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Title : More excellent mailbag on the perils of passive ETFs
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More excellent mailbag on the perils of passive ETFs

Here's something received at IKN Nerve Centre midday today, which continues the subject brought up yesterday by VEP. This time, Another Reader has more light to shed. The entrance and exit blurbs are removed, what's left is what matters and darn, I'm lucky to have smart readers. Read on...

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As a mining banker I observe, on a daily basis, the corner of the market where these effects are most acute. Mining has absolutely no cyclical capital coming into it at the moment to paper over the cracks, so I’m left staring at the bare wreckage created by an absence of capital that is primarily due to the structural inefficiencies in the markets. And make no mistake about it, these structural inefficiencies are being caused by passive funds and ETF’s.

The succinct explanation as to why we should all be concerned, mining investment bankers or not, is as follows; If the dominance of passive funds and ETFs is followed to its logical conclusion, there is no need for a stock market.

Why? Because the biggest impact that ETFs and passive funds are having, invisible to most market observers (and especially those who don’t care about mining), is that the primary market for mining companies has been obliterated. While the secondary market seems superficially healthy, the new issue market is dead. A company with a good project, sensible capital structure and a a competent management team used to walk up and down Bay St before collecting a modest capital infusion for a drill program of merit, but there is now barely anyone left to write a cheque for them. And that is only partially due to the decline in the number of people willing to invest in mining, but everything to do with the fact that when ETFs take your capital, they don’t invest it in the primary market. If all of the capital willing to invest in mining is domiciled in ETFs, not a dime of new issue paper would ever get issued again.

“So what?”, I hear you say. Well, there are two reasons we should all care about this. Firstly, put yourself in the shoes of a mining junior. If you know you can’t raise capital on the public markets, why list? Sure, there’s a point being a public company if you’re big enough to get into an ETF or a passive fund, but the primary reason that juniors list is to raise capital. Which is a good thing because people like me and you get to participate in the upside of some great projects. But if you want all of the junior mining projects to be controlled by private capital, feel free to cheer on the rise of the ETFs.

Secondly, in my humble opinion, ETFs are indeed starting to look scarily like the sub-prime market before the collapse. In short, the liquidity of many ETF instruments is probably not matched by the liquidity of the underlying stocks, so in the event of a mass liquidation of ETF positions not all of your capital is coming back to you. I suspect that a significant market correction could create a scenario where ETFs have the potential to implode in a liquidity crisis reminiscent of that which eventually blighted the mortgage backed securities market. If you own ETF’s and there is a mass stampede for the exits, do you think that your only risk is the price of the underlying securities? The reality is that ETFs and passive funds are mispricing the risk that the holders bear. What every ETF holder is unlikely to be accounting for is the counterparty risk with the ETF provider who will need to liquidate ETF positions much faster than they can sell the underlying instruments in the event of a mass liquidation event.

On top of all this, don't even get me started on tracking error. I'd make a heavy bet that if you could ever precisely replicate the contents of an ETF over any given period in a portfolio of stocks you bought and sold yourself, that your performance would be significantly superior to that of the ETF itself. Call it a hunch, based on how much money the ETF providers are making.

Thus Article More excellent mailbag on the perils of passive ETFs

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