Complexity And Transparency

So, Jim, if investors really don’t know what they are doing in some of the more complicated areas of the ETF/ETC/ETN market, what’s the solution?

What you wrote in your blog yesterday brought to mind a book I was reading in the plane on my way to the “Inside ETFs” conference a couple of weeks ago, and also a comment I saw yesterday.

In J.K. Galbraith’s classic study from 1975, “Money – whence it came, where it went,” the author asserts that complexity is used by practitioners in the world of money to disguise or evade the truth. Think of all the jargon bankers have invented in the last few decades – alphas, betas, SIVs, CDOs, conduits, to name just a few, and you can see Galbraith’s point. Then you can add the acronyms that regulators and finance ministers (probably the worst offenders) have come up with over the last year or two for their (largely ineffective) rescue packages – TAF, TSLF, PDCF, CPFF, MMIFF, TALF and now TARP. It’s no wonder legislators are having trouble working out where the money is going.

On a similar note, here are Joseph Stiglitz’s comments from this week’s Davos conference, reported yesterday on Bloomberg. “The financial system will kick back against transparency. Those working in markets see information as power and money, so they depend on a lack of transparency for success,” Stiglitz, of course, won his Nobel prize for research on information asymmetry – what happens when one party in a transaction has access to knowledge that others don’t.

Developing this idea further, would Bernie Madoff really have been able to get away with his alleged scam if he hadn’t claimed to be investing his clients’ money in something called “split-strike option conversion”? And how about this for Jerome Kerviel’s explanation to his bank’s internal audit department, when asked to explain why he was running such huge trading positions – “That materialises give-ups of the futures that were made late, I owe money to the counterparty. We’ll rebook asap.” Got that? Me neither.

Now none of this is to imply that there is anything wrong with commodity trackers, where having to deal with the intricacies of the futures curve, negative and positive carry is simply a fact of life – there really is no way around it. But it reminds us that we should all remember, as investors, to add a second key principle to the first (“caveat emptor” or “buyer beware”) – if you don’t understand, ask, and if you really don’t understand, don’t invest.

The age-old tension between complexity and transparency will always be with us, and if ETFs have, overall, represented a healthy move towards making things cheaper and clearer for investors, then the providers of financial products will always have an incentive to complicate things and add an extra 50 basis points to the cost as a result.

In general, this tension provides grounds for healthy competition. Is it worth spending an extra half a percent or more a year on fees to buy a RAFI fundamental indexation ETF, or Lyxor’s WISE quantitative ETF, rather than buying the cheapest DJ Euro Stoxx 50 tracker at 0.1%? Good question, and this is something we’ll be looking at shortly in a feature on the site.

But if the principle behind an investment product can’t be explained in a few jargon-free sentences, then it is probably best to stay well away.

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