Unlocking Real Value Blog

Why ETF Criticism Stings – but Won’t Stick

Published on November 23, 2010 – Ignites – An Information Service of Money-Media, a Financial Times Company- written by Andrew Klausner, Founder and Principal of AK Advisory Partners LLC.

The recent negative publicity surrounding exchange-traded funds validates the old saying that success breeds contempt. Or, put another way, all good things must come to an end. The growth of ETFs since their introduction in 1993 has been impressive. Assets under management in ETFs are approaching the $1 trillion mark; trading in ETFs equals close to 25% of all trading on U.S. exchanges today; and ETFs are gaining market share at the expense of mutual funds.

But as the product continues to grow, so does the criticism about ETFs and the different risks inherent in these products. ETFs are now being haunted by two characteristics that have traditionally been seen as positive: their ability to be sold short and to be purchased on margin. A Nov. 8 report by the Ewing Marion Kauffman Foundation claimed that short selling of ETFs can generate liquidity risks when demand for the underlying security, even if it is from authorized participants and not the asset manager itself, overtakes supply. The report also seeks to connect the rise of ETFs to the May 6 flash crash.

The ability to short and purchase ETFs on margin stems from the fact that the product can be traded like stocks, continually throughout the day, as opposed to mutual funds, which are bought and sold at the previous day’s ending net asset value. What happened with ETFs is that as they became more successful, market participants found ways to create derivatives on them. Now today’s more aggressive leveraged ETFs are designed to move two or three times more than their underlying indices. The risky characteristics of these ETFs are a far cry from those of the SPY — the iShares S&P 500 ETF. Commodity ETFs have also been getting some negative press, with detractors claiming that they distort the value of the underlying assets; the jury on this is still out.

Without a doubt, it is these newer ETFs that are at the crux of today’s controversy. And unfortunately, controversy often overshadows business as usual. Many of the conclusions of the recent negative reports on ETFs, including the Kauffman Foundation study, have been diligently and effectively disputed by industry participants. A few of the criticisms, including that ETFs are responsible for the slowdown in IPOs and the flash crash, seem to be groundless. Similarly, the arguments concerning the shorting of ETFs, namely that this might cause the funds to run out of cash in a “short squeeze,” seem unlikely given the role of market makers in creating and retiring shares as demand increases or decreases.

However, we all know that when it comes to the market, perception can be reality. Even as the industry repudiates these studies, the fact remains that as ETFs have evolved, the number of risky derivative-like ETFs is increasing. And this scares people, and rightfully so, since they are inappropriate for most retail investors.

What the public needs to know is not that ETFs are bad or structurally flawed — because they aren’t. It’s that a small number of the most aggressive ETFs, which are in large part utilized by hedge funds and day traders, are driving the criticism with the help of those authoring these scathing reports. Let’s not throw out the baby with the bathwater. Most ETFs do what they are designed to do; they mirror the performance of the underlying index or commodity that they are modeled on.

More investor education on ETFs is crucial. Advisors need to proactively educate their clients on the characteristics of ETFs — both positive and negative — and make the argument that certain ETFs are effective investment tools that can be used as part of a diversified long-term investment portfolio. ETFs such as the SPY are not the ones being heavily traded by day traders and hedge funds. With more than 900 ETFs to choose from, advisors should also stress their due diligence process in identifying those ETFs that are most appropriate for their clients.

Mutual funds have had their good days and bad days, as have most other investment vehicles. Have no fear, this too shall pass for ETFs.

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