The recent UBS “rogue trader” debacle illustrates that, while exchange traded funds based on major indices may be suitable investments for many investors, more extreme and exotic exchange traded funds often involve tremendous risk, and are therefore unsuitable for most investors.
The press has been reporting on how a UBS exchange traded fund trader, who worked on the firm’s Delta One desk, racked up losses of $2.3 billion for the bank. The Delta One desk is a complex area that designs trades using a variety of swaps, futures and exchange traded funds that allow the bank and its clients to speculate in and hedge baskets of securities. The trader in question, Kweku Adoboli, reportedly helped structure exchange traded funds for clients and hedged the bank’s positions presumably entered into as a counter party to the client. This situation underscores how dangerous exotic exchange traded funds can be.
The first exchange traded funds provided low-cost, liquid exposure to a broadly diversified index of stocks. The benefits of lost cost and high liquidity resulted in a huge spike in demand for exchange traded funds. The increased demand led to a proliferation of funds, many of them extremely concentrated and complex, using derivatives (futures and options contracts) to increase leverage. With the increase in complexity and leverage came a vast increase in the level of risk associated with these products. A fund may or may not be backed by collateral, and if it is, the collateral is not necessarily the index that the fund is tracking.
Most investors lack the background and expertise to understand and evaluate the risks of such complex investments. Vanguard’s Jack Bogle, who invented the retail mutual fund industry, refers to the growth of extreme and exotic exchange traded funds as “insanity” that “caters to investors’ worst instincts.” Regulators too have expressed concern. It will be interesting to see if the UBS debacle converts that concern into regulatory action.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. For further information, please contact us.