Senate Holds Hearing on Exchange-Traded Products

Earlier today, a U.S. Senate subcommittee held a hearing titled "Market Microstructure: Examination of Exchange-Traded Funds," or ETFs, chaired by Jack Reed (D-R.I.)--the only senator in attendance. There was broad consensus among the four witnesses that there has been a great deal of product proliferation, and that more education and transparency is needed. But there were opposing views among certain witnesses regarding the impact of ETFs on the markets and investors.

Harold Bradley, chief investment officer at Kauffman Foundation, is an outspoken critic of ETFs, and he cited a number of ways ETFs have negatively impacted the capital markets, much of which he supported with anecdotal information. Eric Noll, executive vice president from Nasdaq OMX, and Noel Archard, managing director from BlackRock iShares, both asserted that recent market volatility is due to uncertainty in the marketplace, and not ETFs. The SEC, represented by Eileen Rominger, director of investment management, said that it is continuing its broad review of exchange-traded products, including trading dynamics and possible links between the performance of ETFs and the overall market.

Bradley started off by saying that ETFs are driving the price performance of their underlying securities. Archard responded by saying that with any stock, there is an element of market risk and an element of firm-specific risk. In a large and diverse market, it turns out that market risk is actually a key determinant of performance. For example, if events in the Middle East cause oil prices to skyrocket, all stocks will be affected to some extent, not just energy stocks. This causes a high degree of correlation between stocks that are seemingly unrelated, and this occurs regardless of the ETF. Noll pointed out that being part of an index has not seemed to hurt the performance of Apple stock, and he instead pointed to the burden of regulation such as the Sarbanes-Oxley Act as a bigger detriment to new initial public offerings, rather than ETFs.

Consensus developed around the need for investor education regarding leveraged and inverse products. These are products with magnified volatility that need to be used with care by traders rather than buy-and-hold, long-term investors. There was disagreement about the possibility that these products could actually be the cause of market volatility. It is our view that fundamental, economic factors drive volatility. Assets in leveraged and inverse ETFs account for less than 4% of ETF assets and account for a small portion of market-trading volume. While not for everyone and certainly not for the long-term investor, these products do have a legitimate use, however narrow, and we would not go so far as to suggest that they should be banned or eliminated.

On the technical issue of trade settlement failures and high short interest, Bradley suggested that there is a potential for some sort of "daisy chain" reaction because ETF market makers have an advantage of being able to settle trades in six days rather than three. Both Noll and Archard stated that this is not an issue that they or their clients have experienced. In essence, despite these trade settlement failures or cancellations, investors' orders are still being filled properly, and no one is left paying for shares that they did not receive.

Bradley suggested that ETFs have some sort of unfair tax advantage and that ETF products were being created to avoid taxes. ETFs can use an in-kind share transfer mechanism to minimize capital gains taxes. However, these same techniques are utilized by mutual funds, and Vanguard has gone on record stating that ETFs are not automatically tax-efficient but must be judiciously managed to achieve low taxes. As predominantly index funds, ETFs benefit from be ability to use this strategy more often.

One of the more interesting developments from the panel was that Archard, the sole witness from the fund industry, used the opportunity to call for clearly defined categories and naming conventions for the different types of exchange-traded products, particularly for those that use derivatives. 

It is true that the various types of exposure present investors with disparate considerations. Exchange-traded funds, or ETFs, are structured under the 1940 Act and are generally used to provide traditional index exposure. Exchange-traded notes, or ETNs, are technically debt obligations from a backing bank that do not necessarily hold the index's underlying constituents. And while they can be used to provide traditional index exposure similar to the ETF structure, they can also provide 2 times and 3 times leveraged and inverse and commodity strategies.

Commodity exchange-traded products, or ETPs, that actually hold their index constituents introduce further variety. Those that use futures contracts are structured as limited partnerships, while those that hold the physical commodity are structured as grantor trusts. In many cases, however, the use of various structures comes because of existing regulation. Funds structured under the 1940 Act, for instance, cannot devote 100% of their assets to physical gold bullion because of diversification requirements.

These are only a select few structural differences, so the idea to introduce standard naming conventions has some appeal in terms of limiting investor confusion. However, there are some benefits and distinctions common to all ETPs that suggest grouping them together--such as the ability to trade them intraday, unlike a mutual fund, or the ability to create more shares, unlike a closed-end fund. We certainly agree that investors should have the ability to discern between ETP structures (and their consequences) in some convenient way. Investors already have some of these tools at their disposal--such as through the prospectus, through the analysis on Morningstar.com, or from the provider websites.

To say so isn't necessarily a knock on the vehicle, as we will be the first to highlight that ETPs have been shining examples of transparency. The fact of the matter is that this is an investor education issue, not a structural one. Further, investors already have the ability to quickly make these structural distinctions through tagging and category schemes developed by Morningstar and other data providers or by paying a visit the Web page of the provider of the ETP of interest.