ETFs And a Phantom Market – How The ETF Industry is Changing Wall Street

While the rest of the world is piling their cash into ETFs I begin to wonder what kind of effect this might have on the market just a few years from now. Think back to 1992, when the housing market was plummeting and the Asian Financial crisis was reaching its peak. The Asian bust was largely the result of huge derivatives holdings, and what are ETFs? Nothing but derivatives.

I have to wonder where the ETF scene will take the stock market. At present you can buy into hundreds of sectors, commodities and even indices.

But with many of these ETFs you never truly own what you think you do. Usually your money is thrown into a basket, complete with futures and other complex instruments meant to artificially replicate the returns of hard assets. But to do so is nearly impossible and no one on the planet can perfect natural volatility.

Look at the most popular ETFs on Wall Street right now. They’re precious metal ETFs, iShares Silver Trust (ETF) and SPDR Gold Trust (GLD). Both of these ETFs do maintain gold and silver so they are not a derivative. But what they do is track the return of gold on the open exchange. However there is a problem with that, with each ounce put into either of these trusts it takes one ounce from the open market.

Simply, ETFs lock up supply. When you sell SLV, you’re selling shares of a trust and are unlikely to get any silver in return. This silver does not trade on the market, is not calculated in the metals markets and does not affect supply.

Let’s consider that these funds get even bigger. What if we get to the point where ETFs are all the rage, that investors focus only on exchange traded funds and forget the smaller stocks that make them up. Stocks would become nearly irrelevant, as the only price changes would come from ETFs buying and selling to eachother. And exactly how many ETFs make frequent trades, well, that number is just about zero.

So at what point is the tracker bigger than the lead? I mean, at what point do ETFs become bigger than the market they seek to track. And if this happens, does the ETF set the price for say, gold and silver, or does the ETF merely track a smaller market. Does that make any sense?

I fear what we’re doing now is going down a path of inefficient prices set by increased speculation. If ETFs continue their growth, which they should considering their many advantages particularly at tax time and when annual fees are due, they could easily grow to lock up supply of the daily commodities we need to get things going.

At this point I see ETFs as a phase that will naturally select itself out. If growth in the ETF industry continues as it has, they’ll exceed the value of the stock market in just a few years.