ETFs Need ‘Holistic’ Regulation: SEC’s Stein

Even plain-vanilla, equity index ETFs may presents risks that are ‘not always anticipated or fully understood’ by investors, says Stein

Will exchange-traded funds ever live down their contribution to the Aug. 24 market plunge? Securities and Exchange Commission member Kara Stein doesn’t think they should.

Stein, an SEC commissioner, repeated Friday at the Practising Law Institute’s annual SEC Speaks conference in Washington her belief that the SEC must take a “holistic” look this year at ETFs’ transparency and how these products interact with the capital markets, as even the plain-vanilla types of ETFs can be risky to investors.

Stein warned in her remarks that ETFs have expanded “far beyond their equity index origins to include far more complex offerings.”

While retail investors are being introduced to “innovative ETFs that may offer attractive yield,” these products “also feature more complex and other higher risk strategies,” including currency hedged ETFs, smart-beta strategies, and bank-loan ETFs. Some of the new products are being hailed as “exotic or innovative within the industry,” but others “have been described as ‘toxic,’” Stein said.

The risk presented by some of these new products, she continued, “may not be fully understood by those who have invested in them.”

Indeed, even plain-vanilla, equity index ETFs may present risks that are not always anticipated or fully understood, as evidenced by the events of Aug. 24, when the stock market dropped 1,000 points in early morning trading.   

While Commission staffers and market participants continue to assess what happened, Stein said, “one fact” about that day is “crystal clear … many ETFs behaved in an unpredictable and volatile manner.”

ETFs experienced greater increases in volume and more severe volatility than corporate stocks, Stein noted, with nearly 20% of all ETFs trading on the morning of Aug. 24 exhibited abnormally high volatility. More than 40% of the 499 ETFs invested in U.S. equities experienced a trading pause, Stein noted, with the pauses varying depending on an ETF’s focus, size and capitalization.

Noah Hamman, CEO of AdvisorShares, told ThinkAdvisor in an email message that “it seems that there has been a ‘blame the ETFs’ type of attitude” for market volatility “from many outside of the investment management space." However, the ETF industry “has been able to proactively educate on the differences among the risks of trading on an exchange, as well as versus product structure and versus investment strategy risk.”

As for Aug. 24, when the market dropped “5% within minutes,” Hamman continued, “there was a clear impact to market making prices for both ETFs and individual securities," so “it’s unclear why it’s labeled as an ETF issue."

However, "given that ETFs are some of the most actively traded securities on the exchange, they are treated as a leading issue. They instead react secondarily to any issues related to the value of their underlying securities and how well the exchange and market markers are dealing with any challenges.”

Stein suggested in her Friday remarks that the agency take a three-pronged approach to creating “greater transparency and accountability” in the ETF space while also “being mindful” of the benefits that stem from innovation in the ETF space.

First, Stein said the agency should “carefully review the roles of authorized participants and market makers in facilitating ETF operations and trading.”

For example, she asked: “Do ETFs face a greater risk of market makers stepping back during times of extreme volatility?  Is there too much concentration among authorized participants and should that be a cause for concern?  Is there sufficient capacity among market makers and authorized participants to ensure that ETF markets operate efficiently and behave as investors expect?  Do investors have adequate disclosure of these risks?”

Second, the SEC “should reinvigorate SEC staff working groups and provide them with the resources they need to examine the products that are being offered,” and work with the Financial Industry Regulatory Authority and other self-regulatory organizations “to take a look at how these products are being marketed and by whom” and whether certain products are “even suitable for buy-and-hold investors.”

The agency also needs to finish analyzing the events of Aug. 24 and “work with the exchanges and other market participants to take appropriate action,” Stein said.

“Perhaps such an analysis will lead us to the conclusion that trading rules for ETFs should actually differ from those for equities.”

Third, the agency needs to “think about a roadmap for holistic regulation of ETFs and other exchange traded products, given their explosive growth and evolution.”

--- Check out Will SEC Crash the Liquid Alts Party? on ThinkAdvisor.

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