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Exchange-traded funds are widely held as one of Wall Street's best ideas. They provide retail investors with cheap access to a wide array of asset classes and investment strategies; they are generally less costly than their mutual fund ancestors and are a lot more tax-efficient. However, Wall Street has a well-known tendency to turn good ideas into bad. ETFs have certainly reached the “investment fad” stage. Have they reached the bubble stage?

Here are five reasons to worry:

1. ETFs have gone from cheap and simple to expensive and obscure

ETFs came out of a simple idea: making index funds more easily tradable, cheaper and tax efficient. Yet, the recent years have seen a proliferation of obscure, illiquid and high-fee strategies. I am not talking about the risks of leveraged ETFs. Investors who do not understand that a 20% gain does not compensate for a 20% loss should not be investing at all.

I am talking about obscure indices tracking illiquid stocks at a very high cost. Did you know that Van Eck was planning a Mongolia ETF? While I am convinced that Mongolia offers tremendous opportunities for private equity and emerging markets hedge funds, a country with a $6 billion GDP and a stock market capitalization of about $1 billion is clearly not ready for the ETF crowd.

Or who needs the IQ Merger Arbitrage ETF (the aptly-named MNA)? The fund holds only five long positions on large pending merger targets, offset by a short position on S&P 500 futures. Unsurprisingly, the fund has gone nowhere since its launch in November 2009 (its 0.8% expense ratio is partly to blame).

Generating investment fees seems to be the only justification of many of these funds. According to my calculations, the average expense ratio of ETFs launched in the past five years was 0.58%, up from 0.25% in the prior five years.

In addition, one of the biggest attractions of ETFs, their transparency, is under threat. Active ETF providers are lobbying hard to be exempted from the obligation to report their daily holdings, which could increase the possibility for funds to trade further away from their underlying value.

2. About half of ETFs are losing money

Remember the Internet bubble with all these start-ups boasting stupendous page views and traffic growth and no revenue? The same is happening with ETFs. It takes between $25 and $50 million for an ETF to break even, depending on the strategy. About 558 of the 1,372 U.S.-listed ETFs have less than $25 million in assets. Most of them will never grow to make a penny.

ETFs closures are relatively painless for investors, who can recoup most of their assets through the sale of the holdings of the ETF trust. But closing a zombie fund causes unnecessary trading (and associated tax events), expenses that are incurred by investors.

3. Have you looked into the collateral of your synthetic ETF?

Synthetic ETFs account for about half of European ETF assets, a lot less in the U.S. where most funds are regulated by the 1940 investment act. Synthetic ETFs replicate the performance of an index by engaging in derivative trades, usually swaps. Providers must post collateral of at least 90% of the fund’s value, but there is no requirement that the collateral matches the advertised objective of the fund.

Take the DB X Tracker MSCI Emerging Markets (XMEM:GR), a highly liquid ETF traded on eight exchanges with more than $3 billion in assets. Its collateral basket is made of 31% of Japanese stocks, 20% of U.S. stocks and 5.4% of French corporate bonds. Did I mention that that 10% of its bond holdings were rated less than A3?

All of the largest European ETFs (DB-X Tracker, RBS, Amundi, Lyxor and Credit Suisse) engage in synthetic index replication. Rules regarding collateralization of ETF assets, disclosure of collateral basket and swap structure vary across providers. I encourage investors to read a recent research note by Morningstar and choose the structure they are most comfortable with.

4. Synthetic ETFs create conflict of interest issues for investment banks

The collateral rules on synthetic ETFs create a nasty conflict of interest for investment banks that also provide ETFs. They can essentially use the ETF collateral basket as a cheap source of funding for market-making activities.

Banks win on all sides of the trade: They collect a management fee from the ETF, act as the counterparty to the fund’s total return swap (in exchange for a fee, of course) and use the ETF collateral basket as a dumping ground for whatever securities are left on their trading books at the market close. With so many eggs in the same basket, investors in synthetic ETFs should pray that no European bank goes under.

This scenario is not so far-stretched: Synthetic ETFs posted redemptions of $2.8 billion this past quarter as several large ETF providers came under speculators’ pressure (Société Générale (OTCPK:SCGLY) plunged by 15% on August 11 on rumors of liquidity problems).

5. Should you worry about excessive short interest and failed trades?

Disclaimer: These criticisms are at the border of conspiracy theories. H. Bradley, from the Kauffman Foundation, who recently testified to the senate banking committee on the dangers of ETFs, points out that short interest on certain ETFs often exceeds 100%. Short interest on XRT (SPDR retail) went up to about 500% of outstanding shares on September 30 due to chain-shorting (I sell short a share to another investor who sells it short, etc). In theory, margin requirements and the fact that ETF shares can be created at-will to cover short positions should prevent the proverbial run on the bank. But I wonder if the creation/redemption mechanism is robust enough to accommodate such imbalances in times of market stress.

H. Bradley also points that the total value of failed ETF trades soared to $272 billion in 2010, or about 60 % of all equity failed trades. As I understand it, it is not as bad as it sounds: Most of these failed trades are only delays and this is really a back-office issue that goes unnoticed by investors.

Overall, I remain convinced that ETFs are a useful innovation that ultimately benefits retail investors. The vast majority of ETFs present no risk for investors. But the proliferation of obscure and illiquid instruments and the conflicts of interest underlying synthetic ETFs could expose investors to losses. The consequences could go from mild (these obscure, high fee funds go broke) to severe (a major European investment bank goes bust leading to massive losses on synthetic ETFs) to terrifying (a replay of the May 2010 flash crash with a run on ETFs causing a breakdown of their trading infrastructure). While I do not believe in this worst-case scenario, the sheer size of the ETF market ensures that ETFs will play a large role in the next market crisis. When that happens, regulators will wish they had looked into these issues before the crash.

Source: 5 Scary Facts About ETFs