American Consequences - February 2019

It’s simple economies of scale and power. Any time human effort is multiplied, the good and bad effects are multiplied as well. The effect becomes progressively greater and potentially worse when humans are removed from the equation and no longer understand either the technology or principles involved. That last part is key. After all, both mutual funds and exchange-traded funds (ETFs), consist of capital gathered by investors that allow fund managers to invest vast quantities of money. In both cases, investors are no longer buying shares in a specific company, but shares in an idea. Then the fund proceeds to buy assets that meet the criteria of that idea. But even though mutual funds and ETFs move the investor a step away from direct ownership, there’s still transparency and human oversight. The investor knows the criteria that the fund or ETF is using to buy assets and can see what assets were bought and why. Should a fund or ETF go belly up, it’s relatively easy to sort out the wreckage. While funds and ETFs hold enormous sway in the markets, the transparency and self- imposed limits make

One of the major causes of the financial crisis were the derivatives which Wall Street brokers and insurance companies were selling to investment managers and corporations as ways to play investment ideas and “hedge themselves.” But these derivatives were so complex no one fully understood what they were owning. And the hedges didn’t work like they expected. Many of the derivatives were baskets of different ideas lumped together. And unlike ETFs, they contained far more exotic products than garden variety stocks or bonds. Because these exotic components were blended together, when one part (subprime mortgages) went bad, the whole thing had to be thrown out. Imagine if there was a nationwide recall of flour... If you had separated and labeled all your ingredients in your kitchen, all you have to do is throw out your bag of flour. But if you’ve already baked a cake, you must throw out the whole cake. Because ownership of derivatives was vast, everyone was trying to unload them at the

Without a human with a hand on the throttle or brake, these programs can intensify the havoc on days with big moves up or down.

them a wise use of economies of scale.

$16,000 $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2.000 $0

ETP ASSET GROWTH

In the chart to the right, we’ve marked the growth of these exchange-traded products (ETPs)... The real problems come when you have zero transparency and zero humans.

1993

2003

2013

2023

68

February 2019

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