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Proceed with caution: State of the Exchange Traded Products

Our Reformed Broker ruminates on the future of Exchange Traded Products (ETPs), which he believes will, at a certain point in the coming decade, completely swamp the mutual fund and ultimately eliminate it from the market.

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Jonathan Ernst/Reuters
Securities and Exchange Commission Chairman Mary Schapiro and Commodity Futures Trading Commission chairman Gary Gensler talk to reporters after testifying at a Senate hearing on systemic risk and market oversight, in Washington in this May 2012 file photo. The SEC in 2010 stopped approving new funds, including ETFs, that make significant use of derivatives, pending a review.

Exchange Traded Products (ETPs) are probably in the 3rd or 4th inning of their renaissance.  As a professional and both a frequent user and critic of them, I've learned to take the good with the bad.

I believe that at a certain point in the coming decade, the ETP wrapper will completely swamp the mutual fund and ultimately put it out of its misery.  This is not to say that I'm thrilled with everything happening in ETP land, specifically the rise of derivative-based ETNs that are probably way less steady and understandable than they should be.

The state of the biz via Bloomberg below:

ETPs were the fastest-growing major investment product over the past decade, as investors embraced their simplicity, tax efficiency and low cost. Assets in the U.S. increased almost 14- fold in the 10 years through April 30 to $1.19 trillion, according to the Investment Company Institute. US investors added $4.82 to exchange-traded products last year for every $1 they deposited with mutual funds.

Those same investors can choose from more than 1,400 ETPs, a term that includes funds, trusts and unsecured notes, according to data compiled by Bloomberg. Exchange-traded notes, the equivalent of bonds, are unique among ETPs in that they aren’t backed by a pool of holdings owned by shareholders. They represent merely a promise to pay a return, defined typically by an index.

Derivative-based ETPs and ETNs have swelled since they were introduced in 2006 to $58.8 billion, accounting for 4.9 percent of ETP assets in the US. The SEC in 2010 stopped approving new funds, including ETFs, that make significant use of derivatives, pending a review. The suspension doesn’t affect products such as ETNs that aren’t registered under the 1940 Investment Company Act.

Innovation is great, but we have to accept the fact that there will be failed and even dangerous innovations along the way.  In my view, we are at the stage now where many dangerous notions are being productized - so it is up to the individual to not do stupid things with new vehicles they don't truly understand.

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