As the ETF world booms, so do the risks

In Steven Spielberg’s original Jurassic Park, the chaos theorist played by Jeff Goldblum chastises the theme park father’s folly in resurrecting dinosaurs by noting: “Your scientists were so preoccupied with whether or not they could, they didn’t stop to think if they should.” The exchange-traded fund industry should take note.

This is a heady time for the ETF world. Overall inflows last year topped $1tn for the first time. Coupled with the buoyancy of financial markets, this means that the ETF industry is on the cusp of crossing the $10tn of assets under management mark.

The industry is also broadening. Bond ETFs took in about $244bn in 2021 — a new record and the third $200bn-plus year in a row. Many traditional investment groups are also embracing the ETF structure for active strategies, underscoring how it has transcended its genesis as a passive vehicle.

Yet like so often before in the annals of financial innovation, a brilliant idea can be taken to extremes. To stretch the Jurassic Park metaphor, the ETF industry has gone well beyond cloning triceratops, and has for some time now manufactured tyrannosaurs.

This is not a new phenomenon. The first “leveraged” and “inverse” ETFs — which use derivatives to juice returns of an underlying index, or deliver the opposite performance of it — were first launched in 2006. “Thematic” ETFs dedicated to niche areas like pet care or cyber security have proliferated for more than a decade. But it is a phenomenon that is now growing and evolving rapidly, as the industry tests to the limit what can be shoved into the ETF structure and sold to investors.

Many of the riskier or gimmicky ones have proven wildly popular in the recent retail-trading frenzy. The assets under management of leveraged and inverse ETFs more than doubled over the past two years to $180bn, according to Morningstar. The assets of thematic ETFs have almost quintupled to $227bn. 

However, even the existing suite of leveraged, inverse and or simply weird thematic funds are being outdone by some newer entrants and their increasingly esoteric approaches. The number of ETFs globally jumped by a record 710 last year, according to Morningstar data, and, frankly, many are asinine.

There are now leveraged and inverse versions of Ark Invest’s ETFs or the stock of Warren Buffett’s Berkshire Hathaway; quintuple-leveraged versions of ETFs that track the Nasdaq and the S&P 500 — and even bitcoin futures and non-fungible token ETFs, despite the unregulated nature of the underlying markets.

Leverage Shares, one of the providers churning out these products, said in a statement that it “is committed to educating investors”, but argued they fulfil a need. “Modern investors are very different from those of yesteryear; volatility for them isn’t exactly a source of fear, but an opportunity,” it said.

Some of these products are strictly speaking exchange-traded notes, in other words synthetic debtlike securities rather than traditional funds. ETFs, ETNs and exchange-traded commodities (ETCs) are collectively known as exchange-traded products (ETPs). But the confusing jumble of similar acronyms means that many investors call everything an ETF.

The problem is that many of these funds are at best useless fads designed primarily to extract fees from investors, not serve an actual need. Frequently, they are potentially dangerous to the financial health of those buying them, and at worst arguably to the health of broader financial markets.

Some give ordinary investors easy access to derivatives and complicated trading strategies they might not be equipped to understand. In some cases, retail investors would be precluded by regulators from directly using the strategies without an ETF.

Take the array of ETFs linked to the Vix volatility index that contributed to a violent stock market correction in 2018. Over the past decade 19 such vehicles currently tracked by Morningstar have taken in a net $11bn of investor money. Currently only $2.4bn remains.

That means that investors would have recovered more of their money investing in Bernard Madoff’s Ponzi scheme than in the Vix-linked ETF ecosystem.

For years now, ETF critics have savaged the industry’s fixed income products, arguing that they were dangerous due to the mismatch between their instant tradability and the often only occasional buying and selling of the underlying bonds. Yet the real dangers arguably lie in complex, expensive, derivatives-based ETFs that are thinly disguised fee extractors sold to retail investors or day traders looking for thrills.

Email: robin.wigglesworth@ft.com
Twitter: @robinwigg