A sharply worded report that ties exchange-traded funds to the flash crash has been met with a wave of criticism from the industry and the biggest ETF sponsors and advocates.
The report was authored by former American Century investment officer and chief trader Harold Bradley, now CIO of the Ewing Marion Kauffman Foundation. It claims, among other things, that the proliferation of exchange-traded products is creating disincentives for young companies to go public, and worse, that ETFs have given rise to systemic risks that create “a potent new financial Molotov cocktail aimed at the markets.”
The report has been met with widespread media coverage and resounding criticism from across the industry. In response, the foundation released a revised version of the report late Friday. The revisions were intended to supplement the foundation’s arguments with more examples and data and to correct some technical errors, Bradley said in an interview with Ignites before the revised version was released.
While many sponsors say the industry’s strong response is simply to eliminate any untruths about the ETF product, they acknowledge that these reports have a real impact on the common investor. Many chalk the reaction up to the product’s complexity combined with its growth rate among retail clients.
“A big worry is that investors read this and become attuned to something that isn’t really an issue,” says George “Gus” Sauter, CIO of Vanguard, the third largest ETF sponsor by assets. “We certainly do need to respond, we need to educate people, because when they don’t understand, they start thinking there are demons that don’t really exist.”
Sauter says there are aspects of the report that are on point, such as the discussion of market structure and exchange issues that have led to imbalances. But to link ETFs to the flash crash or other systemic risks is “rather sensational and inappropriate,” he says.
On Thursday the Investment Company Institute weighed in on the matter, claiming “the paper levels several accusations against ETFs that are just not plausible.”
In the report, which was published Nov. 8, Bradley contends that ETFs create a systemic risk when they are highly shorted, theorizing that the demand for the underlying securities would outstrip supply if investors decided to cover their short positions en masse.
The second argument Bradley makes is that the rise of small-cap ETFs, and the massive trading around them, is creating stronger correlations between stocks and is artificially setting their prices, which undermines the ability of young companies to reap the benefits of the public markets.
The updated report includes a footnote explaining that the revised version no longer paints the emergence of ETFs as the primary reason for the decline in the number of public company listings, but argues that “the high correlation of small-capitalization companies and the high costs associated with compliance are making companies reluctant to list.”
The ICI and ETF sponsors, however, claim both arguments are fundamentally flawed. One of the chief complaints is that the report does not take into account the creation and redemption process between sponsors and authorized participants. They also argue that indexes are good for small-cap companies, and that most total market indexes will pick up a stock as soon as it goes public, providing trading volume for the stock.
The rise of ETFs as a popular investment vehicle among retail investors, combined with their inherent complexity, creates an environment ripe for contrarian criticism, sources say.
“Larger ETF sponsors understand that we are a mass market product now, and this comes with the territory,” says Gary MacDonald, global head of ETF marketing for State Street Global Advisors, the second largest sponsor of ETFs by assets. “I don’t think anyone expects anyone to dump a 65-page paper in the media with so many glaring errors in it. However, when you think about the rapid growth of ETFs, you understand that the communication bandwidth that you’re dealing with is growing…. This requires time, resources and energy, but this organization and the other major providers would be foolish not to embrace that challenge.”
For his part, Bradley of the Kauffman Foundation says the “ad hominem attacks” on his report blur the real issue of ETFs — that unbridled short selling can cause real risks to liquidity when demand for the underlying security, even if it is from authorized participants and not the asset manager itself, outstrips supply. This philosophy is what leads to his alternative thesis that ETFs contributed to the flash crash.
“The systemic risk problem is the promise of liquidity in an illiquid asset, that there can be an infinite ability of supply on a finite number of underlying securities,” he says.
“We’re not out to get ETFs,” Bradley adds. “We’re trying to fix the markets.”
The argument over whether the report adequately explains the fundamental structure and processes around ETFs shows how complex the products are and how important investor education is to sustaining the industry’s growth.
“This report demonstrates that while the transparency of ETFs is pretty good, the transparency around the process could be better,” says Scott Burns, director of ETF research at Morningstar. “The problem is that it’s too complicated for most people. How do I explain to the average Joe investor how an institutional trader closes out short sales? There’s more layers to the ETF than a traditional mutual fund.”
Yet some ETF providers appear to be embracing the barrage of criticism. In a letter to investors refuting many of the Kauffman report’s claims, WisdomTree president and chief operating officer Bruce Lavine links what he describes as attacks to the transformative nature of the products.
“In a sense, [ETFs] are a disruptive technology that is changing the face of financial services. As part of the natural evolution of the product, ETFs will be subjected to scrutiny. The ETF industry should welcome such scrutiny and do its best to educate investors and correct any misconceptions,” he writes.
In addition, both MacDonald of SSgA and Sauter of Vanguard said their respective firms were committed to ongoing investor education efforts.
But the industry should expect greater examination as it grows, observers say, and how it responds will say a lot about its resilience.
“In order to become mainstream like how a mutual fund is now mainstream, you have to go through these battles,” says Richard Keary, a former Nasdaq ETF official and now president of Global ETF Advisors. “The more the ETF people stand up and say, ‘Hey, this is not right,’ and then go out and educate not just their clients but people thinking about buying ETFs, that’s how they’re going to overcome this.”
