Exotic ETFs - the innovator, the imitator, the idiot

Warren Buffett has been quoted saying something along the lines of every idea goes through 3 stages; the innovator, the imitator, and the idiot.  The ETF idea went straight from innovator to idiot.  Frankly, ETFs have always been a dumb idea after they created broad based ones that followed broad indices.  The implicit benefit behind the creation of an ETF has always been low cost access to the broad return of the market.  That's simply no longer the case.  A Russell 2000 or S&P 500 tracking ETF is an investing vehicle that intuitively and empirically makes sense.  All of these alternative energy, Brazil this, China that, triple leveraged future gold or oil and all these new derivative ETFs are a fee driven perversion of a simple idea that was beneficial to markets.

This paper by the Financial Stability Board says it all in more diplomatic and eloquent tone as well as warning about all the danger that lies ahead as these products are traded in more volatile markets.  Obviously this will turn into the black swan of 2013 or whatever "oh, shucks" nonsense the media, financial industry, or politicians/"regulators" cook up.  That isn't sarcasm, that's cynicism.

The paper focuses on the increasing innovation in the industry, which I would call blatant idiocy.  The real innovation was creating the plain vanilla funds that broadened access to liquid, tax efficient ways for passive investors to achieve better returns than through handing it to mutual funds.  All the other stuff is just an excuse to take your money.  If you have the capacity to establish X industry is going to do well or is undervalued, why not take the extra step and identify the companies that will really win?  I like what some investors are doing with buying baskets of large cap tech like Microsoft, Cisco, and Dell, but a tech ETF would leave you owning plenty of unsavory names.  If you can't do that work, just stick with the broad based ETFs because you probably couldn't articulate an objective data driven thesis on the industry anyways.  I digress.  The paper is short and filled with fairly easy to digest analysis on where it can all go wrong.

On financial stability risks from exotic ETFs:

Among recent innovations, a specific trend warranting closer scrutiny is the recent acceleration in the growth of synthetic ETFs on  some European and Asian markets. In this type of ETF, the provider (typically a bank’s  asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.  Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults.  Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.  

I know I said the analysis was fairly easy to digest and maybe I lied, but I promise most of the paper isn't like that.  The paper continues to note the misaligned interests of banks being in this position.  They note additional fee sources, such as securities lending that are another reason why the creators love these things.  These funds make more money on securities lending than from the management fee on the ETF itself.  The asset management arms of companies use their own parent company trading desks as counterparties for derivatives which is a complete fee-fest.  If this has ignited your interest, I recommend reading the full paper.  It's short and you will be more aware of downside that people will say nobody saw coming whenever this blows up.

There's likely a bunch of money to be made in profiting from this all blowing up.  I don't know enough about the plumbing of the financial system to figure out where it will all go sensationally wrong, but c'mon, how could this not go horribly wrong?  For now, I'm sure the "innovators" are minting money.  The only bet I would make is that in +/-2 years, there will be some Propublica on Magnetar-esque epic documentation of the ETF industry equivalent.  Maybe it will resemble more AIGFP.