Don’t Buy What You Don’t Understand: ETF for Millennials and Finance Nerds.

What is an ETF?

With the rise of robo advisers such as Betterment and the word of mouth praises for how cheap and good it, more and more have dabbled in ETFs, but many may not know much more than what the acronym stands for and how it is a stock that buys a basket of stocks. Here is my ETF primer for my fellow millennials and finance nerds.

According to Bloomberg analyst Eric Balcunas’s ETF origin story, one of ETF’s inventors Nate Most said the idea of ETFs came from commodity warehouse receipts. Given it is costly and difficult to move commodities around the globe, commodity traders keep them stored at the warehouse and trade the warehouse receipts around. ETF does the same thing, except the commodities are stocks and they are stored at a custodian bank rather than in a warehouse.

ETFs are essentially the same, except slightly more complicated. To begin, the ETF issuer finds a fund custodian to store the basket of stocks. The ETF shares are created off of the basket of stocks stored at the fund custodian. Then, the ETF issuer finds a broker dealer bank to serve as the authorized participant (AP) to help manage the size of the ETFs and the basket of stocks stored at the custodian bank. For instance, if people want to buy more shares of ETF than created, the AP may buy stocks and exchange them for newly created ETF shares and sell these ETFs to the investors. Thus, the AP helped increase the size of the ETFs and the basket of stocks stored at the custodian bank. Similarly, if people want to sell their ETFs, the AP may buy ETFs and exchange them for stocks from basket of stocks stored at the custodian bank. Thus, the AP helped decrease the size of the ETFs and the basket of stocks stored at the custodian bank.

If this again sounds like gibberish, here is an analogy that might help. The basket of stocks is gold, the ETF is gold standard British Pound, the ETF issuer is the Bank of England, the custodian bank is Bank of England’s vault, and the AP is the Bank of England’s bankers. During the gold standard era, one could theoretically go to the Bank of England to exchange one’s British Pound into gold from its vault. As a result, gold and British pound are interchangeable (this requires the ridiculous assumption that there is no fractional reserve banking and there is enough gold to cover all the British pound). Similarly, the ETF and the basket of stocks are the same because one could theoretically exchange one’s ETF into the basket of stocks from the custodian bank. Also, when Bank of England has more gold, it can issue more British pound, which is no different from the ETF issuer creating more ETFs when it has a bigger basket of stocks. This is how ETF works.

What are its risks? (More for finance nerds)

First, what if the gold in the vault is impure or fake? In that case, the people who bought British Pound for the gold would have lost all faith in their British Pound. They will rush to the bank to exchange whatever pure or real gold in the vault and sell the rest of their British Pound. This could happen to ETFs. Since many ETFs hold financial derivatives that mimic the value of the basket of stocks rather than the actual stocks, it is possible that when investors rush for the exit one day, the financial derivatives will fail to mimic the value during extreme periods, leading to panic. Second, what if Bank of England changed British Pound’s conversion to include silver because it ran out of gold? In this case, people may also lose faith in their British Pound and rush to the exit. This could also happen to ETFs. There have been instances where too many people wanted to buy ETFs and not enough stocks to back them up. In this case, the ETF issuer decided to add other stocks into their basket of stocks so that they could keep on creating and selling ETFs. Third, what if many new countries are formed and they all start creating their own precious metal backed currencies? How will it affect the normal mining and trading of precious metals? The liquidity of ETFs and stocks are now called into question as ETF continue its explosive growth both in terms of size and number.

What are the implications of its risks? (definitely for finance nerds)

If the financial derivatives that back up many ETFs fail or lose value unexpectedly, many will take big losses. This may be just another market sell-off like the dot com bubble or it could lead to a bigger financial crisis where large systemically important financial institution are challenged. One reason to feel downplay this risk is that the global ETF market is only about $3 tn compared to the $240 tn total wealth worldwide and it is unfeasible that all ETFs will suffer big value losses due to the unforeseen risks mentioned above. However, one must also refrain from being complacent. The supposed infallibility of Mortgage Backed Securities led to the massive credit default swap bets on the side. While the MBS market at the time was only $8 tn, the notional value of the CDS was around $60 tn! It is often difficult to see the risks lurking in the shadows until it is too late. Lastly, even if it is unlikely ETF will be a trigger of a financial crisis, it is possible that ETFs’ explosive growth in terms of number and size have introduced changes to the market ecology that increase the system’s vulnerability. 

Casino Like Financial Markets

In this world where too much money is chasing too few assets, asset price inflation and subsequently, gambling on prices, become inevitable. This means that financial markets may turn into casinos, but this outcome is better than the alternatives.

To begin, money and assets are different in that money is cash, deposits, and cash like funds while assets are things that provide future benefits. In the past 70 years, the combination of post WWII peace, globalization, and the break from gold standard has led to the creation of lots of money. Peace allows households to just live and enjoy life, giving them the opportunity to make money without interruption. Globalization enables those who are good at making money to make lots of it. Lobster men in Maine and miners in Mongolia can now sell their goods far and wide at speeds and scales unseen before. Fiat currency made money printing possible. Whether the printing is to meet genuine economic demand or spurred by government stimulus, central banks no longer had to worry whether they have enough gold to back their money up. Putting it all together, it has been a perfect storm for money creation.

As for assets, there is simply not enough of it. There are lots of consumption goods, but there are not enough investment goods. While they both provide future benefits, only investment goods are assets worth chasing with one’s money. Since consumption goods’ values expire and depreciate, it makes little sense for people to park their money in these assets that lose value. As a result, money naturally gravitates toward investment goods, lured by the promise of capital preservation and appreciation. (Preservation is important because inflation eats away the value of money and appreciation is desired because what is a better way to make money than to make money with money).

What does this mean altogether? It means that asset prices will rise over time since there is too much money chasing too few assets.  Money has to go somewhere and it will pour into available assets. However, the process is messy and unpredictable (largely). The inflow of money is disorderly, unlike water filling an ice cube tray. Money will come in and out and assets will rise and fall. This volatility makes it difficult for assets to find and stay at an equilibrium price. Such opportunity to make quick bucks by predicting the direction of prices draw people in and those who captured by their animal spirits turn into gamblers. Also, as markets become more sophisticated, the typical buy low sell high strategy has evolved beyond one’s imagination. Instead of picking good stocks or a good house, there are now strategies betting on prices, interest rates, exchange rates, spreads, volatilities, and everything else.   

However, this is not a bad thing. This casino is better than other forms of gambling. Financial markets create much more good than Las Vegas’s casinos or horse race betting. Furthermore, it is much better to isolate the gambling on investment goods than consumption goods.

First, unlike Las Vegas and race tracks that end up creating lavish hotels and genetically engineered horses, this casino allocates capital, creates endless jobs, and spreads financial literacy. Though gambling sounds bad, the large number of market participants help enable a deep market. This deep market increases the possibility of someone out there willing to take the other side of the trade as a buyer or a seller. Whether it is buying a stock, foreign exchange, or an interest rate swap, one can feel confident that their transaction will go through at a given price. Through this deep market, resources can be allocated more efficiently. Stock picking rewards good companies by giving them a cheaper cost of capital. Foreign exchange forwards allow companies to put their idle foreign exchange to good use to those who wants to buy it now for the future. Interest rate swaps enable companies to swap their less desired fixed interest rates for a preferred floating exchange rate. Also, ever since financial markets evolved from a room of loud traders to electronic markets that now exists in the clouds, financial markets can now create jobs anywhere. In comparison, the jobs created by casino and race tracks are mostly limited to those within the proximity of these sites. Lastly, working as part of the value chain of financial markets, one is able to become an expert in financial matters. These workers are not only able to use these skills for themselves, but also become agents to spread financial literacy to others. Financial skill is much more applicable and useful compared to knowing how to deal in black jack and knowing how to brush horse’s hair.  

Second, it is much better to have this casino on investment goods than consumption goods. If the flood of money is channeled toward chasing consumption goods, it would no longer be known as capital appreciation, but as hyperinflation. The first allows people to preserve and grow their wealth while the second destroys their wealth through the erosion in their purchasing power. One is happy to see his or her 401K investment balance goes up, but one will be distraught to see the price of daily items spin out of control. One observable example can now be seen through housing. Homes are both a consumption good and investment good. People consume housing for shelter, but they also invest in homes for their retirement. The dual purpose real estate serves doubles the demand for this asset. As a result, home prices have skyrocketed in past decades as more and more wealth chases this asset, which often struggles to keep up with the demand. This phenomenon has forced poorer people out of their neighborhoods at best and created destructive housing bubbles at worst. Even till today, housing continues to be a thorny issue despite the numerous painful experiences of housing bubble bursts in Japan, US, Europe, and elsewhere.

In the end, we are left to choose our own poison. By accepting conflict, protectionism, and gold standards, one can create a world with less money. However, the weak and powerless will undoubtedly suffer more. Destruction is more costly to them, protectionism hurts poor nations’ income and deprives rich nations from cheap goods, and gold standards limit stimulus and cheap credits. If one accepts the current arrangement and let money creation continue, then one may be left with hyperinflation or casino like financial markets. I do not know about you, but between the two, I pick casino like financial markets.