the retail money faddishly pouring into these funds, and how it is distorting market prices. Stuffed with exotic derivatives and super-concentrated bets on very risky markets, regulators are closing in. The steps they are taking will lead to a cascade of falling dominoes, as the more speculative ETFs are unwound.

ETFs’ big selling point has been that they are cheaper than traditional mutual funds, and they’re giving retail investors easy access to emerging markets and commodities for the first time. The assets they manage have doubled to $1.1 trillion since 2005, and the market is expected to grow another 20-30% this year. Mutual funds still dwarf ETFs, with $19.5 trillion in assets, but ETFs are taking a disproportionate amount of the money being invested in emerging market funds. Half of the $30 billion U.S. investors bet on emerging-markets in 2009 was in ETFs – which had $277 billion invested in commodity ETFs and other securities linked to raw materials by the end of 2009.

But many of the markets that ETFs are indexed to are too small to absorb this kind of money, and so indiscriminate buying has forced up the value of bad companies as well as good. For some time, there have been suspicions that ETFs are pumping up emerging markets and commodities – which are, of course, interrelated.

U.S. regulations are supposed to limit ETFs from huge concentrations in a given emerging market stock, but with few liquid companies to invest in, dangerous concentrations are inevitable. A fund like the iShares MSCI Brazil Index ETF (NYSEARCA:EWZ), which nearly tripled in size in 2009 to $10.9 billion in assets – though it’s fallen back to $9.3 billion – has 33% of the fund invested in only two firms: oil giant Petrobras (NYSE:PBR) and mining company Vale do Rio Doce (NYSE:RIO). So a play on the Brazilian stock market is essentially a play on the oil price. “If you invest in an ETF with most of its assets in a few stocks and think you have made a diversified bet, the real bubble is the one between your own ears,” is how the Wall St Journal puts it.

As money pours into these ETFs, and they are mechanically forced to match their holdings to those in the emerging-market indexes, that forced buying drives up share prices, attracting still more new money into the ETFs, as shares spiral even higher. In this way, ETFs are exacerbating swings in markets with already pronounced boom bust cycles.

But with more than 4 out of 10 trades on U.S. stock exchanges involving ETFs on some days, and hundreds of billions of dollars of ETF funds invested in contracts that were once dominated by producers and consumers who sought to hedge against oil-market volatility, the regulators are closing in.

In a reversal of findings published under the Bush administration, the Commodity Futures Trading Commission – under its new chairman, Gary Gensler, appointed by Obama – has concluded speculators played a significant role in driving wild swings in oil prices that caused the oil price to spike to $145 in 2008. The “flash crash” of U.S. equities on 6 May, when more than 70% of the trades cancelled due to excessive declines involved ETFs, will only have reinforced its views on the impact of the massive influx of capital into commodities.

That is why the financial reform bill President Barack Obama signed on 21 July included provisions that will allow for new rules to limit the amount of investments in commodities by big institutions betting on their direction purely for financial gain, and enhance the CFTC’s ability to prosecute trading abuses. With the CFTC set to impose caps on energy trading within a year, and limit the size of funds, the regulatory threat to the ETF industry is clear and present.

The CFTC’s explicit responsibility is to guard against commodity market distortions, and it appears to be dead serious about addressing the mess ETFs have created in commodities, and shutting down aggressive commodity products. Its main concern is a bubble in certain energy and agricultural products that has become so obvious that they cannot delay taking action any more. Congress still needs to appropriate funds and write guidelines for implementation and enforcement, but they are now at the beginning of a rule-writing process. They could seek additional authority to crack down on abuses like pre-rolling, where futures traders make money at retail investors’ expense by exploiting the ETFs big monthly programmed roll-over of positions, by buying or selling the next months contracts in advance, to manipulate prices.

The biggest ETF fund managers believe the furore over commodity ETFs is more about the structure of the underlying commodity futures market than about ETF products themselves (though they would say that wouldn’t they). Yet in the last couple of weeks, various gas and oil ETFs have begun to suspend the issue of new shares in anticipation of the strict position limits the CFTC will impose.

With Bloomberg BusinessWeek calling commodity ETF’s “America’s worst investment” and printing “Do Not Buy Commodity ETFs” three times on the cover of its 29 July issue, investors can’t say they haven’t been warned! Jack Bogle, the creator of the first index mutual fund in 1975, and founder of Vanguard Group Inc thinks, “It’s insanity… a classic case of Wall Street trying to capitalize on the worst instincts of investors.”

Meanwhile, the Financial Industry Regulatory Authority that polices broker-dealers has several investigations under way to see if investors are being sold ETFs they may not understand, or that may be too risky for their needs. The “retailization” of leverage, derivatives, and other hedge fund-style investing techniques, is also alarming the SEC. It is deferring approval of new ETFs that use derivatives while it reviews the leverage and complexity of products aimed at retail investors.

The Bank of England has also highlighted ETF market risks. The benefits of ETFs may be outweighed by “complexity, opacity and contingent risks” - and it is worried about the transparency of the risks arising from securities lending (many funds lend out the securities bought with retail investors money) and counterparty risks from derivative exposures. It thinks the auditing processes that should ensure the shares in ETFs are backed by an equivalent value of the underlying commodity or index, may not be up to the task.

The structure of the ETF market makes fraud easy. “Often, for tax and stamp duty reasons, as well as cost and finding the right legal framework, many ETFs are listed in one country, the management resides in a second, and the commodity or securities are held in a third,” Bedlam Asset Management warned in October last year. It has unearthed ‘beverage’ ETFs where the manager, trustee, custodian and listing are in the Indian sub-continent, the Gulf, Africa and Europe; which convinces them there are ETF frauds out there just waiting to be discovered. Because the verification is being done by junior people in small firms with a limited track record, they are becoming “twitchy.”

Whatever triggers a mad rush to exit the ETF market – fraud, the regulatory crack down, or simply general market panic – global equity prices are likely to be hit by a chain reaction. “Wall Street has created a dangerous new kind of global weapon of mass destruction – a bomb primed to detonate like the 2000 dot-coms, the 2008 sub-primes – and detonation is dead ahead,” Paul Farrell recently wrote in Dow Jones’ Market Watch.

If ETF funds become forced sellers to meet redemptions, it could create a downward spiral as a wave of physical gold and other commodities are sold into thin markets, in turn triggering falls in the share prices of companies that produce these commodities. As investors sell shares in the more concentrated ETFs, the very act of selling the underlying investments is likely to put pressure on the share price of those companies, hurting the ETF’s net asset value and precipitating additional sales.

The losses could be even more precipitous for investors in leveraged and inverse ETFs, which the SEC and Finra have warned could deviate widely from their underlying indexes. And the failure of a firm providing ETFs could leave investors holding something other than the intended index exposure; and facing liquidity constraints on exiting their investment. Such risks, says the Bank of England, “should not be under emphasized.”

How typical it is that the great and the good of the financial world are in Jackson Hole debating the role of regulations in the preventing and deflating the next asset bubble, just as new regulations are set to burst yet another gigantic bubble that has occurred under their noses? The financial regulators’ early warning systems have failed, and we are all about to become victims of the ETFs' success; paying the price, once again, for financial products with three letter acronyms.

Disclosure: No positions