Financial Markets: There's Nowhere to Hide

The history of Wall Street is littered with financial products that work well in theory and then when they are introduced on a small scale. Next comes the overhyping by salespeople who don't (and may not want to) understand the risks. Sales ramp up to customers who have even a smaller understanding but who are enamored by prospects of high returns. At some point an event sparks some selling in these "low-risk" assets, buying dries up, panic selling ensues, then governments must step in to save the entire system.

We saw this pattern in 1987 with portfolio insurance and in 2008 with mortgage-backed securities and collateralized debt obligations.

Now there are warnings about exchange-traded funds (ETF's):

these funds rely on a complex Wall Street trading ecosystem. An investor never trades directly with the fund company; instead, shares are created or redeemed through major investment banks and brokerage houses, such as Goldman Sachs. These firms, called authorized participants, or APs, are always a step removed from the end investor, and function as the ETF market's hidden chemists. Their buying and selling securities in exchange for ETFs is what keeps ETF prices accurate and close to the index a fund is supposed to track.

The specific task of APs is to exchange baskets of securities for ETF "creation units," which are sliced up for purchase by individual investors, advisors, and small institutions. APs also do the same in reverse, retiring unwanted ETF shares by exchanging them for the underlying assets.....The result is that exchange-traded fund prices mostly hew to the value of their underlying baskets, thanks to arbitrageurs who boost the supply of ETF shares when they're in demand (as exhibited by an ETF's price rising above the fair market value of its assets) or reduce it when an ETF's share price sinks below net asset value.

When there are many buyers and sellers of shares of both the ETF's and the assets that ETF's hold, all is well. But the words "complex Wall Street trading ecosystem", "creation units," and "arbitrageurs" should be setting off alarm bells to experienced observers of the Wall Street scene.

For our own portfolios we can try to limit the damage by avoiding ETF's altogether, but as recent events have taught us there's nowhere to hide.