SEC preparing large-scale review of exchange traded fund industry

Concerns rising that fast-growing sector could be exacerbating market volatility

by: Robin Wigglesworth, Nicole Bullock and Joe Rennison in New York

The US Securities and Exchange Commission is gearing up for a root-and-branch review of the rapidly growing exchange traded fund industry amid concerns massive flows into ETFs may be exacerbating volatility in financial markets.

In the US alone, ETF assets stand at $2.4tn, and globally they hold $3.3tn, according to ETFGI, a data provider. They account for about 30 per cent of the value of all US shares traded, according to an estimate from Credit Suisse.
ETFs were at the centre of wild equity trading in August 2015. In one session, more than 1,000 securities were suspended from trading for sharp moves and some ETFs veered sharply from their net asset values. The chaotic trading highlighted how interconnected ETFs are with the underlying stocks as well as the futures market.
But the SEC is expected to examine every aspect of the industry and the consequences of its growth. These range from issues such as the implications of an ever-greater share of the US stock market being dictated by ETF flows, to structural concerns around such instruments tracking bonds.

The SEC has done “bits and pieces,” but is now “laying the groundwork for a bigger review”, said a person briefed on the matter. “ETFs are growing like bunnies. It’s a great success story, but as a forward-looking regulator the SEC has to be on top of any potential issues that may arise in the future.”

A working group of at least a dozen people from across the SEC’s divisions was formed about a year ago to examine ETF products, said another person briefed on the matter.
Growing disenchantment with the underperformance and high fees of traditional mutual funds has accelerated the seismic shift towards passive investment products like ETFs, which track a specific index or prices of an asset class.

Most ETFs only seek to replicate the return of a market, like US stocks, corporate bonds or oil, but newer incarnations such as “smart beta” — ETFs that splice and dice various investment factors — are also growing in popularity.

The rapid expansion of ETFs has been a great boon to many investors, who can make bets in a variety of markets ever more cheaply, but the industry’s increasing size, complexity and influence has raised concerns.
In a speech earlier this year, the SEC’s chair Mary Jo White highlighted the ETF industry’s “astounding” growth and hinted the regulator was considering a wider examination of its implications. “The SEC has taken a number of initial actions to share our thinking on these issues, and further regulatory steps beyond additional disclosures may be needed to address some of these issues,” she said in May.

The US regulator has already moved to rein in so-called leveraged ETFs, vehicles that use derivatives to increase returns, and singled out ETFs in general for “enhanced attention” in the wake of last August’s stock market slide.

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