The Perils of Exchange Traded Funds

And with ETFs now accounting for somewhere near 40% of all exchange trading volume, institutional ETF traders occupy a very important position in the daily functioning of financial markets.

ETF sponsors are aware of the heavy institutional ownership of ETFs, and even cater to it. When BlackRock's iShares unit launched the Emerging Markets Small Cap ETF in August, the NYSE/Euronext called the move "a direct response to the growing trend among institutional investors" to use ETFs.

The periodic reports warning of the inherent dangers of ETFs have failed to put much of a dent into their popularity, but there are real risks that investors probably should be more aware of. The Securities and Exchange Commission is investigating multiple issues surrounding ETFs.

One issue SEC regulators want to look at is whether ETFs, and particularly leveraged ETFs, have added to the recent stock market volatility, according to a Wall Street Journal report.

ETFs also lend themselves to some unsavory activities. The SEC is charging a former trader from Goldman Sachs with using his knowledge of the firms trading activities surrounding the SPDR S&P Retail ETF to buy or sell the underlying securities when large orders for the ETF came.

Insider trading can also be accomplished through ETF "stripping," in which a phantom position can be created by simultaneously buying an ETF and selling all the underlying securities but one.

As a result of the May 2010 "flash crash," in which ETFs suffered a disproportionate number of trades that were later broken, it has come to light that ETFs are at increased risk for wild price fluctuations because there is only a thin market for them. The SEC's final report on the flash crash stated that "anecdotally, market makers in ETFs reported that ETFs trade distinctly from individual securities, which often results in more concentrated liquidity on exchange order books.

Specifically, they considered ETFs a "professional's market," in which depth of book is more limited compared to individual stocks, and there are little, if any, resting retail orders far from the mid-quote. Sell pressure that overwhelms immediately available near-inside liquidity is less likely to be "caught" by resting orders farther from the mid-quote in an ETF versus an individual stock, according to the SEC report.

Of even more concern is the increasing complexity of the investment strategies ETFs use. New leveraged ETFs are being launched every month, as are hedge fund replication ETFs, volatility and Beta ETFs, as well as active ETFs whose strategies are not disclosed at all.

Also, as sponsors rush to grab any unfilled market niches, ETFs are pushing into less-liquid markets, which may create problems during periods of high market volatility. Furthermore, there appears to be significant pressure from prospective managers of active ETFs to relax disclosure requirements so as to avoid revealing their daily activities.

How investors will benefit from less disclosure will be a difficult, but interesting, argument for ETF sponsors to make.

The ETFs listed in the accompanying table are thinly traded, suggesting that do not attract the attention of institutional investors, yet all garnered a top "overweight" ranking from S&P Capital IQ's proprietary ETF ranking methodology, as of October 6. (S&P Capital IQ ETF rankings are subject to change at any time.)

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S&P Senior Editorial Manager Vaughan Scully can be reached at [email protected]. Send him your ideas for ETF and mutual fund stories.