ETFs' Rapid Growth Sparks Concern at SEC

The proliferation of exchange-traded funds is causing concern at the U.S. Securities and Exchange Commission, the latest sign of increased scrutiny of the popular products.

Investors have piled into the funds over the past decade, attracted to the products’ low fees and issuers’ pitch that they provide exposure to a variety of asset classes while offering the chance to get in and out of positions easily. But they have been drawing scrutiny from the SEC, even before wild trading on Aug. 24 exposed problems with how the funds are set up to trade.

“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,” said SEC Commissioner Luis Aguilar in remarks dated Thursday on the commission’s website.

The SEC declined to comment on the remarks or say what changes, if any, it might make to ETF trading rules or to its approval process for new exchange-traded products.

The number of exchange-traded products in the U.S. has swelled by more than 60% over the past five years to 1,787 as of the end of September, according to ETFGI, a London consulting firm. And a record number of new providers launched products this year, the firm has said.

Competition to list new products is ramping up. Last month, BATS Global Markets Inc. said it would start a new plan to pay ETF providers as much as $ 400,000 a year to list on its exchange.

On Aug. 24, some funds, including ones run by the largest ETF providers, priced at steep discounts to their underlying holdings during that session. Circuit breakers halted trading more than 1,000 times of stocks and ETFs, interfering with pricing of some the funds.

“Why ETFs proved so fragile that morning raises many questions, and suggests that it may be time to re-examine the entire ETF ecosystem,” Mr. Aguilar said in his remarks.

Some large ETF providers have said the tumultuous trading on Aug. 24 was partly because of market-structure issues, not the products themselves.

“The events of Aug. 24 were a result of the convergence of various market structure issues, including market volatility, price uncertainty, and the use of market and stop orders,” said Vanguard Group in a statement on Friday. (Market orders are instructions to buy or sell a stock at the market price, as opposed to a specific price.) “These issues exacerbated trading difficulties with respect to some ETFs.”

BlackRock Inc., BLK 1.60 % which runs the iShares line of ETFs, expressed a similar view in a research paper this month.

The SEC is trying to get its arms around ETFs, said Todd Rosenbluth, head of ETF research at financial information and analysis provider S&P Capital IQ. “Investors are increasingly using them instead of traditional securities. There are ramifications,” he said.

While ETFs have provided investors with easy access to broad swaths of the stock market, that very structure can backfire, Mr. Rosenbluth said. That is because if the price of a single security is unknown, it can cloud the pricing of the value of the entire fund, he said.

“There’s a benefit to diversification but there are risks of connectivity,” he said.

SEC Chairwoman Mary Jo White said in a Thursday statement on the commission’s website that the SEC is “paying close attention to pricing issues in ETPs, a product class that has proliferated in recent years.”

The SEC in June requested public comment about exchange-traded products, particularly with regard to how they trade in times of market stress.

Last month, the SEC voted to propose new rules to address how mutual funds and exchange-traded funds manage liquidity, including requiring them to classify the time it would take to convert their assets into cash.

Concerns over the liquidity of the assets in ETFs have increased in recent months.

Some investors, including Carl Icahn, have warned that illiquidity in bond markets could cause a problem for fixed-income ETFs, if investors suddenly and simultaneously rush to sell.

And earlier this week, Nomura Asset Management Co. said it would suspend on Friday the creation of new shares in a large leveraged exchange-traded fund, as well as two others, citing liquidity concerns.

Write to Leslie Josephs at [email protected] Markets

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