Buyer beware: ETFs can bite you

Is the stock market giving you a case of mental whiplash? The market rallies on hints that Europe's leaders will manage the massive Greek debt restructuring. But wait -- maybe European politicians lack the political will to cope with the Mediterranean sovereign debt crisis -- and stocks retreat.

The high-octane market turmoil is also being fueled by a two-decade-old innovation: exchange-traded funds or ETFs. Market regulators fear that the ETF market could be a bubble in the making. The heightened scrutiny of the market is welcome and, hopefully, will stave off problems.

Readers of this column know I'm a long-time fan of so-called passive index investing. Investing in low-fee, broad-based equity index mutual funds and bond index funds has moved over the past three decades from the margins of Wall Street to a Main Street mainstay investment. Nobel laureate William Sharpe rightly called indexing "a dull, boring way to be a better investor than many of your friends."

There is nothing dull and boring about ETFs. They offer investors an alternative way to take a stake in the performance of an index. An ETF is based on an underlying index but it can be continuously bought and sold on an exchange just like a stock.

Here's the rub: The rapid growth of ETFs and the market's embrace of speculative returns. The history of finance is to turn a good idea that addresses a need into a bad product that feeds the speculative frenzy of the crowd. A recent example is mortgage securitization. Wall Street tapped into the securitization technology to bring much-needed capital into the U.S. housing market in the 1980s. The product eventually evolved into highly toxic collateralized debt obligations -- CDOs -- in the 2000s. Investors took a huge hit when the CDO boom went bust.

History may not repeat itself, but it certainly seems to rhyme when it comes to ETFs. It has been transformed from a plain-vanilla, low-cost index-investing option into highly risky, complex and opaque security.

Many of the newer ETFs rely on derivative securities to leverage potential returns -- and potential losses. The market is rank with conflicts of interest. It lacks due diligence and sufficient regulatory oversight. Put it this way: It's easy to get into trouble buying complex investments and financial strategies. Yes, there is still a role for the "old-fashioned" ETF for some long-term investors. But for most people there's too much fast money at play.

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org.

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