Remember when exchange traded funds (ETF news) burst onto the scene? They were marketed as the wave of the future, a retail-friendly cross between mutual funds and stocks--a way to gain the benefits of both. They made a huge splash, and the ETF industry took root. Today, the industry's growth still boggles the mind. In 2000, there were about 90 traded. That has since soared to 4,000 with another 1,000 in the pipeline.

With this phenomenal success, however, has come some problems that are not often mentioned but are perhaps rising in significance. 

We recently discussed one issue that has stoked concern, that hedge funds are approaching ETF sponsors to create designer ETFs that serve the hedge funds' purposes more than investors. This is akin to the situation regarding some CDOs, when hedge funds were able to influence the creation of CDOs without a lot of disclosure to the end CDO investor.  There are other concerns as well, and in this commentary we'll examine an issue recently highlighted by the Kauffman Foundation and various academics: the role of ETFs in the market and the systemic risk they pose, if any. 

In some ways, ETFs were built to meet rising demand. Unlike closed end funds, the sponsor can create more ETF shares as demand dictates by working with authorized participants to buy the underlying securities necessary to create more units. This can be a difficult process when the underlying securities or  commodities are in short supply. But on paper, anyway, the capacity for unlimited share creation is there. And that's how ETFs are generally marketed. 

When ETFs are in heavy demand, the sponsor is required to buy more of the underlying securities, which can bid up prices. At some point, it is possible the value of the securities get bid up so high that it may not be possible for the ETF sponsor to purchase the necessary securities to keep the underlying portfolio in balance with the ETF shares that trade. Some arguethis exposes the ETF to failure. One could also argue the ETF may be forced to limit the supply of shares, almost like a closed end fund. 

At a minimum, any issues with buying the securities could wreak havoc for sponsors, which, to be sure, have a lot of tools at hand to help them create units--such as futures. This is definitely a concern, but one could argue about how much of a systemic threat this actually imposes. While they got less attention than high-frequency trading, ETFs did figure in the recent SEC-CFTC report on the May 6 Flash Crash. It does appear, as the Kauffman Foundation report notes, that ETF market participants were confused enough to pause their trading to sort out issues with the fast-moving prices of underlying securities. 

The arbitrage function appears to have broken down. But is this a symptom or cause of a Flash Crash?  

What does appear clear is that specific ETFs have put end-customers at risk. Consider commodity ETFs. There is a finite supply of commodities but the ETF industry touts itself as one that can scale to meet "unlimited" demand by creating new units on the fly. But that will bid up the price of underlying commodities, like, ahem, gold. This is pro-cyclical in the extreme. What happens when the bubble bursts? And then commodity ETF holders want out. That could get chaotic. - Jim