[Infowarrior] - WSJ: SEC Looks Into Effect Of ETFs On Market Volatility

[Richard Forno]

SEPTEMBER 6, 2011, 9:00 P.M. ET
WSJ: SEC Looks Into Effect Of ETFs On Market Volatility

http://online.wsj.com/article/BT-CO-20110906-716528.html

   By Scott Patterson 
   Of THE WALL STREET JOURNAL 
 

U.S. securities regulators are looking into whether turbocharged exchange-traded funds amplified August's topsy-turvy swings in the stock market.

Securities and Exchange Commission officials have had discussions with firms that trade ETFs, asking questions about whether they added to the market's volatility, according to people familiar with the talks.

ETFs, which typically track market indexes, trade on exchanges like stocks. Exchange-traded funds have surged in popularity and now generate 35% to 40% of exchange trading volume, according to Morningstar Inc. Such funds sometimes are used by high-frequency traders, who buy and sell stocks and other assets at a rapid clip, making money on small moves.

(This story and related background material will be available on The Wall Street Journal website, WSJ.com.)

SEC officials are zeroing in on "leveraged" ETFs, which amplify investor bets, often through derivatives. Derivatives are financial contracts with values linked to another asset. The funds typically offer double or even triple the return of an index, such as the Standard & Poor's 500-stock index.

So-called inverse ETFs, which also can be leveraged, are like mirror-image indexes, gaining if the index falls and falling if the index gains.

The SEC inquiry into ETFs is part of a broader look by regulators into exotic trading vehicles and high-frequency trading. The SEC voted last week to open up a public dialogue about the use of derivatives by mutual funds and ETFs, among other things.

Some critics have long said the high-octane funds can intensify market volatility, because ETFs often reflect moves in a number of securities through a single trade, in contrast to individual stocks.

In August, stocks swung wildly as investors reacted to Europe's debt crisis, economic woes in the U.S. and Standard & Poor's downgrade of long-term U.S. government debt. The Dow Jones Industrial Average swung by at least 400 points on four consecutive days for the first time in its 115-year history.

Numerous high-speed trading firms posted high profits during the August volatility, according to traders.

While popular with high-frequency traders, leveraged ETFs also are increasingly traded by individual investors. The ETFs can magnify profits, but they also raise the risk of big losses. Leveraged ETFs are primarily intended for short-term day trading and often miss their mark on returns if held for longer periods.

Last week, SEC officials spoke by telephone with Thomas Peterffy, chief executive of Interactive Brokers Group Inc. The Greenwich, Conn., brokerage firm's Timber Hill unit is one of the biggest market makers in ETFs, buying and selling the funds on behalf of investors.

Mr. Peterffy said he was asked if leveraged ETFs can add to the market's volatility at the open and close of trading. Market makers buy and sell stocks or other underlying assets in ETFs just after the open and before the close to rebalance their portfolios.

If the market makes a big move in overnight trading or during regular trading hours, ETF market makers must buy or sell large chunks of underlying assets during a short period. The moves can be worsened by other investors trading in anticipation of a rebalancing.

Mr. Peterffy says he told the SEC that ETF trading can produce big swings anytime during the trading day.

"It is not only during the open or close but also during the day," Mr. Peterffy said in an interview. He said he told SEC officials that "many high-frequency traders go with the momentum by [trading ETFs] in the direction the market is moving."

ProShares, a unit of ProFunds Group, which says it is the world's largest manager of leveraged and inverse funds, declined to comment.

More than "half the volume on the exchange is high-frequency trading, and ETFs have become the vehicle of choice for high-frequency trading," said Robert Litan, vice president for research and policy at the Kauffman Foundation. Mr. Litan has written about the risks posed by leveraged ETFs.

Scott Burns, a Morningstar researcher who tracks ETFs, says the use of leveraged ETFs "picked up dramatically" during the August turmoil. The funds likely didn't play a major role in the swings because not enough cash is invested in the funds, he said.

In the first two weeks of August, leveraged ETFs accounted for about 13% of total ETF trading volume, according to Morningstar.

Big end-of-day swings were more likely caused by mutual-fund managers buying or selling to meet jittery investor demands during a time of high anxiety, Mr. Burns said.

High-frequency trading came under scrutiny in 2010 after the May 6 "flash crash," when the Dow Jones Industrial Average fell about 900 points in minutes. Many high-speed traders sold their holdings as the decline accelerated, putting further pressure on the market, according to the SEC.

Other factors, such as heavy selling of futures contracts and ETFs, also played a large role in the flash crash, the SEC found.