7 Looming Financial Bubbles
Recently, Forbes published an article that pointed to seven different areas where there may be financial bubbles. The interesting article does highlight some areas with which we concur but the article completely misses out on some important structural changes that are driving the financial markets in the recent past. The slide show in the artcile points out to seven areas (reproduced as in their order) where bubbles may be forming including:
1. Gold
2. China
3. Emerging Markets
4. US Treasuries
5. College Tution
6. Exchange Traded Funds (ETFs)
7. Copper
We would probably agree that there is a possibility of a bubble in Gold and maybe even in the US Treasuries while completely agreeing about the likelihood of a bubble in China and Emerging Makets.
One area where we think there will be little scope for a bubble is in the area of Exchange traded funds (ETFs). We believe that the rise of the exchange traded funds is a unique structural change that is taking place in the world of finance. It is likely that these funds will over the next few years replace mutual funds as the preferred investment destintation for a class of investors who willing to take more risks for the sake of higher returns. This is not to suggest that mutual funds will disappear. Instead mutual funds are likely to cater to a different set of investors whose risk profile is completely different from those who invest/speculate in Exchange Traded Funds.
We believe that the rise of ETFs is part of the process of financialisation that has accompanied the growing monetisation which in turn has been accompanied by the increased influence and spread of the financial markets. An important reason why the ETFs are likely to stay is that they not only enable even the most sophisticated speculators who oversee billions of dollars but also enable small time investors/speculators/traders to take directional bets on a particular market or or a particular segment of the market or asset, something that was not possible even five years ago. More importantly, the scope for financial speculation is now truly global. It is now possible for investors in any part of the globe to open trading accounts and buy/sell these funds.
The special appeal of the ETFs is that they have financialised any type of commodity/currency or their derivatives. These new financialised products are now available to even to an individual investor with limited surplus and little or no leverage. The minimum number of units that an investor has to purchase is one (though it would be uneconomic to purchase such small quantities due to high transaction costs). Investors can now bet on the direction of even something like nuclear power through ETFs (traded under their symbols: PKN, NUCL and NLR), most of the major currencies, most of the commodities and even countries. Since they are avaialble even to investors who can only invest in small amounts they have become popular. It is likely that investors (especially the larger ones) will increasingly consider ETFs as being central to their trading/investing strategies and one should not be surprised if over the next one decade they overtake the Assets Under management of the Mutual funds. Such indications are clearly visible in the exponential growth of some of these funds. Take the case of the SPDR Gold Trust (Symbol: GLD). Over the years (it was originally listed in 2004), it has emerged as the sixth largest holder of gold (1132.71 tonnes as on 22 December 2009) exceeding most of the countries of the world.
There are also growing concerns about the economic impact on the real (actual economy and not the financial markets) that these financialised funds are having. It has also led to record trading in those commodity futures. The case of the United States Natural Gas Fund (Symbol: UNG) and the recent debate about the size of the fund because it owned nearly 20 percent of the outstanding natural gas contracts in the USA and its subsequnet problems with the US Regulator, CFTC. It led to a change in rules.
The ETFs have drawn widespread interest due to their ability to facilitate financial speculation by reducing costs (since they are traded like any other securities,) liquidity, as well as their abiliity to attract even people with limited resources. This is a far cry from the past when speculating in some of the important markets in the sphere of commodity and currencies were limited to institutional players. Unlike in the past, one need not (though it is still preferable) to be close to the metropolis to speculate in the financial markets. ETFs combined with technology means that one could reside in any part of the world and still specluate (successfully).
It is pertinent to note that a number of these funds have been unable to meet the demand and have frequently had to approach the regulators in order to increase the shares that they would like to issue. The most recent is the currency ETF (symbol: UUP).
Another important innovation in the world of global finance is the possiblity of betting on the possibility of a country going bankrupt through the purchase of a Credit Default Swap (CDS). This is supposed to work as an insurance policy on a country. It rises when investors perceive there to be trouble in the economy of a country. This is precisely the problem in the world of present day modern day finance. There need not be actual economic trouble at that juncture, but if a set of influential institutional investors think that there is trouble then the CDS may start rising and that would in turn lead to more capital fleeing the country, thereby accentuating the decline, which may have started with a speculative attack (more on this later as it is beyond the scope of this post).
Welcome to the world of highly speculative agile world of capital.
Read this interesting article on money managers who are now activing as "risk Vigilantes"
Speculators have never had it so good: Zero percent interest rates, sovereign guarantee for banks means that our money is safe (at least as long as the government is solvent) and amazing choice of financial products to speculate on.
