Caveat emptor – “buyer beware” – is always a vital cultural trait for asset managers, even if you’re just researching hedging instruments. The danger is not giving it the necessary attention: if it’s a candidate for a spot in your portfolio, be it a long-term investment or a hedge, it must be subject to the same rigorous research effort. This LEX piece on ETF regulation reminds us that even standardized, liquid, exchange-traded instruments can be as opaque as the “darkest” of OTC instruments. In this particular case, some ETFs are built low-risk assets as collateral for the principal with a layer of derivative contracts/ instruments to replicate the index or security basket the ETF is supposed to track. The problem is transparency – sometimes it isn’t clear at all what exactly is being used. And it’s amazing how little the salespeople really know about what they’re offering, so the burden is on you.
Here’s a link to Part Two of their LEX series on ETFs. This one argues that the growth of ETFs can maybe increase price distortion (since most ETFs are just “blindly” following indexes that mix “good and bad” assets) and, in the long run, favor stock pickers. Makes sense, but seems a bit of a stretch.