ETFs — a financial innovation, but caveat emptor
Given the explosive history of other innovations, it makes sense to ask whether exchange-traded funds will also lead to a disaster
In the comic strip Calvin and Hobbes, Calvin asks his dad how engineers determine the weight limit on bridges. The dad answers that they do this by driving heavier and heavier trucks over the bridge until it breaks, then rebuild the bridge after discovering what it took to break it. This isn’t how engineers actually figure out the safety specifications of bridges: as they know a lot about how physics works, they can predict how much it would take to break a bridge without actually breaking it. But the same isn’t true in the financial world. No one knows the basic laws that govern asset markets, so there’s a tendency to use new technologies until they fail, then start over. Calvin’s dad was effectively describing the process by which we test financial innovation. Mortgage-backed bonds are a good example. The original idea of securitisation of mortgages was diversification — instead of lenders taking on the risk of individual houses or geographic concentration, they could, effectively...
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