ETFs have given investors many significant advantages

Few things — if any — in Washington, D.C., make sense these days.

This is the exactly the case as evidenced by the recent Senate hearings on Oct. 19, titled “Market Microstructure: Examination of Exchange-Traded Funds (ETFs).” The purpose of the meeting was to analyze the impact of ETFs on the financial markets.

Why have financial markets been so volatile? What are the reasons and causes behind the “Flash Crash” on May 6, 2010? Does anybody know? The Senate figured it would call in some experts to get to the bottom of it, but instead of answering questions, the Senate found a good scapegoat: the U.S. exchange-traded products or ETP market, which encompasses ETFs, and has around $1 trillion in assets under management.

ETF Detractors — A Passionate Sect

So far this year, the S&P 500 has experienced more than 60 consecutive days in which it has fluctuated by 1% or more during intraday trading. Who or what is behind the cause of this increased stock market volatility? A small but passionate group of anti-ETF crusaders argue that ETFs are to blame.

Andrew Sorkin of The New York Times calls ETFs the “new derivative.” While statements like this are journalistically cute, they’re factually incorrect. ETFs never have been and never will be derivatives.

Furthermore, ETFs, unlike other entities that invest in derivatives, such as hedge funds, are closely regulated and fall under the Investment Company Act of 1940 or the Securities Act of 1933. Put another way, the regulatory requirements for ETFs are burdensome enough to appease even the most bureaucratic bureaucrat. Does an already heavily regulated industry need more regulation?

It’s true that certain ETFs do invest in derivatives to obtain their market exposure, but it’s not illegal, it’s always fully disclosed and there’s no empirical evidence what! soever t hat it’s causing market disruptions of any kind.

Other Scapegoats: Leveraged and Inverse ETFs

Are leverage and inverse performing ETFs to blame for increased market volatility — particularly late-day market swings? That’s the assertion made by Sorkin and others in his camp, but nobody can explain — using factual evidence — how or why an investment category that controls less than $50 billion in assets is distorting multitrillion-dollar global markets.

“Users of leveraged and inverse ETFs tend to be less deferential to market action than traditional investors,” says Dan O’Neill, Chief Investment Officer at Direxion Shares. “Net asset flows into the funds are often inversely correlated with the day’s market action. Such activity by leveraged and inverse funds’ shareholders tends to counteract somewhat the movements of the markets themselves and to reduce the need for rebalancing trades by the funds themselves.”

Do inverse or bear ETFs put undue downward market pressure on the market? Here too, the numbers shed some light. At the end of October, there was $15.34 billion in leveraged short ETFs compared to $13.30 billion in leveraged long ETFs.

Put another way, each group has nearly the same amount in assets and thereby offsets the other group. There are no imbalances as critics allege.

A History of Copycat Complaints

For those of us who still remember history, similar complaints of market distortions were lodged against futures and program trading when they were blamed for the root cause of the 1987 stock market crash. While this remains the most popular explanation of the ’87 crash, is it the most accurate? To avoid looking foolish, perceptive Wall Street historians and economists have backed away from the previously dogmatic arguments that blamed one particular product, system or event for the massive meltdown.

John Bogle, Fo! under of the Vanguard Group, is another individual who has bum-wrapped ETFs at every opportunity.

I have deep respect for Bogle and he’s been a guest on my weekly radio program, the Index Investing Show, multiple times. Bogle is 100% right about everything he says about the self-serving financial services industry, minus his spurious arguments against ETFs.

Contrary to Bogle’s assertions, brisk ETF trading volume is good for ETF shareholders. It creates tighter bid/ask spreads, greater liquidity, and has no negative effects on buy-and-hold ETF investors. Also, the same long-term investing principles that Bogle advocates can and are being used with ETFs. Look no further than Vanguard ETFs, which continue to vacuum in record assets. In 2010, the company led its peers with net ETF cash flows of $35.4 billion. What kind of company would Vanguard be today had it taken Bogle’s advice to not offer ETFs alongside mutual funds? We can only imagine.

The undeniable truth is that ETFs have introduced many significant advantages for investors, including lower expense ratios, intraday liquidity, tighter bid/ask spreads, better tax efficiency and multiple hedging strategies. “As a retail investor, I wouldn’t want to be in a mutual fund,” admitted Harold Bradley of the Ewing Marion Kaufmann Foundation in his Senate testimony. Interestingly, Bradley is another ETF detractor.

Barking Up the Wrong Tree

It’s disingenuous for the Senate and other regulatory bodies to be focusing their attention on heavily regulated ETFs while simultaneously turning a blind eye to other areas of the financial services industry that remain — unlike ETFs — largely unregulated.

The opaque $2 trillion hedge fund industry is a perfect example of supreme regulatory incompetence. Despite all the tough talk, hedge funds continue to run loose, doing and saying just about anything they’d like. It’s akin ! to the f ree-love era of the 1960s.

Did you know that the Securities and Exchange Commission just eased hedge fund filing requirements? The SEC is “reducing the number of large firms that have to file quarterly and exempting small firms,” according to a Wall Street Journal report. Regulators are perfecting their mistakes.

Conclusion

Although the $1 trillion ETP marketplace has become a cluttered cesspool, this unfortunate phenomenon is hardly exclusive to ETFs and is readily visible in the hedge fund and mutual fund markets, where the trend was started. Likewise, it’s completely accurate to say that ETFs have taken a radical departure from their original roots to traditional index investing, but that doesn’t diminish the valuable role ETFs play in portfolio management, nor does it negate their overwhelming benefits.

Lastly, if ETFs are such an immediate threat to the financial system and if they’re the true culprit behind the stock market’s latest volatility bout, how come Senator Mike Crapo, R-Idaho — the investigation team’s lead dog — didn’t show up to the ETF Senate hearing?

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