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, IndexUniverse.com 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.

 

Dangers Of Short Selling

The Kauffman study also revisits a theme developed by Bogan Associates LLC in a report the Boston-based money management firm distributed in September that warned of the dangers of short selling of ETFs. While the Bogan report warned of how an ETF might collapse under the weight of its own short interest, the Kauffman report went a few steps further, arguing that shorting ETF could pose systemic risks.

The systemic risks are twofold, according to the Kauffman report. One is that the ease of short selling ETFs makes them ideal potential triggers for marketwide free falls of the kind experienced on May 6 during the flash crash, Bradley and his co-author Litan, vice president of research and policy at the Kauffman Foundation, wrote. The other, less well-recognized danger is that ETFs could be caught in a “short squeeze” should investors for any reason decide they want to cover their short positions.

“Claims by such market participants as The Susquehanna Financial Group that ETFs pose no systemic risks simply are not credible,” the authors wrote.

Of course, both the Bogan and the Kauffman Foundation overlook a crucial fact; namely, that shorting ETFs is very different from shorting individual stocks. An ETF short-seller can have an authorized participant create the shares necessary to cover a short.

In other words, real squeezes aren’t possible in the ETF world because anyone who has to cover shorted shares can have them created by an AP at a price, as opposed to having to scour the market, perhaps in desperation, for existing shares.

Making 'Dark Pools' Lighter

The authors also said the SEC should require all off-exchange trading venues—so-called dark pools as well as internalized trades completed by broker-dealers—to first satisfy all publicly displayed orders at the price they intend to trade. In other words ,it should prohibit off-exchange venues from processing trades at the same prices revealed in the public markets unless the public orders are filled first.

In addition, the SEC should adopt the “trade at” rule it has proposed that would require off-exchange venues to improve by one cent the best-quoted price. Together, these two rule changes would restore value to limit orders now undermined by proprietary routing and internalization techniques, the study said.

The Kauffman study authors also argued that the U.S. Congress exempt small companies with a market capitalization of $100 million or less from complying with regulations under the 1933 Securities and Exchange Act to insure that a true small-cap marketplace, much as existed in the earliest days of the Nasdaq market, can thrive again.

They also said shareholders of small-capitalization companies of $1 billion or less in market cap should be free to choose whether they wish to comply with provisions of the Sarbanes-Oxley Act, which made accounting rules much stricter following scandals at the start of this decade involving now-bankrupt companies such as Enron and WorldCom.

 

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