ETF Exchange

An ETF Giant Warns About the 'Fringe' of the Business

Traders work on the floor of the New York Stock Exchange.
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About 1,300 investment advisers and ETF players have descended on Hollywood, Fla., for the annual Inside ETF conference, sponsored by IndexUniverse.

One of the keynote addresses was given by Vanguard Chairman Emeritus Jack Brennan.

Brennan began by singing the praises of ETFs, calling them a "disruptive innovation" in investing, on par with money market funds and index funds. He predicted that ETF assets under management could go from $1.3 trillion at the end of 2012 to $2 trillion "in the blink of any eye."

But Brennan also expressed two specific concerns about the rapid growth of the ETF business.

First was the proliferation of "fringe" or "alternative" ETF products like volatility ETFs and leveraged and inverse ETFs. Though only a tiny fraction of the ETF universe (less than 2 percent, by the reckoning of most observers), Brennan warned that the broader universe of ETFs could be "splattered" by blow-back from retail investors who did not understand the products and got burned by them.

(Read more: Herb Greenberg's Weird ETFs, Revisited)

He openly wondered whether regulators were doing a sufficient job of scrutinizing new products. Some asked if there should be "gates" put up around some ETF products; others felt that the marketplace — and sufficient education — would reduce the adverse impact of these types of products.

Indeed, retail investors may have already caught on to the problems in some of these ETFs.

Steve Sachs, Head of Capital Markets for ProShares, one of the main providers of leveraged and index ETFs, appeared on CNBC and noted that most of the users of his products are institutional investors; only a small percentage are retail.

The second concern for Brennan is the coming of actively managed ETFs. Almost all ETFs are tied to indexes, but the success of PIMCO Total Return (BOND), an actively managed bond ETF, is encouraging others; several are in registration.

Brennan said he had "head scratching doubts" about the value of actively managed ETFs, even going so far as to call them an "oxymoron." His thinking: one of the reasons you index is to take the management risk out of the equation. Why reintroduce it?

This, of course, is not surprising coming from a famous index shop like Vanguard. But Vanguard has also had success with actively managed mutual funds, so Brennan's comments cannot be dismissed as merely self-serving.

Most participants I spoke to echoed Brennan's skepticism of actively managed ETFs. Regardless, the only real player in the space — PIMCO — announced they would begin trading their Foreign Currency Strategy ETF (FORX) tomorrow.

(Read more: When It Comes to ETFs, How Much Is Too Much?)

I spoke with Managing Director Scott Mather about his fund. It will invest in 18 currencies, including Canada, Mexico, Brazil, India, Indonesia, Korean, Singapore, and a little of the Chinese yuan.

What you won't see in the fund: the yen, the euro, and the dollar.

What is the criteria for inclusion in this special club? Low debt, high real growth, and a fiscal surplus, Mather said.

And what about all the talk of a currency war? Mather said "it's not a war, it's a skirmish," but admitted it could deteriorate fast. So far, he said, everyone has shown restraint, but the decline in the yen is beginning to strain relationships.

When will we know it's become a full-scale currency war? When you see trade barriers put up, and you start seeing currency and price controls. But we've already started to see that: look at Brazil.