Recent market volatility is prompting Congress to examine the role ETFs may play in the gyrations. At the same time, ETF vendors are squabbling over the best way to dampen the risks arising from the popular funds.
Recent market volatility is prompting Congress to examine the role exchange-traded funds may play in the gyrations, as lawmakers try to avoid being caught flat-footed on these products the way they were with collateralized debt obligations. At the same time, ETF vendors are squabbling over the best way to dampen the risks arising from the popular funds.
“This is a very appropriate time … to start asking difficult questions about ETFs,” said Sen. Jack Reed, D-R.I., chairman of the Senate Banking Subcommittee on Securities, Insurance and Investment. “We've in the past seen situations where innovation looked very attractive to us until it exploded. Then it looked very dangerous to us.”
Mr. Reed conducted a Wednesday hearing of his subcommittee alone. Although none of his colleagues showed up, the legislator held court for about an hour and a half with regulators, market participants and experts, discussing whether ETFs are the main cause of recent wide market swings, represent systemic risk and make it harder for companies to raise capital.
“While ETFs began as a constructive financial innovation over 18 years ago, they have grown so fast in number and in variety that they now account for roughly half of all the trading in U.S. equities markets today,” Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation, said in prepared testimony. “In the process, in our view, ETFs have increasingly distorted the role of equities markets in capital formation, while posing systemic risks from potential settlement failures.”
A Nasdaq official, however, disputed the notion that ETFs are creating unusual market volatility.
“From rolling flirtations with debt and sovereign failure in Europe, to potential government debt payment interruptions in the U.S., to a global demand curve for goods, services and human capital that no one can accurately determine, our markets are simply trying to rationalize and apply metrics to far too many unknowns,” Eric Noll, The Nasdaq Stock Market Inc.'s executive vice president and head of transaction services, testified. “[Exchange-traded products] do not cause this; they, like other asset classes, are just trying to move within this turbulent environment.”
An executive with BlackRock Inc., a leading provider of ETFs, said that the products offer a low-cost way for investors to get into the market and diversify their risk. He cautioned against increasing regulations on the funds, which total approximately $1 trillion in assets and accounted for about 40% of trading activity in August. Rather, he said, their upside and downside potential must be fully explained before being sold to clients.
“You can never have enough disclosure, enough education, to the investing public,” said Noel Archard, BlackRock's managing director.
Mr. Archard reiterated BlackRock's proposal for delineating more clearly between ETFs that are indexed and passive, and those that are actively managed. Under the scheme, leveraged and inverse offerings would not be allowed to use the ETF label, which would be reserved for publicly regulated products appropriate for long-term investors.
BlackRock also wants ETF vendors to disclose frequently holdings in the funds, as well as financial exposures, fees and use of derivatives.
BlackRock's plan was rebuked by a competitor.
“We were disappointed when one of the witnesses used today's hearing as a platform to promote its own agenda,” Michael Sapir, chairman and chief executive of ProShare Advisors LLC, said in a statement. “The classification system recommended by BlackRock is arbitrary, anti-competitive and unworkable. The recommendation may serve BlackRock's competitive interests but would not serve investors' interests and likely result in confusion.”
Eileen Rominger, director of the Securities and Exchange Commission's Division of Investment Management, said that the BlackRock classification system “deserves consideration.”
Ms. Rominger pointed out that in March 2010, the SEC placed a moratorium on regulatory approval for ETFs that invest heavily in derivatives. She also said that the agency is seeking comments by Nov. 7 on a concept release about the use of derivatives in investment funds and is looking into whether leverage and inverse ETFs roil the markets.
“We hope to reach some conclusion on that in due course,” Ms. Rominger said.
Mr. Reed said he is raising questions and drawing attention to the issue rather than pursuing a legislative remedy.
“There has to be increased transparency,” Mr. Reed said. “That's one of the fundamentals of the markets. If people know what they're buying, they make better decisions on what they're buying.”
