The $5tn ETF market balances precariously on outdated rules

Let us create regulations that put all these investment products under one umbrella

Henry Hu

The US has neither a dedicated system of regulation nor even a workable, comprehensive legal definition of what constitutes an ETF © Getty

In 25 years, the exchange-traded fund has become one of the most popular financial innovations of the modern era. In 2016, seven of the 10 most actively traded US securities were ETFs. But the sector is a regulatory backwater.

Even though these funds pose distinctive risks and the industry continues to grow, the US has neither a dedicated system of regulation nor even a workable, comprehensive legal definition of what constitutes an ETF.

The ETF’s closest cousin is the mutual fund, which is about 70 years older. Both securities offer investors collective exposures to portfolios of stocks, bonds and other assets. Shares in either can usually be bought and sold “at cost”; that is, at or near the value of the portion of the fund’s assets that corresponds to each share, which is also known as the net asset value.

While the prices of mutual funds are set once a day, ETF prices change constantly as the value of their underlying assets fluctuate. The funds also offer a dazzling array of investment possibilities: from plain vanilla equity trackers to exotic mixes of long, short and leveraged exposures. In effect the ETF serves as a universal portal to a wide section of the financial world. No wonder their assets under management have smashed through the $5tn mark.

But this product creates special risks. The integrity of an ETF’s price is only as good as the models and contracts that link everything together, which are collectively known as the “arbitrage mechanism”.

In times of stress, this mechanism has sometimes failed dramatically. On February 5 2018, the shares of an arcane, “inverse volatility” ETF closed at a price roughly 18 times greater than the collective value of its underlying holdings. Large, plain vanilla ETFs have not proved immune to the same issue. Immediately after New York’s 9:30am market opening on August 24 2015, the share price of the US’s second-largest ETF — one that tracks the S&P 500 — lost 20 per cent of its value, even though the index only fell about 5 per cent.

Current US oversight of ETFs stems from an odd mix of stock exchange listing rules and laws designed for very different products. The Securities and Exchange Commission largely makes it work by improvising regulations for each new ETF.

This state of affairs falls short in two ways. First the disclosure rules, which are rooted in a system designed for mutual funds, fail to address the potential for significant problems with the arbitrage mechanism. Under the current SEC scorecard, that S&P 500 fund that plummeted in August 2015 was still able to report a perfect 100 per cent tracking performance covering that period.

Second, the ad hoc reviews undermine the fairness and consistency of regulation. Functionally identical funds are often subject to disparate rules, and gaining approval for new funds can be opaque and unpredictable. When new requirements emerge, they apply only to new funds, allowing older funds to continue operating under looser rules.

We need a regulatory framework dedicated to ETFs. John Morley, a professor at Yale Law School, and I have proposed that the SEC put all investment products that use the arbitrage mechanism under the same regulatory umbrella. Writing down the rules would avoid the need for ad hoc, individualised reviews for all but the most esoteric or risky products.

We need tighter disclosure requirements that would capture breakdowns such as occurred that August day in 2015 and suggest all ETFs be forced to provide broader, more forward-looking information about their engineering.

The time to act is now: this unique market rests on a fragile, outdated and complex structure.

We need something far stronger.

The writer teaches at the University of Texas. John Morley, who teaches at Yale, also contributed to this article.

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