FInancial Innovation Equals Risk

"The no-brainer step: investing in index funds." - an excerpt from A Random Walk Down Wall Street by Burton G. Malkiel

The book A Random Walk Down Wall Street was published in 1973.  The theory behind the book was to invest in a basket of stocks or an index rather than individual stocks.  The reason was simple; human investment outside of the index more often than not lags behind the index return.  There are multiple reasons for this but one of the main ones is that the cost of trading makes it a negative sum game so it is far better just to buy and hold the index than to spend countless hours trying to beat the market.  Malkiel's theory was based on the theory that the market is efficient so there is no way to extract any additional benefit from trading.

Since then a new industry has sprung up called Exchange Traded Funds or ETFs.  In the good old days of 1993 when the first ETF was launched to track the S&P 500 (called the SPDR or termed "spider") it seemed like a good idea.  Not only could you use the SPDR to invest in the S&P 500 at a fraction of the cost of buying all the stocks individually but you could also use it to hedge or protect your portfolio by buying Put Options on the ETF.  Two problems solved in one go!

From this lowly beginning ETFs have become common place.  The top 100 ETFs command over $1 trillion of market capitalization.  Behind these top 100 come thousands of less well known ETFs.  You can literally buy an ETF for anything.  Some of the more bizarre ones are Uranium, Global Carbon, Global X Lithium and Livestock Sub index just to name a few.  You can buy a 3x Bear Fund that will move three times faster than a market collapse and on the flip you can buy a 3x Bull ETF.

However with all this proliferation of ETFs there come numerous side effects.  First of all there is an increase in overall market risk.  With innovative financial products meant to reduce risk, often times there comes an increase in the overall market risk in the form of increased market volatility.  Traders believing that they can protect their portfolio by structuring downside protection take on ever more risk to achieve their returns.  They have to as the cost of protection needs to be more than offset in order to produce a return.  In addition if you believe that you are protected then you will risk more than if you are not.  Think about cars as an example: how fast do you drive now that you have airbags and state of the art brakes versus driving with no seat belts and a sharp stake in the middle of the steering wheel?  The faster you drive negates a lot of the new safety features so more safety features are required to keep you alive and then the faster you drive because you feel protected!

Second is that with the large array of ETFs comes a large array of exotic trading strategies.  It is these strategies that could easily derail a burgeoning market when it least expects it much like the blow up of the Whale trade for Morgan Stanley.  How about a trade of 2x Oil prices coupled with an S&P 500 bear strategy?  Or what about betting on a a spike in the Daily 2x Vix against an S&P 500 bear coupled with a dollar short?  Now consider that these are the types of trades going on and if there is a widening of the "normal" spread traders are forced out.  Then consider what happened when Long Term Capital Management went bust and they were home to a number of Nobel Prize economists!  Now put that horsepower in the hands of thousands and who knows what can happen and it need not even be a market catastrophe but just a trade gone wrong.

Third is a break in the true function of the market.  Stock markets exist to provide companies with the ability to raise money by selling an equity ownership in the company to investors.  If investors are not interested in buying individual company stocks but turn more and more of their attention to indices there is a disconnect between the value of stocks that are part of the index and those that are not.  This is a very real problem in the small company space and has resulted in a barrier to entry for small companies to raise cash through an IPO. 

Furthermore there seems to be a lack of concern for individual company earnings.  A company can miss earnings and really have no impact on your ETF as it makes up only a small portion of the portfolio.  Why even care just buy the ETF?  What this does is skew the trading to those companies that are in the ETF at the expense of those that are not.  There are plenty of excellent stocks that languish at low price to earnings multiples while ETF participants are rewarded for the simple reason that they are included in the index.  There is already talk that Facebook's stock will recover when it becomes part of the spider index regardless of their poor numbers.

The amusing part of this all is that Malkiel's premise was that if you just buy the index you would take advantage of the efficient market whereas now with the proliferation of all of the ETFs the theory of efficient markets itself is falling apart.  So just when you think your are safest there is more risk present than meets the eye.