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Milken Institute | Newsroom | Currency of Ideas - ETFs In the Spotlight Currency of Ideas: ETFs In the Spotlight
October 25, 2011 at 05:16 PM
ETFs In the Spotlight
  Financial Innovations Public Policy
  Posted by
Daniel Gorfine
Daniel Gorfine
US Exchange Traded Funds (ETFs), which hold approximately $1 trillion in total assets and account for over one-third of all equity trade volume, now provide retail investors with unprecedented access to investment categories previously available only to large, institutional investors.

ETF purchasers can own real gold, silver, copper, and other commodities, as well as short the market (or specific sectors of the market) through leveraged products that offer two-or-three times inverse returns. By simply buying shares of ETFs just as one would any conventional US equity, an investor can own SPDR Gold Trust ("GLD"), an ETF that buys and currently holds $65 billion of gold bullion (more than the gold reserves of China, India, and the EU); iPath Dow Jones-UBS Livestock Subindex Total Return ("COW"), which seeks to mirror the price of hogs and cattle; or ProShares UltraShort Silver ("ZSL"), which returns triple the inverse of silver price movements.

The rapid growth and increasing complexity of ETFs, which frequently utilize derivatives and futures contracts to mimic market sectors or assets, have begun to raise concerns over the impact these financial products have on markets, attracting the attention of lawmakers and regulators.

Last week, at the Dirksen Senate Office Building, Sen. Jack Reed (D-RI), Chairman of the Securities, Insurance, and Investment Subcommittee, held a hearing examining ETFs with a panel of experts, including Eileen Rominger, Director of the SEC Division of Investment Management; Eric Noll, Executive VP of Transaction Services at NASDAQ OMX; Noel Archard, Managing Director of BlackRock I-Shares; and Harold Bradley, CIO of the Ewing Marion Kauffman Foundation.

The hearing covered a broad range of issues relating to ETFs, most notably focusing on ETF transparency and the related benefits of an ETF classification system, ETF impact on market volatility, and ETF contribution to systemic risk in the global financial system. Other topics discussed included the potential impact of ETFs on underlying security prices, whether some ETFs were created solely for tax advantage, ETF trading and settlement problems, and the potential contribution of ETFs to increased market correlations. There was little consensus beyond the clear need for more research.

With respect to ETF transparency, the panel largely agreed with Ms. Rominger of the SEC that the majority of ETF products offer a "very high degree of transparency." Mr. Archard of BlackRock noted, however, that approximately 10% of ETFs are complex products whose underlying securities are not equities, but rather are a combination of derivatives, swaps, and notes. Mr. Archard proposed increasing ETF transparency by requiring daily position disclosures and product-label differentiation.

But views differed among players in the market: following the hearing, the CEO of ProShares, a leading proprietor of leveraged ETFs, said "[t]he classification system recommended by BlackRock is arbitrary, anticompetitive and unworkable. The recommendation may serve BlackRock's competitive interests but would not serve investors' interests and likely result in confusion."

As to the potential impact of ETFs on late-day volatility due to end-of-the-day portfolio rebalancing, Mr. Noll stated that NASDAQ research has found that ETFs do not impact volatility. Ms. Rominger and Mr. Archard were more circumspect and called for additional research into ETF trading and the potential for increased market volatility.

As for potential ETF contribution to systemic risk, Mr. Bradley of the Kauffman Foundation warned that delays or failures in trade executions or settlements and lack of transparency with respect to underlying positions may be contributing to increased systemic risk -- especially in the context of leveraged products. Mr. Bradley compared opaqueness in regard to leveraged ETF products to similar information problems that existed prior to the financial crisis.

Ms. Rominger stated that the SEC, whose Chairman is a member of the Financial Stability Oversight Council, would be further investigating the extent to which ETFs pose systemic risk to the global financial system.

Given the increasing popularity, trade-volume, and complexity of ETFs, it is likely this Senate hearing will not be the last to examine the impact of ETFs on the market. Following are takeaways that may offer guidance as to where the ETF debate is headed:

• Despite NASDAQ research results cited by Mr. Noll, it is clear that the SEC and other organizations have work to do in providing empirical evidence on key issues, including ETF contribution to market volatility and systemic risk. There is still debate as to whether ETF trading contributed to or was disproportionately impacted by the May 6, 2010 "Flash Crash," where the DJIA suddenly plunged more than 1,000 points, only to recover within minutes. Until research into this and related questions is complete, expect the SEC to maintain its moratorium on the creation of leveraged ETFs that rely on derivatives.

• Though ETFs are generally viewed as transparent for consumers, expect increased debate over potential regulations requiring product-differentiation labels highlighting the composition of an ETF's holdings.

• It was curious that the hearing did not address the questions of whether commodity-based ETFs in particular pose a systemic risk to the financial system or could contribute significantly to market volatility. Because of the vast holdings of the SPDR Gold Trust, which of the top 10 largest owners of physical gold is the only non-sovereign entity, anticipate continued scrutiny of how commodity ETFs impact the market.

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