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What the ETF?


Securitized debt, commodities now global risks.

Having been there at the beginning, I can comfortably represent that beyond the obvious goal of capital arbitrage, there were two other principal objectives of securitization: expanding the investor base for financial assets (a critical concern with the on-going consolidation of the financial services industry) and increasing the liquidity for what were at the time perceived as largely illiquid loan assets.

What I did not appreciate then was that a broadened investor base, particularly inexperienced investors, and enhanced liquidity have been critical elements of every financial bubble in history – from tulip bulbs to Chinese stocks. (And in the interest of full disclosure, bubbles always begin with a seemingly credible demand proposition – "The Internet will change how business is done," "China represents an invested market," and "Housing always goes up in value.")

Of late these principles have had me thinking about the commodity space: Credible demand proposition? Absolutely. The world, particularly Asian economies, are growing dramatically.

Broadened investor base? Also absolutely, starting first with new entrants like pension and endowment funds, then moving into retail investors.

Enhanced liquidity? Bingo. Can you say "commodity ETF's"?

So this got me thinking about ETF's. What started with the simple goal of creating "tradable index funds with lower cost and greater tax efficiency for long term investors" has exploded into a vast array of commodity and leveraged long and short funds.

But after recently reading that GLD, the largest gold ETF fund, was the sixth largest holder of physical gold after the nation of Japan, I got to wondering whether the "broadened investor base and new found liquidity" of commodity ETF's has contributed in a meaningful way to the bubble in commodity prices.

In thinking about the sales process, who wouldn't want to buy GLD – as a hedge against the falling dollar/global instability - or OIL or DBC – as a hedge against rising fuel and food prices?

And given that global instability and inflation are key issues for professional money managers and retail investors alike, everyone has signed on. But, as Irving Fisher pointed out back in the 1930's, "Every man who hoards does it for his own protection; yet by hoarding he aggravates the very condition that started his fear."

I believe that we are either at or quickly approaching that point.

But as we have seen in the world of securitized debt, those seeming benefits of a "broadened investor base and new liquidity" can (and I would suggest likely will) add speed and severity to the downside as investors exit. (And if you don't believe me, take a look at the chart of SKF – the Ultrashort Financials ETF – which, after peaking at $150 on March 17th, fell to $100 a mere 4 trading days later!)

But what I believe very few investors fully appreciate is that for the first time in financial history, the bubbles – in securitized debt and commodities – are truly global phenomena. And, at least to these eyes, if they have been the fuel behind the rapid economic expansion of the past ten years, their price collapse is likely to be a significant drag for the next phase of the world economy.
Position in DBC, SKF and USO options.
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