ETFs: New Warnings of Systemic Risk

Concerns over the possibility that ETFs could lead to systemic risk are hardly new.

I’ve certainly written about them enough, starting with a controversial report in September about whether an ETF could collapse, and another, in November, with the Kauffman Foundation study about systemic risk.

In each case the critics assailed the reports as having been written by people who in, in some way, are biased in favor of the traditional mutual fund industry.

Never mind how nonsensical that is: The risks are and were real — even if they never amount to anything.

But now several warnings are coming back-to-back-to-back that can't be ignored:

- from the International Monetary Fund,

- the G20 Financial Stability Board,

- and the The Bank for International Settlements — no slouch organization, considering that it is the central bank of all central banks.

The BIS's take, in a working paper headlined, “Market Structures and Systemic Risks of Exchange-Traded Funds" is, in effect, this:

ETFs originally were marketed as “plain vanilla type flexible and transparent investment products that can be traded like stocks on an exchange.”

But in classic Wall Street style, investors seeking an edge have demanded more innovation.

The result: Increasingly exotic ETF structures are more complicated and risky, even with their claims of transparency. Many of the most exotic are leveraged ETFs, which juice returns to multiples of the indexes they track. According to the study, those leveraged ETFs account for nearly 20 percent of ETF turnover, even though they represent 3 percent of ETF assets.

Then there are options on ETFs, which have become popular with hedge funds. Citing a J.P. Morgan report, the study notes that average daily volume of options on ETFs now exceeds “those of all U.S. stock options combined.”

The report also discusses counterparty risk associated with ETFs, but the bottom line: Those "structured product" derivatives that got us in the last financial mess started as transparent, plain-vanilla products, too.

My take: I realize there is strong disagreement on this issue, but this is not uninformed, Henny Penny "the sky is falling" analysis. It's simply raising awareness of the risks. If you’re interested, I suggest reading the report. Good history starts in Section 5, Page 10.

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

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