THE ECONOMIST: Gamblers go all-in on ETF fad. Why retail investors are punting big on exchange-traded funds

Finance is an industry of ceaseless experimentation. The experiments which pay off are quickly copied and propagated through the market. That is often to the good. But left unchecked, innovation places intolerable risks on investors and the financial system.

Consider exchange-traded funds (ETFs). The idea — that securities can be wrapped together and the resulting bundle traded on an exchange — is straightforward. For most of their history, which began at the Toronto Stock Exchange in 1990, so were the assets they held. ETFs have reduced the cost of passive investing in equity indices like the S&P 500. More recently they have had the same effect in bond markets.

But the past few years has also seen the rapid expansion of more complicated products, including leveraged ETFs.

These funds, designed to give investors multiples of the daily return of an asset using swaps and futures contracts, now manage around $US100b.

Retail investors punted huge amounts into these funds as markets swooned in April, in the hope that they were exploiting a dip, rather than being exploited as dips themselves. The boom in speculative ETFs is mad indeed. But how risky is it?

There have been 340 ETFs launched in America this year, around 50 per cent more than during the same period last year (leveraged ETFs are predominantly an American phenomenon). Among these fledgling funds, most offer exposure to some country, sector or trend. Others have more esoteric pitches.

The Anti-Defamation League, an advocacy group, launched one to invest in companies it says align with Jewish values. Some mimic the strategies of famous investors, including Warren Buffett.

Mostly, though, these new funds are designed for gamblers: one fund promises investors triple the inverse of the daily return of shares in American banks; another, leveraged exposure to Nvidia and AMD, two chipmakers; another, twice the daily return of Donald Trump-owned Trump Media & Technology Group. Some of these funds would make the credit derivatives of the 2000s blush.

ETFs are certain to get spicier still. One prospectus proposes an ETF which would bet against two other double-leveraged ETFs linked to the share price of Strategy, the volatile tech company investing billions of dollars in bitcoin.

Gary Gensler, the head of the Securities and Exchange Commission under President Joe Biden, did little to prevent these funds growing. His replacement, Paul Atkins, is likely to be even more amenable, especially when it comes to funds investing in cryptocurrency.

Trump Media has said it will soon start selling MAGA-themed ETFs in partnership with Crypto.com. (Scott Bessent, Mr Trump’s treasury secretary, recently told school-age children in a recorded message, “Financial literacy will make all the difference in your future.”)

Most of these funds seem designed to incinerate investors’ money. In addition to their volatility, and unlike their low-cost forebears, they charge high fees; fee rates on leveraged ETFs approach those levied by hedge funds.

How dangerous are these new ETFs for the rest of the financial system? One worry is that they are making markets more volatile, since leveraged ETFs often cause large bouts of buying and selling at the end of trading days so that they continually reflect a promised return on underlying assets. This effect will only increase as the asset class grows.

A more hypothetical, but potentially more severe, worry involves the mechanics that allow ETFs to function in the first place. When the price of an ETF differs from the value of the securities it holds, financial institutions, often hedge funds, create and redeem ETF shares to close that gap. This arbitrage opportunity keeps the value of ETFs in line with their holdings, underpinning investors’ faith in the funds.

Recent volatility has led to some uncomfortably large gaps between ETFs and the value of the assets they hold, particularly where those assets were illiquid loans. More complex products and volatility could test this process further, perhaps to its limits. Even if it does not, these new funds indicate that the market is becoming a casino.