AllianceBernstein CEO Peter Kraus is not a big fan of ETFs. In fact, he’s not much on the whole idea of passive investing. Given who he works for and where he comes from that’s not too surprising, as AB sells mutual fun products and Kraus spent 22 years at Goldman Sachs. But his views are still worth a look regardless of his bias.

“Let me bring it down to reality,” Kraus commented in a recent sales meeting with a large group of financial advisers. “You guys woke up one morning in August and the Dow was down 1,090 points. And on that day a $40 billion E.T.F. traded at a 30 percent discount. That should never happen, and if your client traded on that day, you will never get that back. Never. These funds may have low fees but they are not safe, and your clients need to understand that.”

ETFs

Concerns about the impact of ETFs on the financial industry

Kraus went on to note: “If you absorb too much liquidity, there is just not enough grease to make the wheel work. We have seen much higher volatility and much faster price reactions over the past few years, and the main reason is this shift from active to passive investing.”

The ETF industry has grown rapidly over the last five years as active management has underperformed, with around $3 trillion under management today. As ETFs have become an investor mania, worries that too much hot money has been lured into hard-to-trade areas of financial market and into risky strategies are surfacing.

Recent critics include Stanley Fischer, vice chairman at the Fed, and well-known investors like Carl Icahn, Howard Marks and others. Nearly all of the critics point to the same worrisome scenario: what if heavy selling hits these funds, and investors are unable to get their money back as promised?

The ETF critics argue that a rush of money into funds that offer instant liquidity favors players with a short-term, trader’s outlook as opposed to the patient, longer-term investor’s perspective.

Moreover, the volatility seen in markets over the summer and early fall has heightened these fears. The critics argue that the promise of instant liquidity in illiquid areas — such as emerging-market bonds, leveraged loans and credit-default swaps — is a recipe for disaster. They also highlight the 2X and 3X leverage many ETFs offer as another significant risk.

Only time will tell.

AB's Peter Kraus Says ETFs Are A Big Problem
Source: Wikimedia Commons