ETF Pioneer Raises Doubts To SEC

Gary Gastineau calls for tougher scrutiny of new products.

Reviewed by: Trevor Hunnicutt
Edited by: Trevor Hunnicutt
New York (Reuters) – After volatile pricing of exchange-traded funds in August last year forced trading halts and an investigation by U.S. regulators, an early champion of the industry is now raising concerns about the products he helped build.

Gary Gastineau promoted ETFs to investors because of their cost savings when he was an American Stock Exchange executive in the 1990s and he oversaw the listing of the first U.S. funds tracking industry sectors and foreign markets, but now he now argues that many funds cost more than investors realize.

Some of the concerns will be detailed in an article to be published this weekend in the Journal of Portfolio Management.

Seeks Tougher Scrutiny

In an interview, Gastineau now says he wants the U.S. Securities and Exchange Commission to police data published by fund companies to ensure it is not misleading, and he is also asking the SEC to deny applications for some new ETFs.

Securities lawyers expect ongoing public comments will inform a new rule governing ETFs, but the timing is unclear. Such a rule has long been on the industry's wish list because it could make launching new ETFs easier.

"Many ETFs just don't work very well," Gastineau, now an industry consultant, told Reuters in an interview.

Gastineau claims investors cannot determine whether an ETF price is fair value, and that exchanges favor Wall Street trading firms over individual investors.

Hidden Costs

Further, some new kinds of ETFs may expose investors to costs, taxes and trading halts that may undermine their ability to sell when they want to, he says.

Gastineau, 76, has some standing in the industry, and his letters to government officials have informed policy before. The SEC cited Gastineau's research or correspondence six times when, in 2014, it tabled a proposal to launch a new kind of ETF that would compete directly with NextShares, a hybrid of mutual funds and ETFs that price once daily.

But Gastineau helped invent NextShares, a type of fund from which he still earns revenue, and he may profit from preventing competition, creating a potential conflict that could discount his views.

Careful Approval

"The fact that he's a competitor to a firm that's been denied an exemption would certainly make the SEC look at anything he says with a skeptical eye," said Mercer Bullard, a University of Mississippi School of Law professor and former SEC official. "That being said, there are good reasons to be careful about what they approve."

Yet Gastineau is not alone in raising concerns about how ETFs trade and whether investors trade at fair prices, and even some SEC commissioners have done so.

Investors rely on what Gastineau calls “shallow data,” the bid/ask spread between the prices offered to sell and buy ETF shares, and so they underestimate the cost of trading, according to Gastineau in the upcoming Journal of Portfolio Management article he co-authored with two colleagues that was reviewed by Reuters.

Assess The Underlying Securities

To assess the true costs, investors should consider harder-to-discover data, such as the value of the stocks or bonds the fund holds at the time that the ETF is being traded, he argues.

The funds publish their so-called net asset value (NAV) every day after the markets close, but the securities prices change as soon as markets open the next day, leaving investors to buy a portfolio they cannot completely evaluate. Even at the close, an ETF's trading price and its NAV can differ by as much as 3.0%, Gastineau said.

Gastineau is all for keeping the industry he helped build alive, and still argues that investors are better off for having exchange-traded products, but with some limits.

"With better valuation information and improved trading methods, ETPs should continue to grow," he said.

Trevor Hunnicutt is a staff writer for Reuters.