Exchange-traded funds are facing new scrutiny
Chances are you will never drop a nickel into Direxion Daily Russia Bear 3x Shares, an exchange-traded fund designed to produce three times the opposite daily price performance of the Russian stock market.
But just in case the hankering ever hits you, should a fund like that exist?
Amid growing public disgust with Wall Street generally and with gut-wrenching stock market volatility specifically, the mushrooming industry of exchange-traded funds, or ETFs, is facing new scrutiny.
Critics say the ETF business is a prime driver of market swings by allowing traders to effectively buy or sell massive numbers of shares at any moment of the trading day.
That’s what the funds were designed for when they arrived on the scene in 1993 as a new form of index investing, meaning they tracked stock market indexes such as the Standard & Poor’s 500.
And after all, that indexing message is what built Vanguard Group into one of small investors’ favorite mutual fund firms. Vanguard, too, has become a big player in ETFs since 2004, with about 50 funds now.
But with $1.4 trillion in ETFs of all kinds worldwide, and $954 billion of that in U.S.-based funds, the argument is that ETFs’ influence is becoming extreme in a market already prone to enervating conniptions.
ETFs also are under attack as another example of the financial industry’s mad-scientist lab run amok, hoping to attract more traders by creating ever-riskier portfolios aimed at ever-narrower market index niches.
The Securities and Exchange Commission is concerned enough to have launched a “general review” of the industry, the agency said this week. Among other things, the SEC is looking at the “adequacy of investor disclosure” by the funds.
All of these issues were on the table this week at a U.S. Senate hearing on ETFs and their effect on markets.
Among the panelists invited to testify was Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation in Kansas City, Mo., and a longtime thorn in the ETF industry’s side.
Bradley and his colleague at Kauffman, Robert Litan, have a fairly straightforward message: ETFs are a major force fueling stock-price correlation, the tendency of seemingly the entire market to surge, or plunge, at once and often in a matter of minutes — a phenomenon that has become all too familiar since the 2008 financial meltdown.
Given their scope, popularity and ease of trading, “ETFs must be facilitating that correlation,” Litan said in an interview.
Besides the obvious debilitating effect on investor psychology, the market’s swings may corrupt the capital-raising role of equity markets, and thereby harm the economy, by discouraging fast-growing private companies from going public, Bradley and Litan assert.
Shares of small companies have become “the proverbial tiny boats tossed around on the ETF ocean,” Bradley told the Senate committee.
To the ETF industry, Bradley and Litan are all wet. The market volatility of the last few years stems from the gigantic unknowns facing the global economy, ETF proponents say. Market correlation is a function of the environment, not an inevitable evil of ETFs, they say.
Eric Noll, an executive vice president of the Nasdaq Stock Market’s parent company, told the Senate that although ETFs are a “tempting target, restricting or eliminating the business will not solve the sovereign debt crisis in Europe, will not balance the U.S. budget, will not restore bank balance sheets, will not add jobs.... There are very large, very real uncertainties that are driving global financial market volatility.”
The ETF industry also notes that, even at $1.4 trillion, the funds control a tiny fraction of the stock, bond and commodity markets worldwide, a figure estimated at more than $130 trillion. Conventional stock and bond mutual funds, by comparison, hold $9 trillion.
Still, the heavy trading in many ETFs on a daily basis has convinced some market players that the funds are the tail wagging the dog: When speculators shovel money into or out of an ETF, the fund must quickly buy or sell the underlying shares it’s supposed to track.
And so what? ETF devotees say. Even if it’s true that ETFs have made the market more volatile, the trade-off is that the funds have been an ally of small investors in many other ways.
ETFs were created to advance the indexing concept: Forget trying to choose winning stocks, just buy the market as a whole or in sector slices.
ETFs have low management fees, and unlike a conventional mutual fund, an ETF trades on a stock exchange and so can be bought or sold all day long at prices reflecting the minute-by-minute changes in the value of the underlying portfolio.
A conventional mutual fund, by contrast, can only be bought or sold once a day, at the closing price.
Most appealing to many investors is that ETFs typically are tax-efficient: The investor decides when to generate a capital gain or loss by selling. With a conventional fund, the investor has no control over taxable capital gains, which the fund may pay out every year — even in years when the fund’s share price declines.
For investors who want to bet on a specific industry, ETFs remove the burden of trying to research and pick the best stock or stocks in that industry.
Critics say investors’ growing use of ETFs therefore is another blow to fundamental stock research, or what historically was considered true Warren Buffett-style investing.
Good riddance, said Dave Nadig, research chief at IndexUniverse.com, an independent research shop for ETFs, indexes and index funds. “Most individuals are terrible stock pickers,” he said. “And the same with professional managers. Driving investors away from that is actually a good thing.”
But as ETFs’ market clout grows, even within the industry there is concern about the proliferation of niche portfolios, particularly those that use borrowed money, or leverage, to double or triple the returns of their underlying securities, as well as “inverse” funds designed to do the opposite of whatever the market does.
BlackRock Inc., the money management titan that owns the IShares ETF group, told the Senate this week that the industry should relabel funds to better define their risk levels. The term “ETF” should be limited to funds that are “appropriate for a long-term retail investor,” said IShares chief Noel Archard. Funds that use borrowed money or that follow an inverse strategy shouldn’t use the ETF label, he said.
That recommendation triggered an immediate rebuff from ProShares Advisors, which unlike BlackRock specializes in leveraged and inverse funds. ProShares Chairman Michael Sapir accused BlackRock of trying to gain a competitive advantage by expropriating the term ETF.
IndexUniverse’s Nadig suggests another change some industry players surely won’t embrace: He thinks leveraged ETFs should be “gated” — meaning that before investors could buy the funds they’d have to fill out paperwork indicating that they understand the risks.
With leveraged funds still a sliver of total ETF assets, Nadig said, “This is a great time to get those things in place” to lessen the risk that they could draw in do-it-yourself investors who may not understand how much they could lose.
The alternative is to rely on financial-industry self-restraint. As the mortgage market bubble of the last decade demonstrated, however, just because Wall Street’s scientists can create potential new Frankenstein financial products doesn’t mean they should — but left to their own devices, they almost certainly will.
