ETFs Aren’t the Problem

10/10/2011 8:30 am EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Now that ETFs have become wildly popular, regulators around the globe are starting to worry about their broader implications in the markets and their safety for individual investors, says Ben Shepherd of Global ETF Profits.

Exchange traded funds have come under heavy fire over the past month after a rogue UBS trader was accused of losing $2.3 billion of the bank’s capital while trading ETFs in London. Shortly thereafter, a trader at Goldman Sachs was accused of making illegal trades using confidential information about the firm’s ETFs.

Questions have been raised about ETFs even prior to such headlines. European regulators have been concerned about the extent to which investors understand the risks inherent to trading ETFs.

And in the US, the Securities and Exchange Commission and the Commodities and Futures Trading Commission have been examining the role of ETFs in the “Flash Crash” of 2010.

But these questions are largely arising because ETFs are relatively new instruments, so both investors and regulators are still learning about how ETFs are constructed and utilized.

In contrast to traditional mutual funds, which trade securities as investors purchase and redeem shares of a fund, ETF sponsors trade the basket of stocks underlying these securities infrequently. That’s because ETF sponsors only trade with what are known as authorized participants (AP). APs tend to be large investment banks, like Goldman Sachs.

These institutions are responsible for obtaining the underlying stocks needed to create shares of an ETF. They buy shares of stock on either the open market, or one of the secondary markets shared among institutions, such as “dark pools,” or use shares from their existing inventory.

They then present those underlying stocks to an ETF sponsor, which constructs the ETF and offers the AP shares of the ETF in exchange for procuring the underlying stocks. The AP then either retains the ETFs as a holding or makes a market for them. The process works in reverse when APs redeem ETF shares.

This process provides the necessary liquidity to prevent ETFs from trading at significant discounts or premiums to their net asset value, addressing a serious shortcoming that has plagued similar instruments, such as closed-end funds (CEFs).

It also means ETFs can’t be culpable for the growing market volatility over the past few years. In the US, ETFs that track the S&P 500 currently hold more than $100 billion in assets and have an average daily trading volume of around 400 million shares.

As a result, you might expect to see much heavier trading in shares of companies like General Electric (GE), Exxon Mobil (XOM), and Pfizer (PFE) because they comprise some of the heaviest weightings in the S&P 500.

Thus far, however, there have been no apparent spikes in trading volumes for these stocks directly correlated to their use in ETFs. As such, US regulators’ concerns about ETFs have largely abated.

The real issue is how bad actors have used ETFs—something that can’t be blamed on the ETF structure itself. When an insider illegally trades individual shares of a company’s stock, there is no outcry demanding that trading in equities be banned. Instead, reasonable people understand that there will always be someone hoping to illegally profit at another party’s expense.

Lately, European regulators have been concerned about synthetic ETFs, which don’t yet exist in their purest form in the US due to regulatory restrictions. Synthetic ETFs use derivatives to mimic the behavior of an index.

While exchange traded notes have attributes that may make them appear similar to synthetic ETFs, they’re ultimately rather different and account for only a tiny fraction of exchange traded product assets.

We maintain a healthy skepticism toward products that employ futures and derivatives to build their market exposures. There are only a few such products that we endorse, so we are largely sympathetic to the concerns of European regulators in this instance.

Although it’s tempting to blame ETFs for these problems because they are still a relatively new asset class, investors should expect the traditional asset classes, such as stocks, bonds, and mutual funds, to continue to experience similar depredations.

There are always going to be market actors seeking to press every advantage through both radical and illegal methods, regardless of whether they use stocks, bonds, mutual funds or ETFs to achieve their end.

That’s a problem with which securities regulators will always have to contend, but that doesn’t mean investors should abandon ETFs or any other security that helps them achieve their investment goals.

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