Exchange-Traded Funds: Consequences of Expansion

Thu Jul 15 16:24:38 EDT 2010
By Raymund Wong and Kara Hargadon

Exchange-Traded Funds (ETFs) have garnered close attention from the investment community and regulators in recent years, as they have rapidly increased in popularity, variety, and complexity. Until recently, ETFs had enjoyed a relatively uncontroversial history, having gained popularity as alternatives to similar index-tracking mutual funds, with the advantage of intraday liquidity, lower fees, and greater tax efficiency. As ETFs have expanded in popularity, newer and more complex products have emerged, including ETFs that track bond indices or hold other less liquid securities, leveraged and inverse ETFs, and actively managed ETFs.

In this article from the Securities Litigation Journal, NERA Senior Consultant Raymund Wong and Analyst Kara Hargadon argue that, as these newer ETFs expand beyond simple tracking of equity indices, they may face some challenges in duplicating the success of their predecessors. Leveraged and inverse ETFs have already been the subject of several recent securities class action lawsuits. Additionally, actively managed ETFs have been attracting significant attention after their long-awaited Securities and Exchange Commission (SEC) approval in February 2008. Complex investment strategies may be more costly to implement, and more exotic and less liquid securities may impede the arbitrage mechanism upon which ETFs depend.

The authors suggest that, as ETFs continue to expand beyond traditional strategies, it is not entirely clear that they will be able to maintain their original advantages. If successful, future innovative ETF products may provide a challenge to the dominance of mutual funds beyond traditional index strategies. However, the history of past regulatory scrutiny and litigation risk for other similar types of investment funds suggests that ETFs may still have certain hurdles to overcome.