ETFs Get Their DC Close-Up

October 18, 2011

Chatter surrounding ETFs has grown critical as they have gained in prominence, and the time is right for Congress to take a closer look.

While in earlier days people were quick to sing the praises of ETFs, lately everyone from journalists to bloggers to pundits have blamed ETFs for a variety of ills: the flash crash of May 2010, rising market correlations, as well as the volatility that has shaken U.S. markets in recent months.

The volume of these complaints apparently rose to the level that Congress has taken notice, and scheduled a hearing on Oct. 19 about the role ETFs are playing in financial markets.

Increased scrutiny around ETFs is a good thing—ETFs have grown up rapidly over the past decade after their use expanded much more slowly in their early days following the launch of the first ETF in 1993. They now make up around a third of the value traded on U.S. exchanges.

Moreover, ETFs have given investors access to many new markets. Investing in derivatives contracts like futures and swaps, and accessing leveraged equity products is now as easy as punching a ticker into your online brokerage account. With U.S. assets now over $1 trillion, it’s definitely time for ETFs to get a second look by the regulators.

As an example, why current regulations allow investors to own inverse funds in their individual retirement accounts while prohibiting old-fashioned short-selling is an inconsistency that regulators should address. They should also take a good, hard look at the use in IRAs of leveraged ETFs that are rebalanced daily, which are inappropriate for most individual investors.

Wanted: Hard Data

While regulatory attention to ETFs is welcome, a disappointing number of the recent attacks levied against ETFs lacked hard data. For instance, a piece in the New York Times' “Dealbook” section quoted a fund manager, whose criticisms of leveraged ETFs were based on a “gut feeling.”

Gut feelings shouldn’t be taken seriously when real research has been done: a professor at East Tennessee State University—also mentioned in the Times piece—conducted a study concluding that leveraged ETFs weren’t responsible for market volatility.

IndexUniverse’s own Director of Research Dave Nadig recently came to much the same conclusion as the professor in a piece that looked at the data from another angle.

Other strident critiques of ETFs, such as the idea that a flood of redemptions could cause a fund to blow up, are simply misinformed.

Claims that increases correlations among different assets classes are caused by ETFs haven’t really been substantiated with hard data showing that ETFs are the driving agent for this development.

Index-based mutual funds, which still have far more assets than ETFs, were popular in market regimes exhibiting much lower correlations. To that extent, it remains to be demonstrated that ETFs would contribute to correlations any more than traditional mutual funds have, though it is true that a rise in the ETF popularity would likely increase correlations, all else being equal.

 

 

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