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The mystery of ETFs

By Sheyna Steiner ·
Wednesday, November 17, 2010
Posted: 3 pm ET

A controversial study released November 8 has called into question the safety of exchange-traded funds.

Exchange-traded funds are similar to mutual funds in that they are made up of a bundle of stocks or bonds, but they trade like stocks. However, unlike stocks or mutual funds, shares of an ETF do not represent ownership in companies. ETFs are derivatives, and they derive their value from the pool of securities they're made up of.

"They are selling an interest in something, not the actual shares. That allows them to trade on the open market instead of basing it on the end of the day," says Robert Laura, partner at Synergos Financial Group in Howell, Mich.

"If I want to establish an ETF, I establish the criteria for starting it and then large institutional companies send me shares of the stock of the representative index that we're going to mimic. Then I issue those institutions creation units and those creation units are able to be sold on the open market," he says.

The study came from the Kauffman Foundation, a research group in Kansas City, Mo. The authors of the study, Harold Bradley and Robert Litan, found that ETFs may be impacting markets more than people first considered.

In a press release, Litan, vice president of research and policy at the Kauffman Foundation, states that ETFs "are undermining the traditional price discovery role of exchanges." That discourages new companies from listing their companies on exchanges.

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” says Bradley, chief investment officer at the Kauffman Foundation.  

Litan and Bradley also believe that the explosion of ETFs over the past two decades pose systemic risks similar to the May 6, 2010 flash crash.

With ETF assets reaching 1.2 trillion, the study contends that "ETFs and the derivatives built around them have become the tail that wags the market."

A future market meltdown could be exacerbated by the rush to unwind ETFs, and the companies that sponsor ETFs may not be able to honor their obligations to investors, according to the report.

Critics of the study believe that this is based on a misunderstanding of the structure of ETFs.

This Bankrate story by Constance Gustke, "Are exchange-traded funds dangerous," examined some of the risks posed by ETFs and found that the more exotic the ETF, the more concern investors should have. Leveraged ETFs and inverse ETFs are a few examples of these. More mainstream funds, that simply follow indices such as the Standard & Poor's 500 or the Wilshire 5000, offer more benefits than danger.

In a story on the Wall Street Journal on Tuesday, "Are ETFs a menace – or just misunderstood?" author Jason Zweig discounts the systemic risk claim but does point out that if Bradley and Litan, investment industry veterans, do not understand ETFs, then the ETF industry has not explained itself well enough.

Indeed, if they can't understand them, what hope do the rest of us have?

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