If you have been watching the financial news  lately, you’ve likely heard of the recent implosion of a few exchange-traded products, and the subsequent fallout from the news media about how these products pose a systemic risk to the financial system. In this installment of In the  Spotlight, we’d like to shed our views on the ETF market and examine what happened in the recent demise of two specific products.

ETFs provide a way for investors – both large and small – to gain exposure to certain areas of the market, such as stocks and bonds, in a relatively efficient manner. With a single holding, investors can position their portfolios based on their views of how certain asset classes might perform. The largest ETF – the SPDR S&P 500 (SPY) – began trading in the early 1990s and commands roughly $260 billion in assets. For decades, investors have accessed the large-cap U.S. equity market by holding and trading SPY.

As time went by, and investor demand increased, product providers issued ETFs that tracked other markets, such as international and emerging  market stocks, and fixed income. Investors could now build diversified portfolios with just a few holdings. For example, the equity exposure in a portfolio could be segmented by market capitalization, sector or industry. Likewise, fixed income exposure could be segmented by credit and duration. Simply put, ETFs became very  useful tools for portfolio construction.

ETFs are similar to other pooled investments that trade on exchanges, such as open-end mutual funds that are priced at the end of the day (i.e. the net asset value) and closed-end funds that trade throughout the day with a fixed number of shares. In fact, ETFs are largely governed by the same set of regulations as other mutual funds.

With the substantial inflows in recent years (according to ETF.com, a record $44.7 billion flowed into ETFs in the week ending March 15th), some observers are concerned if the ETF structure itself poses some systemic threat to a well-functioning market. This concern was highlighted by the implosion of two volatility-linked products in February – the ProShares Short VIX Short-Term Futures ETF and the VelocityShares Daily Inverse VIX Short-Term ETN.

If the names sound confusing, it’s because the products were confusing. And therein is our point that not all exchange-traded-products are created the same. First, the VIX products that failed were esoteric strategies that in our view are not suitable for most investors. Second, one of the products was not technically pooled fund, but an ETN, or exchange-traded-note that was nothing more than a credit issued by a bank (and subject to different regulations). And lastly, and perhaps more importantly, the products that failed in    February both used leverage in their underlying strategies.

When the VIX doubled in February, by definition the ProShares and VelocityShares products essentially lost all of their value in a single day (i.e. the products were inverse, or short, the daily change in short-term VIX futures). In our view, losses of this magnitude are highly unlikely in products that track broad benchmarks, such as the S&P 500. The implosion of the VIX products in February was due to a poorly designed strategy, and not necessarily a breakdown in the structure of ETFs itself (after all, the products delivered what they were designed to deliver).

Our point is that investors must do their homework. We tend to avoid products that we simply don’t understand. As the popularity of exchange-traded-products grows, there are bound to be products that move farther “outside the box” into areas of the market that are probably not suitable for the average investor. There will undoubtedly be more products down the road that are based more on marketing ideas and less on sound investment theory, and there will likely be more blow ups to come. However, our view is that these risks don’t pose a systemic threat to a well-functioning market.