Why Is the Senate Witch-Hunting ETFs?

Few things — if any — in Washington, D.C., make sense these days.

This is the exactly the case as evidenced by the recent Senate hearings on Oct. 19, titled “Market Microstructure: Examination of Exchange-Traded Funds (ETFs).” The purpose of the meeting was to analyze the impact of ETFs on the financial markets.

Why have financial markets been so volatile? What are the reasons and causes behind the “Flash Crash” on May 6, 2010? Does anybody know? The Senate figured it would call in some experts to get to the bottom of it, but instead of answering questions, the Senate found a good scapegoat: the U.S. exchange-traded products or ETP market, which encompasses ETFs, and has around $1 trillion in assets under management.

ETF Detractors — A Passionate Sect

So far this year, the S&P 500 has experienced more than 60 consecutive days in which it has fluctuated by 1% or more during intraday trading. Who or what is behind the cause of this increased stock market volatility? A small but passionate group of anti-ETF crusaders argue that ETFs are to blame.

Andrew Sorkin of The New York Times calls ETFs the “new derivative.” While statements like this are journalistically cute, they’re factually incorrect. ETFs never have been and never will be derivatives.

Furthermore, ETFs, unlike other entities that invest in derivatives, such as hedge funds, are closely regulated and fall under the Investment Company Act of 1940 or the Securities Act of 1933. Put another way, the regulatory requirements for ETFs are burdensome enough to appease even the most bureaucratic bureaucrat. Does an already heavily regulated industry need more regulation?

It’s true that certain ETFs do invest in derivatives to obtain their market exposure, but it’s not illegal, it’s always fully disclosed and there’s no empirical evidence whatsoever that it’s causing market disruptions of any kind.

Other Scapegoats: Leveraged and Inverse ETFs

Are leverage and inverse performing ETFs to blame for increased market volatility — particularly late-day market swings? That’s the assertion made by Sorkin and others in his camp, but nobody can explain — using factual evidence — how or why an investment category that controls less than $50 billion in assets is distorting multitrillion-dollar global markets.

“Users of leveraged and inverse ETFs tend to be less deferential to market action than traditional investors,” says Dan O’Neill, Chief Investment Officer at Direxion Shares. “Net asset flows into the funds are often inversely correlated with the day’s market action. Such activity by leveraged and inverse funds’ shareholders tends to counteract somewhat the movements of the markets themselves and to reduce the need for rebalancing trades by the funds themselves.”

Do inverse or bear ETFs put undue downward market pressure on the market? Here too, the numbers shed some light. At the end of October, there was $15.34 billion in leveraged short ETFs compared to $13.30 billion in leveraged long ETFs.

Put another way, each group has nearly the same amount in assets and thereby offsets the other group. There are no imbalances as critics allege.