"I cannot teach anybody anything, I can only make them think."
Socrates
ETFs, your loved investment vehicle, suffers from a Disco Door Fatality, which means they are causing institutional and individual investors more risk and more harm than the convenience they bring.
Collective
The Romanian film "Collective" was nominated for two Academy Awards in 2021. The film highlights a deadly nightclub fire that took place in Bucharest, Romania in 2015. The tragedy occurred due to a lack of safety measures, including a faulty disco door that opened inward, making it difficult for people to escape.
Coconut Grove
In 1942, a nightclub fire in Boston's Coconut Grove claimed the lives of 492 people. This tragedy was a significant catalyst for the development of fire safety regulations, including the requirement for doors to open outward in public spaces. This regulation has saved countless lives since its implementation.
Low Chance
The lack of standardization in disco door policies after the Coconut Grove tragedy can be attributed to several factors. One of them is the failure to think ahead and anticipate the rare but catastrophic events that could occur. Another is the lack of a clear purpose and attention to detail in designing safety features. Additionally, the low probability of such events happening may have led to complacency and a reluctance to incur the costs of insurance. Ultimately, it is a reminder that we must not underestimate the importance of thorough planning, attention to detail, and a willingness to prepare for low-probability events.
The Fooled Frog
Slow-moving investing and thoughtlessly implemented financial “innovation” has transformed the investors into a fooled frog, a metaphor used to describe a situation where gradual changes can be so subtle that they go unnoticed until it's too late to take action. The metaphor comes from an experiment where a frog placed in boiling water will immediately jump out, but if placed in cool water that is gradually heated, the frog will stay in the water until it dies. The experiment has been criticized as not being scientifically accurate, but the metaphor is often used in discussions of risk management, change management, and decision-making. It emphasizes the importance of being aware of small changes and taking action before a situation becomes irreversible. The human brain is designed to herd. This is why financial innovation should have been designed to break that cluster. Unfortunately, when societal goals are more myopic and less foresighted, the fooled frog is the reality of the commons, beyond tragedy.
Disco Door ETFs
ETFs are the Discos of the modern investing world, where the door opens inside. They create more risk for an investor's portfolio and destroy long-term wealth. There are many reasons. First, most of the ETFs, are based on concentrated benchmarks that put 80% of the allocation in 20% of the stocks and offer a non-diversified portfolio. Second, these benchmarks are re-packaged as Index Funds and ETFs, sometimes as undifferentiated copies of each other. This replication has made passive index-tracking funds owners of more than 50% of the U.S. market. Third; most ETF categories are dominated by two or three big issuers, and many issuers in turn depend on a handful of authorized participants. Especially in illiquid markets, such authorized participants are often also the market makers in the underlying.
All this makes Index products the default driver of markets. They become influencers of both the underlying index price and underlying asset prices, forcing a disconnect of the asset price from real fundamentals. Index funds have become the cart that drives the horse. Now add leveraged versions to this list and single stock ETFs.
What do you think will happen when you take a concentrated index, package it as a concentrated Index fund or ETF, run by a few authorized participants, and allow for a new entrant instrument to become the default incumbent that is more than half of the underlying? In corporate jargon, it’s called management control. In psychology, it is called herding, a phenomenon when everyone rushes to the door at the same time, everyone loses. There is no exit. A few remember it as XIV. For an investor, it would mean, Apple prices don’t just move because of iPhone sales but because of end-of-day maintenance of the nearly 500 ETFs that own Apple. Another interpretation for the investor is that, no body knows what will happen to his investment tomorrow, or next year, or next decade.
Markets were always about herding. ETFs amplify that herding, creating more risk than what the market offered initially in the first place. More the risk - more the volatility, more the volatility - more the inefficiency, more the inefficiency - more the mispricing, more the mispricing - more the unpredictability, more the unpredictability - more the resulting death of the poor investor, who expected capitalism to think about capital market integrity. Whom should he[she] go to uphold the code of Ethics and Standards of Professional conduct?
Integrity of Capital Markets
Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.
CFA Code of Ethics and Standards of Professional conduct
The Disco Door ETFs is the tragedy of commons, as it screams to be heard in the deafening noise of the perceived victory of Passive over Active. The markets are broken and the way to fix them starts with our ability to question what we are selling and buying. And whether the purpose of the market is to just make money or is it to safeguard the interests of individual and institutional investors who rely on it for its efficient functioning for a better life.
New age solutions will resolve this stalemate giving investors an alternative, a better Index fund. More about that in my next feature.
Bibliography
"Risks of Exchange-Traded Funds (ETFs)" - This publication from the U.S. Securities and Exchange Commission (SEC) provides an overview of the risks associated with investing in ETFs, including market risk, liquidity risk, and tracking error.
"The Risks and Rewards of Exchange Traded Funds" - This research paper from the CFA Institute provides a detailed analysis of the risks and rewards of investing in ETFs, including an examination of the risks associated with ETF trading, market volatility, and market liquidity.
"Exchange-Traded Funds and Financial Stability" - This paper from the International Monetary Fund (IMF) examines the potential risks to financial stability posed by ETFs, including the risk of fire sales and herding behavior.
"The Systematic Risk of Exchange-Traded Funds" - This research article from the Journal of Index Investing examines the potential for ETFs to contribute to systemic risk in financial markets and provides recommendations for mitigating this risk.
"Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors" - This Investor Bulletin from the SEC provides an overview of the risks associated with leveraged and inverse ETFs and discusses the potential pitfalls for buy-and-hold investors. The bulletin also includes tips for investors on how to evaluate the risks and rewards of investing in these types of ETFs.
"The Hidden Risks of ETFs" - This article from the Harvard Business Review discusses the risks associated with the increasing use of ETFs by institutional investors and the potential for ETFs to exacerbate market volatility.
"ETFs: Understanding the Risks and Potential Rewards" - This publication from the Financial Industry Regulatory Authority (FINRA) provides an overview of the risks associated with investing in ETFs, including market risk, liquidity risk, and concentration risk.
"The Hidden Risks of ETFs" - This research paper from the European Central Bank examines the potential risks associated with ETFs, including the risk of contagion and the potential for ETFs to amplify market volatility.
"Exchange Traded Funds: Risks and Opportunities for Investors" - This report from the Organisation for Economic Co-operation and Development (OECD) examines the risks and opportunities associated with investing in ETFs, including the potential for ETFs to improve market efficiency and liquidity.
"ETFs and Systemic Risk: Myth or Reality?" - This research paper from the Bank of Italy examines the potential for ETFs to contribute to systemic risk in financial markets and provides evidence suggesting that the risk may be overstated.