October 21, 2011

Don’t Blame All ETFs for Market Volatility, Schwab Says

Turbulence caused by investor fears over Europe, U.S. politics and China, says Windhaven’s Cucchiaro

NYSE traders reacting to stock prices in August. (Photo: AP) NYSE traders reacting to stock prices in August. (Photo: AP)

As the Securities and Exchange Commission considers whether exchange traded funds are to blame for causing the recent spate of market volatility, Charles Schwab’s ETF team stepped forward Friday to defend them.

Asked during a conference call with journalists if ETFs cause volatility, Steve Cucchiaro, CIO of Schwab subsidiary Windhaven Investment Management, said market turbulence is caused more by day-to-day news events that keep sending mixed messages to investors. He pointed to three issues in particular: the fear of European debt contagion, political gridlock in the United States and inflation in China.

“If a news item corroborates that the economy is entering recession, we have a bad market day, and if we get an encouraging piece of data, then the market has a good day,” Cucchiaro said. “Market volatility is causing volatility in ETFs and not conversely. We think ETFs provide investors with hedges against risky scenarios.”

Because of the growth and complexity of ETFs, the SEC is reviewing the adequacy of investor disclosure about the products, their liquidity and whether they contribute to market volatility, said Eileen Rominger, director of the SEC’s Division of Investment Management, before a Senate panel on Wednesday.

Separately, in an analyst note published on Oct. 17, Schwab Chief Investment Strategist Liz Ann Sonders said high-frequency trading (HFT) and the use of leveraged ETFs are the primary culprits in market volatility—“but the impact isn’t all bad.”

“Leveraged ETFs give investors the opportunity to bet on a basket of stocks, commodities or an overall index and have become very popular vehicles for traders generally and HFT firms in particular,” Sonders wrote. “It's estimated there's about $1 trillion invested in leveraged ETFs. Their attractiveness to HFT users comes from the fact that investors can bet long or short and leverage the bet, while also moving in and out during the trading day to lock in gains (or limit losses, which can be substantial).”

Overall, retail investors in particular like ETFs so much that they were the only Schwab clients to drive flows in the third quarter, with a 17% increase in assets, said Beth Flynn, vice president and head of third-party ETF

platform management, on the call.

Where is retail investors’ money coming from? “Cash,” Flynn said, noting that 33% of funds flowing into ETFs came from deposits sitting in cash at least three months. “The rationale is that clients are coming off the sidelines, and they’re accessing asset classes that were previously somewhat inaccessible.”

Schwab’s ETF team found that the money came less from equity and mutual funds than the team had hypothesized. ETF investors are moving away from international equities and going into government and short-term bond funds, she added.

Meanwhile, Schwab continues to launch ETFs as their popularity grows. The firm now offers 15 ETFs and also publishes an ETF Select List of its own and other firms’ funds.

On Thursday, Schwab announced that it has begun trading in its U.S. Dividend Equity ETF (SCHD). The new Schwab U.S. Dividend Equity ETF offers investors the potential for current income as well as capital appreciation through exposure to companies with a record of paying consistent dividends and strong relative fundamental strength.

“It’s a good time to be launching it,” said John Sturiale, vice president of product management at Schwab. “With an expense ratio of just 17 basis points, this newest ETF can diversify a portfolio’s income stream, and there’s definitely a demand for yield in the marketplace. With the 10-year Treasury note just a hair over 2%, it’s a good time to be offering yield to investors. We think we’re going to see some good demand in the fund.”

Read The Perils of Exchange Traded Funds by Vaughan Scully of Standard & Poor’s at AdvisorOne.com.

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