Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

ETFs Aren't the Problem


With ETFs now wildly popular and not-so-widely understood, global regulators are starting to fret about how safe they are for the markets and individual investors.

Exchange traded funds, or ETFs, have come under heavy fire over the past month after a rogue UBS trader was accused of losing $2.3 billion of the bank's capital while trading ETFs in London. Shortly thereafter, a trader at Goldman Sachs was accused of making illegal trades using confidential information about the firm's ETFs.

Questions have been raised about ETFs even prior to such headlines. European regulators have been concerned about the extent to which investors understand the risks inherent to trading ETFs.

And in the US, the Securities and Exchange Commission and the Commodities and Futures Trading Commission have been examining the role of ETFs in the "Flash Crash" of 2010.

But these questions are largely arising because ETFs are relatively new instruments, so both investors and regulators are still learning about how ETFs are constructed and used.

In contrast to traditional mutual funds, which trade securities as investors purchase and redeem shares of a fund, ETF sponsors trade the basket of stocks underlying these securities infrequently. That's because ETF sponsors only trade with what are known as authorized participants, or APs. APs tend to be large investment banks, like Goldman Sachs (GS).

These institutions are responsible for obtaining the underlying stocks needed to create shares of an ETF. They buy shares of stock on either the open market, or one of the secondary markets shared among institutions, such as "dark pools," or use shares from their existing inventory.

They then present those underlying stocks to an ETF sponsor, which constructs the ETF and offers the AP shares of the ETF in exchange for procuring the underlying stocks. The AP then either retains the ETFs as a holding or makes a market for them. The process works in reverse when APs redeem ETF shares.

This process provides the necessary liquidity to prevent ETFs from trading at significant discounts or premiums to their net asset value, addressing a serious shortcoming that has plagued similar instruments, such as closed-end funds (CEFs).

It also means ETFs can't be culpable for the growing market volatility over the past few years. In the US, ETFs that track the S&P 500 currently hold more than $100 billion in assets and have an average daily trading volume of around 400 million shares.

As a result, you might expect to see much heavier trading in shares of companies like General Electric (GE), Exxon Mobil (XOM), and Pfizer (PFE) because they comprise some of the heaviest weightings in the S&P 500.

Thus far, however, there have been no apparent spikes in trading volumes for these stocks directly correlated to their use in ETFs. As such, US regulators' concerns about ETFs have largely abated.

The real issue is how bad actors have used ETFs -- something that can't be blamed on the ETF structure itself. When an insider illegally trades individual shares of a company's stock, there is no outcry demanding that trading in equities be banned. Instead, reasonable people understand that there will always be someone hoping to illegally profit at another party's expense.

Lately, European regulators have been concerned about synthetic ETFs, which don't yet exist in their purest form in the US due to regulatory restrictions. Synthetic ETFs use derivatives to mimic the behavior of an index.

While exchange traded notes have attributes that may make them appear similar to synthetic ETFs, they're ultimately rather different and account for only a tiny fraction of exchange traded product assets.

We maintain a healthy skepticism toward products that employ futures and derivatives to build their market exposures. There are only a few such products that we endorse, so we are largely sympathetic to the concerns of European regulators in this instance.

Although it's tempting to blame ETFs for these problems because they are still a relatively new asset class, investors should expect the traditional asset classes, such as stocks, bonds, and mutual funds, to continue to experience similar depredations.

There are always going to be market actors seeking to press every advantage through both radical and illegal methods, regardless of whether they use stocks, bonds, mutual funds, or ETFs to achieve their end.

That's a problem securities regulators will always have to contend with, but it doesn't mean investors should abandon ETFs or any other security that helps them achieve their investment goals.

Editor's Note: This article was written by Ben Shepherd of Global ETF Profits.

New! The TechStrat Report by Sean Udall. Sean provides in-depth analysis, strategies and trades across the technology sector. Take a FREE 14 day trial.

Twitter: @TopProsTopPicks

No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Featured Videos