Bailout Blues' Silver Lining

For more than a decade, I headed up the day-to-day investment oversight efforts at American Century Investments.

I'm not sure if he's still there, but the head trader at the time had a big sign in the trading room. It prominently displayed a memorable and timeless quote from Justice Louis Brandeis, a member of the U.S. Supreme Court in the 1920s and 1930s.

In light of continuing political turmoil as bailout packages are debated, I am reminded of Justice Brandeis' words of wisdom.

Much discussion of the crisis has centered on blame. Who and what is responsible for the crisis? We'll be debating those "blame" issues for a long time.

However, one of the key overriding issues to emerge, in addition to greed, leverage and oversight is transparency.

Why is the extent of the toxicity so vague? Why are all these distressed securities so opaque? How can we not know the extent of the problem debt? Why is it all so invisible?

These are very pertinent questions. There clearly is a lack of transparency surrounding many of the securities at the heart of the credit crunch.

Blackstone Group co-founder, Pete Peterson, who, ironically, ran Lehman in the '70s, told a reporter last week, "The biggest problem we have is how to oversee, regulate and monitor new securities that are not well understood."

He hit the nail on the head. Combining a lack of transparency with inherently complex instruments (and 30:1 leverage) and a lack of understanding by market participants and regulators alike creates a recipe for financial calamity.

A more practical observation is that transparency is bound to emerge as a winner. Complexity is the big loser as are opacity, ambiguity and invisibility.

A new era of renewed emphasis on transparency and understandability in the capital markets is ahead.

And this rolling transparency revolution will further enhance the stature of exchange-traded funds.

A revolution in transparency will be good for price discovery, good for market clearing and good for investors. It may take years to fully play out, but clearly ETFs with their greater transparency figure to be big, long-term winners.

Against this backdrop, ETF structures just got more valuable. This renewed emphasis on clarity and transparency will play right into the hands of ETFs.

Why? ETFs obviously have numerous attributes, such as lower costs, greater tax efficiency, diversification, flexibility and reach, which are allowing them to take market share from traditional vehicles.

However, the attribute that will shine brightly in the ensuing weeks is transparency. ETFs are a ray of sunlight in capital markets where many opaque "products" can lurk.

Contrast the murky, opacity of the collateralized debt obligation (CDOs) and credit default swap (CDS) markets with ETFs.

The credit default wwap market is roughly six times the size of the mutual fund industry with a fraction of the transparency. The CDS market, a $60 trillion market of which AIG was "only" a half-a-trillion-dollar player, is the single biggest reason for the vagueness surrounding the toxic debt problem.

Let's reflect on why the magnitude of bad debt remains so hard to understand. A recent quote from a mutual fund portfolio manager might be very instructive along these lines.

In talking about how to assign a valuation to an individual issue like Lehman or AIG, exposed to "toxic" securities, he said: "Things are so big, so leveraged, it can be tough for an outsider to tell."

Not good for price discovery or market clearing. No wonder credit markets have frozen.

Conversely, with ETFs, positions are known. Exposures can be assessed. Markets can clear because there is price discovery driven by transparency. Without transparency, as we have seen, price discovery is impossible and markets freeze up.

I don't think it is a coincidence that ETF trading volumes have increased dramatically in the last six weeks. Yes, they can be trading vehicles, but they are also transparent investment vehicles whose share of overall equity trading volume was increasing even before the developments of the last several weeks.

There will certainly be other winners in coming quarters from this shakeup in credit markets. The independent investment advisor—those advisors unencumbered by an association with a large brokerage investment banking arm—figures to become more valuable in coming weeks as well.

However, that is a subject for another article. (This rolling transparency revolution will also accelerate what is going on in the world of fees. But that too is a topic for another day.)

In light of what has transpired the last couple of weeks, ETF—now more than ever—are investment vehicles whose time has come. They are simply a better structure for most investors.

The bottom line is that transparency will now be held in higher regard by the capital markets. I suspect Justice Brandeis would be proud. And an ETF fan.

William E. Koehler is chief investment officer at ETF Portfolio Solutions. He's a regular contributor to IndexUniverse.com and can be reached at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it