Most ETFs aren’t technically derivatives, but they may pose similar risks.
CDOs were at heart of 2008 financial crash
After the housing bubble burst, there was a lot of finger pointing. But one thing everyone agreed on was that collateralized debt obligations (CDOs) were at the heart of the crash because people did not appreciate the real risks associated with these instruments. CDOs are a complex financial product backed by a pool of loans that can be sold to investors. Prior to the crash, it was believed that pooling together risky mortgages with solid mortgages would make the entire product safe, so many CDOs were AAA rated.
Theoretically, this should have worked, but there were some problems. Firstly, no one buying these derivative products was checking the health of the underlying mortgages, so they did not realize that the CDOs were filled with far more risky mortgages than previously believed. Secondly, there was an assumption that the growth in housing prices would continue forever (seriously, what were people thinking?) and the system was completely unprepared for a decline, or even a slow-down, in the market.
Few People Think About What is In Their ETFs
Exchange Traded Funds (ETFs) are a tool that allow investors to easily invest in a pool of investments. These can be stocks, bonds, commodities, or some mixture. The value of the ETF is adjusted so that it reflects the value of the underlying basket of investments. Investing in an ETF gives the investor a share in the ETF fund, but not in the underlying assets that they reflect.
Buying an ETF is considered less risky than purchasing an individual stock because there is diversification in the bundle that you are purchasing. For example, some ETFs track the entire market, or the whole S&P 500. The diversification can give a specific ETF the resiliency of the market (or whatever creates the pool of assets) so that risky companies are offset by more stable companies in the pool. Different ETFs offer differing degrees of diversification as some ETFs track relatively small subsets of the market.
Most ETFs are not considered derivatives because they are backed by the actual assets in the pool, not some contractual arrangement based on the assets. However, the value of the ETF is derived from the value of the underlying basket of stocks, so people can fall into a similar trap. They focus on the performance of the ETF and overlook the health of the underlying assets. This is the same kind of thinking that got so many investors in trouble with the CDOs.
Funds Are Not Doing Any Due Diligence on Their Investments
There is another potential problem with ETFs. One reason they are considered safer is because they are usually passive investments. The managers use some criteria to create a basket of stocks and then generally don’t tinker with it. For example, some ETFs track the S&P 500 or the entire market; and they don’t try to pick winners and losers. Since ETFs don’t do research into the underlying assets, don’t have many employees, and don’t have to pay brokerage fees, it keeps costs low.
The prospectuses for ETFs routinely warn investors that they do not research the assets that undergird the fund. Here is an example of some boilerplate from a prospectus:
“[We] does not invest the assets of the Fund in securities or financial instruments based on [our] view of the investment merit of a particular security, instrument, or company, nor does it conduct conventional investment research or analysis or forecast market movement or trends.”
You need to do this research for yourself. We can help.
Not all ETFs cover broad and diverse markets, instead, some are incredibly specific. For example, there are approximately 50 “all-China” ETFs, each offering a different slice of the Chinese market. This is where the lack of research can really come back to bite investors on passive investments that feel “safe”.
The ETF providers are not carefully researching the companies in their portfolio, but instead are putting together a set of criteria that they think will sell. If an investor wants to know how risky the underling basket of stocks are, they need to do the due diligence for themselves.
We can help with that. We have reports available for hundreds of ETFs that list and assess the underlying assets in the fund.
Conclusion:
One big difference between ETFs and CDOs is that the assets backing up most ETFs (stock from public companies) face far more scrutiny than the NINJA loans did prior to 2008. That does provide today’s investors in ETFs with more protection than the investors in CDOs had in 2007.
Still, investors need to be wary of being lulled into a false sense of security surrounding ETFs. They are skyrocketing in popularity, leading to a wide proliferation of different types of ETFs to satisfy every appetite. Investors should not get caught up in the frenzy, but instead make sure that they understand what they are putting their money into.
If you want to buy an ETF, especially a specialized one, then do your due diligence on the underlying stocks, because no one else is doing it for you.
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