ETFs Hurting IPOs, Kauffman Foundation Says

November 08, 2010

Are ETFs hurting the IPO market? Apparently so, a new Kauffman Foundation study says.


A 60-plus page report from the Kauffman Foundation says that exchange-traded funds are the “main" cause for the slowdown in the U.S. IPO market, restricting the access to capital that smaller companies have.

The study also argues that ETFs may have been one of the main factors behind the “flash crash” on May 6, contrasting the conclusion regulators drew last month when they said the swift market sell-off was caused by the sale of a large position of E-mini futures by a single mutual fund company. The foundation, which also argued that short-selling ETFs could pose systemic risk, said without significant market reforms, another "flash crash" and general market instability are almost inevitable.

“We show here that ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” Harold Bradley, chief investment officer of the Kauffman Foundation, wrote in the study’s executive summary.

In a blog today about errors in the Kauffman report, Research Director Dave Nadig wrote that the authors betrayed a basic misunderstanding of how ETFs work when they cautioned that ETFs represent a blowup risk to investors.

The foundation’s argument about the dangers of indexed ETFs also doesn’t square with their place in the market. For example, a bit less than $1 trillion is indexed to the S&P 500, a stock index of the biggest U.S. companies with a market capitalization of about $10 trillion. About $100 billion of that S&P 500 indexing is linked to ETFs, making their influence something akin to a drop in the bucket, as Nadig argued in his recent blog “ETF Poppycock.”

The Kansas City, Mo.-based Ewing Marion Kauffman Foundation calls itself a private nonpartisan foundation that works to harness the power of entrepreneurship and innovation to grow economies and improve human welfare.

“ETFs that once were an important low-cost way for investors to assemble diversified stock holdings are now undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on U.S. exchanges,” wrote Bradley, who was a member of the Nasdaq Quality of Markets Committee and the Investment Company Institute Market Structure committee.

“That is not all … . Absent the ETF-related reforms … we believe that other flash crashes or small-capitalization company 'melt ups,' potentially much more severe than the one on May 6, are a virtual certainty,” the summary of the study said.

Proposed Solutions

The authors argued that the Securities and Exchange Commission should consider prohibiting market orders on stock and ETF trades and instead require “marketable limit orders” on all market and algorithmic orders as part of changes in regulations to ensure well-functioning markets.

The Kauffman study also proposed that the Federal Reserve require weekly reports from custodial banks of “fails-to-receive” and “fails-to-deliver” of equity and ETF securities in a way that’s similar to how the Fed imposes such requirements on U.S. primary dealers for debt securities.

The Kauffman study authors also argued that it might be a good idea for the SEC to preclude the inclusion of small-cap companies from any ETF; ban ETFs whose underlying holdings may be thinly traded; or at least require ETF sponsors to gain approval from small-cap companies before including them in a security.


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