Beloved for their stellar qualities by RIAs, they are nonetheless the casino chip du jour for many traders

March 29, 2011 — 1:26 PM UTC by Elizabeth MacBride

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The promise and dangers of ETFs, the extent to which they contribute to market volatility, and the fact that regulators are just beginning to grapple with them – all came under a spotlight today at a panel discussion at the North American State Securities Administrator’s annual public policy conference.

The panel – Exotics in the Neighborhood – stood out from among the dry regulatory topics otherwise on the slate at the conference in Washington, D.C., attended by state regulators. They are currently coping with the switch to state oversight of more than 4,000 advisors, not to mention implementing other parts of Dodd-Frank financial reform. See: It’s looking official: Advisors switching to state oversight to face many more audits.

At the exotics panel, which consisted of Mark Carver, iShares product manager at BlackRock; Elisha Tuki, an executive director of Morgan Stanley in the legal and compliance division; and Jim McTague, Washington editor of Barrons, there was a strange sense that regulators may have just started to notice ETFs.

Carver gently protested at being part of a panel on exotic investments: ETFs accounted for 30% of the average daily volume on the exchanges, he said. Tuki offered a primer on structured products, including exchange-traded notes.

McTague, meanwhile, argued that traditional investors – buy and hold investors – will be crushed by the newly volatile market. He and Carver exchanged sharp words about the extent to which ETFs contribute to that volatility (see below).

Here are four things that I learned at the panel, moderated by Peter Cassidy of the Massachusetts Securities Division.

RIAs increasingly are using ETFs, but their motivations for adopting them differ.

Carver of BlackRock identified RIAs as a growing market among the five that that company serves:

• Institutional mutual fund and hedge fund managers, which are the company’s largest market and account for 50% of an iShare’s ownership on any given day.

• Foundations, endowments and pensions

• Brokers

• RIAs

• Big private banks (Increasingly, Carver said, the banks are calling on BlackRock for extensive due diligence on ETFs).

Some RIAs load up on ETFs as a strategy for clients who want liquidity for volatile markets.

RIAs that are coming up with complex asset allocations are using them more for very focused investment strategies. See: Schwab closes the Windward Investment Management deal but relinquishes the brand. Some RIAs that offer a core-and-satellite strategy may use mutual funds for the core, and ETFs for satellites.

The extent to which ETFs contribute to market volatility – and the extent to which regulators will respond to the tendency, if it exists – is an emerging issue.

ETFs have been linked to the flash crash, though not definitively. See: Flash crash update: Why the multi-asset meltdown is a real possibility.

“Individual investors are so skittish they want something that allows them to run as quickly to the exit as possible,” said McTague. He also connected ETFs and their use by hedge fund managers to the increase in volatile days in the market.

He said that days in which the market moves 2% or more are more frequent now than at any time in history. “Most high-frequency traders to do not hold on to shares for more than 11 minutes,” he said.

McTague’s new book is Crapshoot Investing: How Tech-savvy traders and clueless regulators turned the stock market into a casino.

“I would strongly argue that investors do not use ETFS as chips,” Carver jabbed back. “We could debate about hedge funds using quant strategies, which is really what you’re talking about.”

Regulators are behind the eight ball when it comes to regulating ETFs.

This causes damage from both the company’s perspective and the investors’ perspective. Carver pointed out that ETFs face a much longer approval process than mutual funds, which are governed under a 1940 law. McTague noted that regulators lack a window even into basic market data.

“They get trading data from FINRA and the NYSE,” he said. “They don’t have the computers to crunch the numbers.”

State regulators are typically much stronger investor advocates than federal regulators. I couldn’t help wondering about how difficult it would be for a small staff at a state regulators’ office to bring a fraud case involving a hedge fund using a complex high-frequency trading strategy.

McTague predicted that this period of volatility – in which ETFs are flourishing – will last for as long as a decade.

“I interviewed a trader who made a 300% annual return by being 2 seconds ahead of the market.

“The market is dominated by the machines,” he said. “We just have to adjust to that fact, like we have to adjust to the fact that our drinking water might have radiation in it from Japan.”

The quant models are all chasing the same signals. “Everybody runs the same strategies,” Tuki agreed.



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