WSJ: In case of ETF emergency

22 June 2011

The ETF has been hailed for its simple and transparent secondary market model: ETFs allow baskets of assets to be traded on an exchange with all the transparency, liquidity and regulatory oversight for which the equities markets have long been credited.

A number of extraordinary market events during the past year – in particular the so-called "flash crash" of May 2010 and the mini ETF flash crash of March this year – have highlighted the potential risks of trading ETFs, particularly for retail and high-net-worth investors that do not have access to the same sophisticated trading tools found in the institutional world. Although the majority of high-net-worth investors in Europe will invest in ETFs through a private bank or wealth manager, there is a small but growing contingent of self-directed investors who prefer to trade in and out of ETFs independently. These investors can access the exchange-traded ETF market as they would the equities markets, through a brokerage firm, but are less likely to understand the market risk involved fully.

Hazardous Properties

"I don't think that high-net-worth investors are aware of the risks associated with trading ETFs", says David McFadzean, head of investment solutions for RBC Wealth Management UK. "The ETF providers are a bit behind the curve when it comes to making information available to end users, although that is now changing quickly in light of the flash crash." The situation is also complicated by the similarity of ETF products. Two competing ETF providers can issue what appears to be the same ETF, offering exposure to exactly the same basket of securities. However, one ETF may have more liquidity if its provider is able to secure stronger commitments and support from ETF market makers to provide bids and offers on that ETF. "When an investor is looking to trade seemingly similar products, they must look at the liquidity in those respective products", says David Bower, marketing director of iShares, the major ETF provider.

Liquidity is not always visible, however. In both the US and Europe, trading of stocks and ETFs is fragmented across multiple public markets, which includes the established national exchanges and a number of less well known alternative markets. To make matters worse, around 60 per cent to 70 per cent of ETF trading actually happens away from the public exchanges in the over-the-counter market between banks, brokers and trading firms directly. Many market watchers are awaiting regulatory intervention to bring greater transparency to the overall ETF market. The European Commission's review of the Market in Financial Instruments Directive (MiFID), first introduced to the equities markets in 2007, is set to include the trading of ETFs.

The Directive is likely to require greater pre- and post-trade transparency of a range of instruments, including ETFs, and would potentially institute a consolidated tape for equities and ETFs too. Paul Inkster, head of product for Barclays Stockbrokers, says: "We would anticipate that the expansion of MiFID to ETFs would lead to a wider distribution of information and improved transparency of the information [in the ETF market], which would always be welcome". Greater transparency will allow high-net-worth investors to assess better if they are trading at a fair price, and allow them to assess more accurately the risks of trading at any given moment.

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