From the December 2011 issue of Research Magazine • Subscribe!

November 23, 2011

The ETF Witch Hunt

What are the reasons and causes behind the “Flash Crash” on May 6, 2010? Does anybody know? What about the stock market’s latest tendency to convulse? People still want answers because nothing they’ve heard up until now is satisfying. As a result, some of them have resorted to good old-fashioned finger pointing. 

This is the exactly the case, as evidenced by the recent Senate hearings on October 19, titled “Market Microstructure: Examination of Exchange-Traded Funds (ETFs).” The purpose of the meeting was to analyze the impact of ETFs on the financial markets, but instead, it found a good scapegoat.

The U.S. exchange-traded products or ETP market, which encompasses ETFs, has around $1 trillion in assets under management.

So far this year, the S&P 500 has experienced more than 60 consecutive days in which it has fluctuated by 1 percent or more during intraday trading. Who or what is behind the cause of this increased stock market volatility? A small but passionate group of anti-ETF crusaders argue that ETFs are to blame.

Andrew Sorkin of the New York Times calls ETFs the “new derivatives.” While statements like this are journalistically cute, they’re factually incorrect. ETFs never have been and never will be derivatives.

It’s true that certain ETFs do invest in derivatives to obtain their market exposure, but that’s not illegal, it’s always fully disclosed and there’s no empirical evidence whatsoever that it’s causing market disruptions of any kind.

Furthermore, ETFs, unlike other entities that invest in derivatives such as hedge funds, are closely regulated and fall under the Investment Company Act of 1940 or the Securities Act of 1933. Put another way, the regulatory requirements for ETFs are burdensome enough to appease even the most bureaucratic bureaucrat. Does an already heavily regulated industry need more regulation? 

Leverage and inverse performing ETFs have been blamed for increased volatility — particularly late-day market swings. But nobody can explain — using factual evidence — how or why an investment category that controls less than $50 billion in assets is distorting multi-trillion-dollar global markets. 

John Bogle, founder of the Vanguard Group, is another individual who has bum-rapped ETFs at every opportunity. Bogle has been a guest on my weekly radio program, the Index Investing Show, multiple times, and he’s right about everything he says about the financial services industry, minus his spurious arguments against ETFs. Meanwhile, Vanguard ETFs continue to vacuum in record assets and in 2010 the company led its peers with net ETF cash flows of $35.4 billion. What kind of company would Vanguard be today had it taken Bogle’s advice to not offer ETFs alongside mutual funds? We can only imagine.

Some will remember that similar complaints of market distortions were lodged against futures and program trading when they were fingered as the root cause of the 1987 stock market crash. While this remains the most popular explanation of the ’87 crash, is it the most accurate? Historians and economists have backed away from the previously dogmatic arguments that blamed one particular product, system or event for the massive meltdown.

The undeniable truth is that ETFs have introduced many significant advantages for investors, including lower expense ratios, intraday liquidity, tighter bid/ask spreads, better tax efficiency and multiple hedging strategies. “As a retail investor, I wouldn’t want to be in a mutual fund,” admitted Harold Bradley of the Ewing Marion Kaufmann Foundation in his Senate testimony. Interestingly, Bradley is another ETF detractor. 

Although the $1 trillion ETP marketplace has become cluttered, this unfortunate phenomenon is hardly exclusive to ETFs and is readily visible in the hedge fund and mutual fund markets, where the trend was started. Likewise, it’s completely accurate to say that ETFs have taken a radical departure from their original roots in traditional index investing. But that doesn’t diminish the valuable role ETFs play in portfolio management, nor does it negate their overwhelming benefits.

Lastly, if ETFs are such an immediate threat to the financial system and if they’re the true culprit behind the stock market’s latest volatility bout, how come Senator Mike Crapo (R-ID) — the investigation team’s lead dog — didn’t show up to the ETF Senate hearing? •

 

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