The regulatory dangers facing ETF’s

Exchange Traded Funds, or ETF’s, have been doing very well of late with retail money pouring into its coffers but regulators are now beginning to take note of all the money being invested in the ETF industry. These funds are distorting market prices and regulators are now closing in on these funds that are chock-a-block with derivatives and betting on extremely risky markets. As one ETF after another will come unstuck, expect there to be a domino effect that affects other ETF’s too.

The Unique Selling Point of any ETF up until this point was the fact that they are a cheaper investment vehicle than mutual funds and it offers easy access to emerging markets and commodities for many that are just beginning to invest money. The ETF industry is expected to grow at 20-30% this year alone and the assets they manage totals $1.1 trillion right now, which still doesn’t compare to mutual funds that hold $19.5 trillion in assets. ETF’s are indexed to several commodity and emerging markets, but many of these markets are just too small to handle this kind of money and so large-scale buying has inflated the value of fundamentally poor companies just as it has fundamentally strong companies. U.S regulatory authorities are by their nature meant to limit ETF’s by taking away a large chunk of the money invested in emerging market funds and commodities, which are interrelated. An intense concentration of funds is not healthy, but it has been inevitable with very few companies to invest in.

Take the iShares MSCI Brazil Index ETF as a case in point. It has approximately $9 billion invested in assets, but 33% of that is put down to oil biggie Petrobras and mining company Vale do Rio Doce. As it stands, investing in an ETF does not mean that your investment is diversified in the slightest because your money is tightly concentrated in a few pockets, such as oil and minerals when it comes to Brazil. As more money enters ETF’s, they tally their holdings with that of emerging markets and this drives up share prices, drawing in more money. This is a vicious cycle that will not help markets that already have very clear boom and bust cycles. And it is to clamp down on this that the regulators are swooping in now. This can only be a good thing since the current structure is very open for fraud and ETF’s are crying out for controls lest investors are left the victims of their success and failure.