SEC Widens Probe of ETFs
February 21, 2012
U.S. securities regulators have widened their inquiry into the trillion-dollar market for exchange-traded funds, according to a person familiar with the matter.
Prompted by a delay in a big trade at a popular ETF, the U.S. Securities and Exchange Commission is taking a closer look at a possible connection between high-frequency traders and hedge funds jumping in and out of ETFs, and instances where ETF trades fail to settle on time, this person said.
The SEC's inquiry is part of a wider probe that began last year and focused on complex ETFs that allow investors to magnify returns or bet against stock indexes.
U.S. and UK regulators are concerned that so-called settlement fails - when trades are not completed on time - could contribute to volatility and systemic risk in financial markets.
The probe's main focus is on illiquid ETFs, but regulators are now also examining popular ETFs and failed trades, according to the person.
An SEC spokesman confirmed that the agency is looking into failed trades and ETFs, but declined to elaborate.
The SEC's inquiry comes amid greater scrutiny of the ETF industry, which has surged in popularity since the early 1990s. It is still unclear how settlement delays might affect retail investors in ETFs.
ETFs are baskets of securities that, like mutual funds, give investors exposure to a pool of assets. But unlike mutual funds, they trade throughout the day. Early ETFs were created to mirror benchmarks such as the Standard & Poor's 500 index. ETF assets have doubled since 2007 to about $1.3 trillion, according to Deutsche Bank AG. Some of the most popular ETFs are those that use derivatives to give investors exposure to commodities, high-yield bonds or ETFs that own other ETFs.
Hedge funds often "short" ETFs, or make a bet that the price of the ETF will fall. In such a trade, the fund sells borrowed ETF shares in hopes of profiting by buying them back later at a lower price. The SPDR S&P Retail ETF, for instance, has a short interest of nearly 200 percent, meaning short investors' bets amount to three times the total number of shares outstanding for the ETF. That is possible because traders lend ETFs to other investors or traders. These ETFs can be lent again to others, and show up on the books of multiple parties.
ETF experts discount criticism of ETFs. In a recent report, State Street Corp, a Boston asset manager that created the first ETF in 1993, said that "short interest theoretically should have no impact on an ETF's performance."
State Street created the SPDR S&P Retail ETF, which is often the most-traded security on U.S. equity markets, outpacing daily volume of large-capitalization stocks like Microsoft Corp and Apple Inc.
State Street said its analysis of SPDR S&P Retail and 19 other most-shorted ETFs, including popular names like SPY, IWM and QQQ, found that high levels of short sales did not affect the ETFs' ability to track their corresponding index.
However, 14 of the 20 most-shorted ETFs on State Street's list also ranked highest in total value of reported settlement fails across all equity securities for 2011, according to data published by the SEC.