But what happens in a crisis? Suppose some bonds turn out to be a lot lower-quality than most investors believed. Without ETFs, those bonds would plunge in price, but other bonds would be fine. But now imagine that both the bad bonds and the good bonds are all bundled into ETFs. Now, when the bad bonds are discovered to be bad, investors who ignored the composition of their funds will suddenly wake up to the fact that they might contain toxic assets. Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don't.
With assets like stocks, this isn’t so much of a danger -- when stocks go bust, everyone can see which ones are bad. But when the ingredients in an ETF are complex, highly heterogeneous assets, as is the case with many bonds and derivatives, one ETF might be fine while another is worthless, and yet investors may ignore the differences until it’s too late.
Another possibility, pointed out to me by a friend in asset management, is that some of the individual securities in an ETF might start to have their own liquidity problems. If banks or other big broker-dealers suddenly become unwilling to facilitate the trading of certain kinds of bonds, ETFs that include large amounts of those particular bonds might suddenly plunge in price. Investors now buying up ETF shares might not realize that danger, thus leading to general overpricing.
So the more bespoke and exotic markets ETFs expand into, the greater the worry that they could be involved in a 2008-style liquidity crunch. That could pose risks for key financial institutions that hold ETFs, and it could also spell danger for individual investors’ retirement savings.
A few people are already worrying about this possibility, which is good. The more we worry about financial innovations in advance, the less chance we’ll need a crisis to teach us the limits of those innovations.
This Bloomberg View column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.