Any routine reader of this blog will know I'm a fan of Exchange Traded Funds (ETFs). ETFs are fast becoming the world's most popular investment product. The king’s crown of most popular product still belongs to active mutual funds, but ETFs are on pace to dethrone them.
With rare exception, ETFs are far cheaper to own and have much lower tax drag than most active mutual funds. Most mutual funds are also sold for a commission by the largest sales force, the million or so stockbrokers in the US. The big brokerages (Merrill Lynch, Morgan Stanley, et al) along with the big active fund families (Fidelity, Dreyfus, et al) generally find ETFs are eating their lunch. The reasons are many; mostly indexed construction (eliminating typical fund underperformance); generally lower cost (sometimes by 40x lower); and better tax treatment (often zero declared taxable gain on a 1099). You can clearly see why a near wholesale shift is underway. But this has not come without the typical gnashing of teeth, as you would expect from those being supplanted.
While ETFs have long been used as a strawman to saddle with blame for a myriad of the market's quirky behaviors, it's often sour grapes behind the motive to discredit ETFs in order to sow doubt. It is not general structural flaws with the ETF industry as many would love for you to believe. With volatility now spiking and some ETF involvement, you should now brace for an entirely new wave of writings attempting to hang the noose on ETFs. As with any misleading argument, there are typically threads of truth that are woven into an erroneous conclusion. There is plenty of evidence that newfangled leveraged and inverse ETFs have had some very surprising outcomes. Levered inverse VIX (volatility index) ETFs got obliterated in the recent spike in volatility. One was recently down 95% in just a few days. This probably spilled over into other areas. One whistleblower also filed a complaint last week claiming the VIX index is getting manipulated by traders reporting bogus stock option quotes that don’t get executed at that price, in order the skew perceptions of risk and the price of volatility. These forces seem unrelated to ETFs, but may have contributed to the near death experience of the VIX double inverse ETF.
But levered inverse ETFs are generally structured as futures funds. Any reasonable person would expect some danger. They generally bet against a particular index with 2x or 3x leverage. But if you're an over-confident novice who’s been shopping for ETFs by reading the performance column in the newspaper, you might have blindly bought the levered inverse VIX ETF because of a multi-year 40%+ annual rate of return. Chasing performance blindly can periodically blow up in one’s face.