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Sounding ETF Smoke Alarm
By Alex Ulam | 21 October, 2011

[This article previously appeared on our sister site,]

Of all the criticism of ETFs swirling around in the past year, none has created quite as much of a stir as the two white papers from the Missouri-based Ewing Marion Kauffman Foundation, the world’s largest nonprofit organisation devoted to entrepreneurship.

So, when's Alex Ulam caught up with Robert Litan, the foundation’s research director and co-author of the two papers with Kauffman’s chief investment officer Harold Bradley, it was a chance to hear more about what Kauffman thinks is wrong with ETFs.

The subject was all the more topical given that their telephone conversation took place on the same day that Bradley testified at a Senate hearing examining ETFs and their potential risks. What’s the takeaway? While they admit they haven’t yet found a “smoking gun”, they have a John Bogle-esque aversion to all the ETF trading that takes place, and aren’t backing away from their sense that ETFs pose a danger to the funding of young companies and to the financial system itself.

Ulam: Your views seem to be getting a lot of traction in the media. There was a recent article in The New York Times about a big market uptick during end-of-the-day trading. Some analysts that the Times interviewed said the late-day gains might be linked to trading in ETFs.

Litan: We call it the “flash-up” as opposed to the “flash crash.” Last week, when the market rallied like 400 or 500 points in 20 minutes, we thought that ETFs probably had something to do with that too. The larger point here is that we don’t think it is a coincidence that we have had such extreme market volatility at a time when ETF trading and the number of ETFs have been proliferating.

We know that there are lots of other factors that can explain volatility. There have been budget crises here and in Europe, so there is a lot of background nervousness in the market. At the same time, what ETFs have done—and we pointed this out in the testimony—is make it so easy to get in and out of the market in a nanosecond. And you are not able to do that with a mutual fund. But you are able to do that with a good portion of the market with an ETF. That is why we think it is not a coincidence that we have seen so much volatility.

Ulam: How did Bradley and you get interested in the ETF issue?

Litan: Here at the foundation, our main mission is promoting entrepreneurship—promoting policies that will facilitate companies going public. Through anecdotal conversations with people in the market, we picked up chatter that companies that were about to go public were not only nervous about the cost of Sarbanes-Oxley [the 2002 Sarbanes Oxley Act], they also were nervous about the market volatility of their stocks once they went public.

And we started doing some more thinking about this, and we formulated a hypothesis, which we will admit has not been statistically validated. But we think that there is at least smoke, if not fire. ETFs have become the tail that wags the dog for small-cap stocks. And a small-cap stock is not like a big stock like Microsoft. The prices of stocks like Apple and Microsoft dictate what happens to the S&P 500, whereas with small-cap stocks, it is the other way around: It is the ETF transaction that determines the price of the underlying stock. That is because a huge amount of the activity is in the ETF and not in the stock. We think this is one of the reasons you are seeing volatility, especially in small-cap ETFs. So this is very likely why companies were not going public.

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