Exchange-traded funds (ETFs), which offer investors diversification and liquidity at a low cost, have exploded in popularity in recent years and now represent a $1 trillion global market. Morningstar estimates that ETFs now account for at least a third of exchange trading volume in the U.S. Recent events, however, have served to highlight some of the risks posed by ETFs. And regulators seem to be well behind the curve when it comes to overseeing this enormous and influential market.
Kweku Adoboli, the UBS trader recently charged with unauthorized trading that resulted in $2.3 billion in losses, apparently established phantom positions in ETFs as a way to offset actual trades. Because in Europe ETF trading is done mostly over the counter, and reporting requirements are less stringent, Adoboli was able to conceal his losses. The European Commission plans to address the need for tighter regulations in October. The UBS case, while still unfolding, could very well serve as Exhibit A for taking action when the Commission convenes.
Yet even before the scandal broke on September 15, ETF critics were taking aim. Earlier that month, Vanguard founder Jack Bogle, in an interview with the The Wall Street Journal, observed that speculation with ETFs “is on the edge of insanity . . . they’ve destabilized the market.” A chagrined Bogle was perhaps compelled to speak out by the fact that in August the largest gold ETF (GLD) briefly overtook the S&P 500 (SPY) as the world’s largest ETF.
Bogle isn’t alone. CFA Magazine recently ran a cover story titled “Emerging Threat Funds,” in which author and former financial analyst John Rubino provides a thorough overview of the ETF market and its hidden risks, particularly those associated with leveraged and synthetic ETFs, which many market watchers point out are popular with high-frequency traders — and thus are considered the root cause of much of the increased market volatility in recent months. Rubino notes that “one of history’s clearest lessons is that when financial innovation really gets going it tends to race ahead of regulators, who only catch up after an idea has revealed its dark side.” In the same issue, veteran value investor Prem Watsa, CFA, warns that ETF-driven speculation in commodities “will end badly.”
Despite the recent negative press, ETFs still have their defenders. Richard Keary, founder of Global ETF Advisors, an industry consultant, argues that ETFs are not to blame for increased market volatility — and points to high-frequency trading as more deserving of regulators’ attention. Used correctly, Keary insists, ETFs actually reduce market volatility.
The SEC has only recently stepped up efforts to investigate the impact of ETFs on the U.S. financial markets, and the agency is apparently focused on leveraged ETFs as part of a wider probe of high-frequency trading. Whether the UBS trading scandal is simply an isolated case of poor oversight and risk management or the result of some of the systemic risks associated with ETFs is not yet clear. But there is no doubt that the ETF market has grown exponentially and that it demands the attention of regulators.
ETFs can be efficient investment vehicles — but in the wrong hands, they are also fraught with risk.