ETFs and the risks of connectivity

story_images_domino-tilesIt was another banner quarter for exchange-traded funds (ETFs).

London-based ETFGI, which tracks fund flows and growth, reported just last week that ETFs in the U.S. gathered a record $145 billion in new assets as of the end of the third quarter 2015. September alone saw another $19.1 billion flow into U.S.-listed ETFs.

And yet another milestone was announced last week: bond ETFs topped US$500 billion for the first time at the close of the trading day Thursday, according to BlackRock.

No doubt, ETFs continue to thrive despite market volatility and the specter of rising rates.

But what about regulatory pressure? Some signs last week show things could be heating up as some market participants raise alarm bells over the size and impact of ETFs on the broader market.

Last week Oeyvind Schanke, CIO of Norway’s sovereign wealth fund, said the US$860 billion fund has concerns over the growing impact ETFs could have on the underlying securities they are connected to.

And while imposing circuit breakers on exchanges that trade them is a good start, he told Bloomberg, ““the interaction between ETFs and underlying securities is also important.” And that increases, “we probably need some set of rules that take care of that inter-connectivity.”

Closer to home, the U.S. Securities and Exchange Commission were raising similar alarm bells over inter-connectivity sparked by issues with pricing on August 24. On that day, extreme market volatility called for number trading halts on the New York Stock Exchange. Prices of some ETFs plunged dramatically: in some cases, much much lower than the combined weighted valued of the underlying stocks.

An anomaly for sure—but one that regulators want ironed out in the future. The Wall Street Journal’s Leslie Josephs picked up on a comment made by SEC Commissioner Luis Aguillar that showed up on remarks posted on the SEC’s website: “It seems fairly certain that the explosive growth of ETFs in recent years poses a challenge that isn’t going away—and may well become even more acute as new ETFs enter the market.”

He continued, referring to trading anomalies on August 24: “Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to re-examine the entire ETF ecosystem.”

How they will do that remains to be seen. New liquidity rules announced last month will seek to tame part of the ETF ecosystem. But the SEC’s latest comments could indicate this might not be the end of it – especially as ETFs continue to grow and find a role in the portfolios of investors large and small.

Stay tuned for more.