Editorial Board

ETFs Are Getting Risky

Regulators are right to start paying more attention to the potential risks posed by exchange-traded funds.
Paul Volcker, not a fan of all modern finance. Photographer: Joshua Roberts/Bloomberg

Former Federal Reserve Chairman Paul Volcker once remarked that modern finance hasn't done anyone except finance professionals much good. The automated teller machine is pretty useful, he said, but that's about it. To which a lot of investors might reply: What about exchange-traded funds?

ETFs have been an astonishing success -- the fastest-growing investment product of the past 20 years. Almost always designed to track an index, they make it as easy to invest in broad segments of a market as it is to buy common stock. Global assets under management doubled in the past four years to $2.4 trillion as of Dec. 31, Bloomberg Markets magazinereports. In 2013, ETFs accounted for 27 percent of all U.S. equities trading.

This remarkable growth suggests an innovation that's been enormously valuable to investors. On the other hand, bundling subprime mortgages was a popular business, too. Are ETFs another accident waiting to happen?

As originally designed, no. Better to buy an ETF tracking the Standard & Poor's 500 Index than pay high fees for an actively managed mutual fund that underperforms its benchmark. The trouble is, straightforward ETFs have been joined by much more complex creations. With increasing sophistication comes greater risk. Regulators are starting to pay attention, and they're right to do so.

There are now ETFs based on commodities and currencies. Devising strange new indexes for ETFs to track is a business in its own right. Today, you can buy a leveraged ETF -- riskier by design than the securities it bundles together. Or an inverse ETF, which goes up when the relevant market bundle goes down. Or a synthetic ETF, which tracks its benchmark with derivatives rather than by holding the underlying securities. Or you can trade options on any of the above.

These ETFs aren't for the wise retail investor, who is best advised to invest for the long term in simple diversified instruments. They're aimed -- or should be aimed -- at helping professionals execute finely tuned investment strategies. In that role, they can help markets work better. Even so, the parallel with conventional mortgages and sliced-and-diced mortgage-backed securities is hard to ignore: The professionals don't always know what they're doing. Their mistakes can hurt everyone.

Do complex ETFs pose a systemic financial risk? In certain circumstances, they might. The biggest danger lies with synthetic ETFs. Use of derivatives can create extended chains of intermediation: Who would owe what to whom in various contingencies might not be obvious. Up to now, synthetic ETFs have been concentrated in Europe. International regulators have drawn attention to the problem but haven't done much to address it. Innovation is good, but in finance, you can have too much of a good thing. ETFs should be high on regulators' list of unfinished business.