Brief introduction to Exchange Traded Funds
An “ETF” is an “Exchange Traded Fund”. In it’s simplest form, it is:
- a company…
- with very specific assets (e.g. gold bullion or a portfolio of shares with the exact weights of a particular index)…
- listed on (and traded on) and exchange
- in which one can invest to get exposure to the underlying assets…
- more easily, more cheaply, in smaller amounts and with higher liquidity than purchasing the underlying assets directly
The trick is that specific rules which allow market participants to “swap” appropriate portfolios of the underlying assets for new shares in the ETF, or redeem shares of the ETF for a proportionate share of the portfolio of underlying assets. This forces the price of the ETF very close to the fair value of the underlying assets. Arbitrage handles it.
This is a pretty simplistic descrition of ETFs, but it covers the major characteristics well enough to explain gearing in the context of ETFs and how this relates to the property market.
How ETFs can increase volatility in their chosen assets
ETFs have become very popular. The increasing gold price has meant that many investors want exposure to gold (since the price is going up at the moment, it will always go up, right?… right?). An easy way to get this exposure is to buy shares in the gold ETFs. This requires the ETF to issue new shares, and invest the cash in physical gold.
So the ETFs suddenly become significant purchasers of gold. Only a certain amount of gold enters the market every day. Some from raw production, some from recycling or sold jewellry, some from tightly held supplies with central banks or other investors. If we create a demand shock by introducing a new player (the gold bullion buying ETFs) on the demand side, the price will increase. The full price increase is mitigated through an increase in supply (think central banks in the short term, jewellry in the short to medium term, and gold production from new exporation and reopening of moth-balled mines in the medium to long term).
As the gold price rises, investors in ETFs tell their friends of their success. More investors want exposure to gold (going up, always going up, can’t lose) and pile further into ETFs. The act of buying in such large amounts forces the prices up.
Hopefully this is sounding much like a bubble to you. And much like a bubble, two things are true:
- For a while, prices will continue to rise and there is money to be made selling on to greater fools
- Eventually the last fool will purchase and the bubble will deflate. Quickly.
Investors are a fickle bunch. Particularly individual investors who only piled into gold (to continue the example) ETFs because their Uncle Mike was doing so. As the price is on the way down, they sell their ETFs. The ETFs in turn sell gold and the geared effect unwinds in a hurry.
Prices move up more than they should due to feedback into the system and the inability of supply to increase instantaneously to meet demand. Prices move down for exactly the same reasons.
The price of eggs and property
FNB announced that they are withdrawing approvals for home loans on a large scale. This is on top of the banks existing moves to tighten lending criteria, and on top of higher interest rates, higher inflation, economic slowdown and both an increase in emmigration and a decrease in immigration.
So yes, demand for property is down. FNB’s move is both a result of declining property market and will become a driver of it.
The extensive expansion of credit financed a large part of the property boom. Credit expansion was profitable and low risk because “property prices are going up and will always go up”. Banks don’t really mind if you stop paying your home loan if you or they can sell your house easily for more than the outstanding loan balance. Once the sure-thing of rising property prices is found out to be the wolf wearing grandmother’s clothes, the party is over and the risks to lending institutions increase dramatically.
The greater fools have all gone.
Sounds like the sub-prime crisis in the US, doesn’t it? And we wonder why our banking shares are so “cheap”?