As Congress begins to assess the possible role of exchange-traded funds in recent market volatility, two ETF providers are clashing over the best way to help investors navigate the increasingly complex products.
Last Wednesday, the Senate Banking Subcommittee on Securities, Insurance and Investment held a hearing on ETFs to hear arguments that they are central to market swings, represent systemic risk and make it harder for companies to raise capital.
In an appearance before the committee, Noel Archard, managing director of
BlackRock Inc., reiterated the firm's proposal to create uniform standards on labeling, transparency and disclosure for ETFs that would distinguish between “buy and hold” varieties and those designed to profit from frequent trading.
A key part of the
BlackRock plan would reserve the ETF label for funds that were publicly offered and “appropriate for retail investors,” such as those that tracked equity indexes or baskets of stocks, commodities, fixed-income instruments or currencies.
Under the firm's guidelines, the term “ETF” could not be used to designate the more complex leveraged, inverse and inverse-leveraged ETFs, which magnify the gains or losses of the indexes on which they are based, and typically hold derivatives.
“It is important for investors to understand the differences among products that are all described as "ETFs,' despite exposing investors to different types and levels of risk,” Mr. Archard said in prepared testimony. “The ETF industry today, both in the U.S. and globally, is not doing a sufficient job in explaining those differences consistently.”
The proposal from BlackRock, which does not offer many of the more exotic ETFs, drew a sharp rebuke from one of its competitors.
“Our problem with the plan is that it is simplistic and arbitrary,” said Michael Sapir, chairman and chief executive of ProShare Advisors LLC. “It will require government bureaucracies to take over the 1,200-ETF universe and make fine distinctions that aren't important to investors. The answer isn't creating some new, byzantine bureaucratic structure that benefits some in the industry, and not others.”
Some ProShares ETFs are leveraged and inverse, and many make extensive use of collateralized-swap agreements and exchange-traded futures contracts, Mr. Sapir said.
He disputed the notion that a line can be drawn between “buy-and-hold” ETFs and those that take advantage of intraday trading.
“A great portion, if not a majority of ETFs, are used for short-term trading,” Mr. Sapir said.
If BlackRock's proposal is implemented, it could benefit the ETF leader, which accounts for $470 billion of the nearly $1 trillion domestic ETF market under the name iShares. ProShares is the fifth-leading ETF provider, with $26 billion in assets under management.
“They're the big gorilla,” Matt Grinnell, buy-side compliance officer at Fidessa Group LLC, said in reference to BlackRock's market position. “
BlackRock does issue a lot of the plain-vanilla ETFs.”
If ETFs were sorted into separate categories, it would be natural to treat the complex and volatile ones differently.
“If there's more regulation around those, that's bad for [ProShares'] market,” Mr. Grinnell said.
But Mr. Sapir said that his opposition to BlackRock's proposal isn't an effort to defend his company.
“We don't think it would have a significant impact on our business,” he said. “Our concern is investor confusion.”
One area where
BlackRock and ProShares agree is that ETFs don't cause market volatility.
ETFs were disproportionately represented in the flash crash in May 2010 and accounted for about 40% of trading activity in August, which was marked by wide market swings. Inverse and leveraged ETFs must reset at the end of each trading day to align their value with that of their underlying assets.
Although these characteristics of the ETF sector in part instigated the Senate hearing, Mr. Archard said that the complex ETFs must re-balance in the market direction. “The historical evidence available to us shows that the broad dynamics of market volatility are reflective of overall macroeconomic uncertainty,” he testified.
OUT OF CONTROL?
But Harold Bradley, chief investment officer at the Ewing Marion Kauffman Foundation, told the Senate panel that ETFs have grown so rapidly that they are spinning out of control.
“ETFs have increasingly distorted the role of equities markets in capital formation, while posing systemic risks from potential settlement failures,” said Mr. Bradley, a market expert who testified on behalf of institutional investors.
“They are now moving the markets rather than tracking the markets,” he said in an interview.
The Securities and Exchange Commission in March 2010 issued a moratorium on regulatory approval for ETFs that use derivatives heavily. It is reviewing the role of leveraged and inverse ETFs in market gyrations.
Meanwhile, Congress will be keeping an eye on the products to ensure that it isn't caught flat-footed, the way it was with collateralized debt obligations.
“This is a very appropriate time ... to start asking difficult questions about ETFs,” said Sen. Jack Reed, D-R.I., chairman of the banking subcommittee. “In the past, we've seen situations where innovation looked very attractive to us until it exploded.”
Email Mark Schoeff Jr. at [email protected]
