To both the public and professional trading communities Exchange Traded Funds, better known as ETF’s, must look like a winning proposition. There are many reasons that the rapidly expanding number of the specialized trading vehicles that are on offer can indeed be of benefit. However, there are also risks, especially for retail investors who might not be as adept as those in the professional trading community at understanding the full nature of these instruments they are buying or selling. Yet, we can not disagree with the proposition that the ability to make specialized investments in subsectors of broader asset classes, or manage risk on positions that occur well after the beginning of a particular trend appears to be very attractive.
And that has never been more so the case than in present markets that have such significant divergence of trend potentials. That is driven by major negative ‘outside’ possibilities (tail risks) within what we are consistently told is a generally improving situation, even for the lagging highly developed Western economies. In addition to any of their other advantages, it makes ETF’s a very good vehicle (especially for retail investors) to attempt to profit from extended market trends while still tightly managing risk.
For the average investor, and even professional capital markets participants, it all feels a bit like Dorothy’s trip through Oz: “Chinese rate hike, Portuguese downgrades and US debt ceiling, oh my!” Of course, some of these things are readily discounted as overblown compared to the reality that is likely to ensue. The third Chinese rate hike this year is simply a further step in cooling a previously overheated economy; and everyone is hoping/suspecting they can achieve a ‘soft landing’.
The downgrade of Portugal’s government debt is still not as bad as the situation in Greece; and even in the latter it is now assumed that even in the event of a default being declared by the credit rating agencies the ECB will continue to accept its paper (with a further lowering of the ECB’s collateral standards.) And as significant a problem as the US debt and fiscal situation might be, it looks like the Democrats have run out the clock on the Republicans, forcing everyone to accept an interim deal that will avoid striking the grand bargain that will include major entitlement program reform. That will now wait for another day.
A final note on the current investment/trading background as it relates to the influence of ETF’s on the underlying markets: There is probably something to be said for both the overall improvement in general economic conditions across the cycle, and the potentially dire nature of the “tail risks.” However, both in light of those primary divergent influences, and also even allowing for the classical anticipatory nature of markets, a somewhat significant amount of recent market activity appears to be more distorted than usual.
The recent activity in the September S&P 500 future (as a proxy for the other equity indices as well) seems to be driven by some sustained buying or selling that goes beyond classical tendencies. Along with that significant divergence of overall trend potentials, our hunch is that this is due to the ease with which retail investors can now feel comfortable managing risk in extended trends.
