Even as lawmakers rail against impossible-to-understand toxic securities and Wall Street vows to clean up its act, the investing public continues to be inundated with new, exotic, and complex financial products.
Main Street investors might benefit from these innovative investments—some already on the market and others on the drawing board—but many present real dangers to the unsophisticated and inexperienced.
Among the proposed offerings are plans to allow traders to bet on the success of blockbuster movies, an idea that has prompted opposition from some in Hollywood and the U.S. Congress. The exchange-traded fund industry is creating new ETFs at a rate of more than 100 per year, tracking everything from financial stocks to natural gas prices, many unsuitable for all but the savviest traders.
Currency trading, meanwhile, has turned into a craze among small-time traders, despite the perils of the volatile foreign exchange markets.
Film Futures Exchanges
Proposals for a movie futures market are the glitziest recent instance of financial innovation. Two firms, Cantor Fitzgerald and the Trend Exchange, have won initial approval from the U.S. Commodity Futures Trading Commission to set up rival exchanges where traders could buy and sell securities that pay out based on how well particular movies do at the box office.
After the Motion Picture Association of America protested, Senator Blanche Lincoln, an Arkansas Democrat, inserted language into the financial reform package being considered by the U.S. Senate that would ban such exchanges.
Liz Friedlander, spokeswoman for the Senate Agriculture Committee, which Lincoln chairs, says the film futures exchanges are harmful because they would be "purely a speculative marketplace."
The creators of the movie futures exchanges dispute this, arguing the markets will be used by a variety of movie players to spread risks in their unpredictable industry. Robert Swagger, chief executive officer of the Trend Exchange, says he expects movie studios, theater companies, talent agencies, banks or private equity firms providing film funding, DVD rental companies, and even toy manufacturers to use film futures. Playing the market can reduce the financial damage if a movie unexpectedly flops, he says.
The Trend Exchange will limit its traders, at least at first, to professionals. Cantor Futures Exchange President Richard Jaycobs says his exchange would be open to individuals, but predicts they would have "no impact on the price of movies."
Opportunity in Uncertainty
Cantor Fitzgerald already operates Hollywood Stock Exchange, a Web site that allows anyone to "bet"—purely for entertainment value, with no financial consequences—on the success of movies, stars, TV shows, and other entertainment commodities.
The film futures exchange, unrelated to the Web site, could also open to other products in the future, Jaycobs says. "Entertainment is one area where finance hasn't really evolved like it has in other markets," he says, envisioning television or radio derivatives as possibilities.
Film futures are not too different from agricultural or energy futures, Jaycobs says. Markets can work "anyplace there is financing being done and uncertainty about what the value of the product is going to be in the end."
And, indeed, there is great uncertainty in the movie business. The University of Iowa already operates its own movie future exchange on the Iowa Electronic Markets, limited to academic traders making bets with $500 in real money.
Traders have a very difficult time predicting how movies will do, says Thomas Gruca, professor at the university's Tippe School of Business. Based on a study of 21 movie futures traded since 1998, the Iowa exchange has had an average error rate of 38 percent, he says. The same study showed the Hollywood Stock Exchange had an error rate of 31 percent with the same 21 films. By contrast, Iowa's market predicting Presidential vote totals has an average error rate of 1.8 percent.
Such large errors suggest the film futures markets will be more reliable for financial hedging than for making box-office predictions. The study also suggests traders could win or lose big on particular movie futures. "Anyone investing here should be cautious," Jaycobs says. "It is an inherently risky activity and should not be taken lightly."
A Rush into Futures, Options
Many small investors take such risks on willingly, hoping for big returns. That is the case as a growing number of individuals directly trade on futures and options exchanges.
"People are coming in droves," says Dave Lerman, director of broker services at CME Group (CME), the world's largest futures market. Many traders are coming to derivatives, he says, after being disappointed over the last decade by so many other asset classes, especially real estate and stocks.
The "hot item" in derivatives markets these days is currency trading, says Jeffrey Friedman, senior market strategist at futures broker Lind-Waldock. Traders can lose a lot of money without the proper training and experience, he warns.
Many individual investors who wouldn't dream of playing the futures market may not be aware they're already making similarly speculative bets in a range of ETFs.
According to the Investment Company Institute, there were 797 ETFs at the end of 2009, a year when 120 new funds were created. ETFs are securities that trade like stocks, rising or falling based on the value of underlying holdings that can include almost anything, including bonds, stocks, commodities, and currencies. The most popular ETFs mimic broad equity indexes like the Standard & Poor's 500, but ETFs can also reflect very narrow slices of the stock market or particular investor interests. In December, for example, FaithShares Trust launched an ETF specially designed for Methodist investors, adding to another ETF designed for Roman Catholics.
ETFs in "Uncharted Territory"
Most ETFs—including the FaithShares ETFs—are relatively conventional baskets of stocks or bonds. But, for financial advisers and experts, one of the biggest concerns about ETFs is that they allow novice investors to wade into very complex parts of the financial markets. "A lot of these investments are getting into uncharted territory," says Aaron S. Reynolds, senior portfolio analyst at Robert W. Baird Wealth Management. ETFs linked to futures and other derivatives can create particular problems. "There are a lot of subtleties that are tripping people up right now."
On Mar. 25, the Securities & Exchange Commission said it was ordering a review of the use of derivatives by ETFs, mutual funds, and other investment firms. The SEC already has singled out "leveraged and inverse" ETFs as "specialized products with extra risks for buy-and-hold investors."
Because different ETFs are structured differently, funds with similar names can often produce very different results. Consider, Reynolds says, three gold ETFs: The SPDR Gold Trust (GLD) holds actual gold bullion; the PowerShares DB Gold Fund (DGL) holds gold futures; and the Market Vectors Gold Miners ETF (GDX) holds the stocks of gold mining companies. In the past three years, the three ETFs have offered investors returns of 68.8 percent, 53.7 percent, and 21.0 percent, respectively—all positive, but in a wide range.
"So many investors limit their due diligence on ETFs to the name of the fund," says Scott Burns, director of ETF research at Morningstar (MORN). The best advice to individual investors, he says: Avoid "anything they don't understand."