Exchange Traded Funds

Lots of people think, as I did until recently, that ETFs are relatively low risk, low cost investments that track well understood and popular market indexes like the S&P 500 without forcing individual investors to actually assemble a portfolio of the underlying assets.

Not so much.

Terry Smith has put together a list of 4 problems with ETFs as they are traded today of which I think #3 is the biggest-

Because you can exchange trade these funds, they are used by hedge funds and banks to take positions and they can short them. Because they can apparently rely upon creating the units to deliver on their short, there are examples of short interest in ETFs being up to 1000% short i.e. some market participant(s) are short 10 times the amount of the ETF. If the ETF is in an illiquid sector, can you really rely upon creating the units as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity? The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear, but amazingly, during the debate in which I have been engaged by various cheer leaders for ETFs, they have claimed that there is no such risk in shorting ETFs. They clearly do not understand the product they are peddling, and if they can’t what chance has the retail investor got?

In other words leverage is creating notional supply in excess of the actual supply of an asset which leads to illiquidity when the demand exceeds it.

I’m sorry, you can’t buy anymore X at any price.

Now economists would argue that there is always a price at which a supply of X is available and on certain theoretical levels they are correct, but there is a practical level at which the price becomes too expensive and someone, somewhere is either deprived of the item they had a contract to purchase OR is forced to spend lots of money making good those promises.

This is apparently what happened at UBS.

The $2 Billion UBS Incident: ‘Rogue Trader’ My Ass

Matt Taibbi, Roling Stone

POSTED: September 15, 8:39 AM ET

Investment bankers do not see it as their jobs to tend to the dreary business of making sure Ma and Pa Main Street get their $8.03 in savings account interest every month. Nothing about traditional commercial banking – historically, the dullest of businesses, taking customer deposits and making conservative investments with them in search of a percentage point of profit here and there – turns them on.

In fact, investment bankers by nature have huge appetites for risk, and most of them take pride in being able to sleep at night even when their bets are going the wrong way. If you’re not a person who can doze through a two-hour foot massage while your client (which might be your own bank) is losing ten thousand dollars a minute on some exotic trade you’ve cooked up, then you won’t make it on today’s Wall Street.

…

In the financial press you’re called a “rogue trader” if you’re some overperspired 28 year-old newbie who bypasses internal audits and quality control to make a disastrous trade that could sink the company. But if you’re a well-groomed 60 year-old CEO who uses his authority to ignore quality control and internal audits in order to make disastrous trades that could sink the company, you get a bailout, a bonus, and heroic treatment in an Andrew Ross Sorkin book.

In other words, “rogue traders” are treated like bad accidents and condemned everywhere from the front pages to Ewan McGregor films. But rogue companies are protected at every level of the regulatory structure and continually empowered by dergulatory legislation giving them access to our bank accounts.

…

Sooner or later, this is going to blow up in our faces, and it won’t be one lower-level guy with a $2 billion loss we’ll be swallowing. It’ll be the CEO of another rogue firm like Lehman Brothers, and it’ll cost us trillions, not billions.

‘Rogue trader’? That’s the same as ‘rogue reporter’

The ‘rogues’ are those who get caught while people presiding over systems that go wrong say: ‘How deplorable’

Michael White, The Guardian

Friday 16 September 2011 06.40 EDT

A “rogue trader” in a City of London bank is really like a “rogue reporter” on the News of the World. He’s the one who gets caught and sent to jail when the people who presided over the system that allowed him to lose $2bn – or, in Clive Goodman’s case, to hack some royal phones – say “how deplorable” before business as usual is restored.

…

Have we learned nothing? Apparently not. Adoboli is 31, with less visible expertise and experience than his evident ambition to make money. Who left him in charge of the tea money? Yet he was able to lose $2bn in a corner of the investment market known as exchange traded funds (ETFs), which even the FT is having a struggle explaining to its more ignorant readers (bank chairmen, people like that) in today’s edition.

Apparently, they’re the hottest thing since the collateralised debt products that blew up Lehman and others in 2008. The FT columnist Gillian Tett says she wrote a column in May warning that ETFs were heading for a scandal, but not quite this soon.

A rogue trader at UBS or a rogue bank?

by John Gapper, Financial Times

September 15, 2011 3:45 pm

Given the recent history of UBS, it is fair to ask if Kweku Adoboli is a rogue trader or his employer is a rogue bank.

…

(T)he bank’s entire senior layer of management was forced out following its involvement in the 1998 collapse of Long-Term Capital Management, the US arbitrage hedge fund run by John Meriwether. UBS had pressed to be closely associated with an operation it regarded as smartly and safely run.

There are similarities between the products relating to the LTCM case and the trading desk on which Mr Adoboli worked. As Izabella Kaminska of FT Alphaville points out, banks’ Delta 1 desks traded and hedged exchange-traded derivatives in  ways that involve complex – and difficult to monitor – risk-taking. Mr Kerviel worked on SocGen’s Delta 1 desk.