More than six years after the collapse of Lehman Brothers triggered six months of near financial anarchy the SEC has announced plans to start stress testing mutual funds. Under the new rules asset management firms will be forced to disclose more detailed information about their holdings and create a variety of scenarios designed to simulate how the funds would act under extreme conditions.
As is the case with all of the nearly endless tests created to prevent another financial crisis, the idea seems full of good intentions but arguably toothless. According to Lee Kranefuss who is credited with fathering the modern ETF and is currently at Source ETFs, regulators are trying to do much with a limited tool.
“I’m not sure you get all that much,” says Kranefuss in the attached video. An examination would presumably safeguard against outright fraud but simulating a figurative run on the bank is unlikely to result in any surprises. Prices will move lower. “It can’t hurt but will it help?”
Perhaps not in terms of defining downside for vanilla funds but some of the levered ETF products that are ceaselessly birthed into the financial system could probably use some more supervision. Basically the two questions are: will a product exacerbate systemic risk and does it behave the way it’s supposed to under given conditions.
The answer to the former is yes more often than regulators think. It is the height of folly to think human nature has evolved to the degree that Wall Street won’t again come up with ill-conceived products like mortgage bundling or the portfolio insurance that dumped gas on the fire in 1987. People are animals. When the herd wants out there is very little that’s going to stop it from selling at any price.
Such is the nature of capitalism. “If your product does what it says you can’t very well beat up a provider for that. The question is whether or not the consumer is going to understand it.”
Alas, it is well beyond the reach of our species to protect ourselves from doing self-damaging things. Were that the case there wouldn’t be any point to opening the market at all as assets would be perfectly priced.
The lesson, as always, is that every investors needs to look out for him or herself. Anyone telling you otherwise is selling a product you shouldn’t buy.
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