Synthetic ETFs are changing the rules of the stock market “beauty contest”

June 12, 2013

This is a guest post written by Stefan Leins.

In his seminal book “The general theory of employment, interest and money” (1936), John Maynard Keynes articulated an interesting observation about the nature of stock markets which we recognize this today as the Keynesian beauty contest.

Keynes’ point? Rather than valuing stocks based on so-called fundamental data, speculators try to anticipate the other speculators’ stock market investment activities. Speculators are thus both observers and participants – and by participating by purchasing stock, they influence the actual outcome of the contest.

So what should we make of this new financial instrument called an Exchange Traded Fund (ETF) which is conquering stock markets?

ETFs are not traded over-the-counter like regular funds, but trade directly at the stock exchange. ETFs can take two different forms: Physical ETFs usually replicate an index by proportionally holding the stocks of a particular index as underlying; while Synthetic ETFs, which do not hold the stocks of the index they claim to replicate, only guarantee the client to pay back the return on investment the index would have theoretically reached. Synthetic ETFs are normally sold if a particular ETF claims to reconstruct the price development of an index whose stocks can only be bought by domestic traders, which is the case in China and many other so-called Emerging Market countries. To generate return, vendors of synthetic ETFs use Swaps or bet on divergent financial products.

Synthetic ETFs are undoubtedly among the most creative financial innovations since the famous Credit Default Swaps. And speculators love them! Since 2003, the ETF market has increased more than tenfold and is now estimated to have a value of almost USD 2 trillion. Given the low earning expectations in the US and Europe, it seems likely that many of these ETFs are targeting Emerging Markets indices and are thus synthetic in their form.

So how do synthetic ETFs influence the nature of the stock market? While some competitors (stock traders) still observe and participate in the contest, others (synthetic ETF traders) only observe without participating. Since their underlying is not the index they bet on, synthetic ETF traders do not influence the actual outcome of the beauty contest.

Or to put in Keynes’ words, synthetic ETF investors are the ones that look at the newspaper’s beauty contest, try to find out which face might be likened by others, but then end up throwing away the newspaper without handing in their guesses.

 

The general theory of employment, interest and money, (1936, New York, Harcourt, p 156): “[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view”.

3 Responses to “Synthetic ETFs are changing the rules of the stock market “beauty contest””


  1. ETFs are great but not as advantageous as physical contracts or assets. For example, the GLD and SLV ETFs (representing gold and silver) frequently have margin changes that effect the price of these stocks. If you want to trade baskets of goods or multiple commodities, ETFs are your easiest route.


  2. […] rules stock market, Synthetic etfs changing rules stock market “beauty contest” june 12, 2013. Click here Stock market analysis, phi fibonacci sequence, Fibonacci numbers . gann .. elliott, pioneers […]


  3. […] Synthetic ETFs are changing the rules of the stock market … – Jun 12, 2013 · Synthetic ETFs are changing the rules of the stock market “beauty contest” June 12, 2013… […]


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