ETFs may be so complex and subject to such volatility that they require a distinct set of rules from equities, suggested SEC Commissioner Kara Stein.

In remarks at the annual SEC Speaks conference, Stein acknowledged that ETFs have been a boon for many investors. Still, the average retail client doesn't understand the risks they carry and the features that distinguish them from common stock and mutual funds, she says.

"I think we need to think about a roadmap for holistic regulation of ETFs and other exchange-traded products given their explosive growth and evolution," she said.

Stein cites the precipitous rise of ETFs as a favored investment strategy, noting that they hold more than $2 trillion in assets. Last year alone, she says, some ETF sponsors saw AUM rise by as much as 35%.

"This growth is astounding, and potentially good, as long as the risks are identified, market participants are informed, and appropriate safeguards are in place," Stein said.

Apart from the sheer growth in volume, ETFs have been diversifying as a class, having "expanded far beyond their equity index origins," Stein noted. Indeed, now retail investors might find themselves invested in instruments like currency-hedged ETFs or bank-loan ETFs.

"While some new products are being hailed as exotic or innovative within the industry, others have been described as toxic," she said. "I fear that the risk represented by some of these new products may not be fully understood by those who've invested in them. Indeed, even plain vanilla equity index ETFs may present risks that are not always anticipated or fully understood."

Stein recalls the morning of Aug. 24, 2015, when the bottom fell out of dozens of ETFs in early-morning activity, triggering trading halts and steep losses when jittery investors sold funds at prices that were well below the combined value of their basket of holdings.

"Commission staff and market participants are continuing to assess what happened, however one fact that is crystal clear about Aug. 24 is that many ETFs behaved in an unpredictable and volatile manner," Stein said. "As a class, ETFs experienced greater increases in volume and more severe volatility than corporate stocks."

Stein is calling for the SEC to convene working groups to take a hard look at the specific types of products that are available in the exchange-traded model. She is urging the commission to coordinate with FINRA and other regulators to evaluate how those products are being marketed, and to determine whether ETFs can even be considered suitable for buy-and-hold investors.


So how might the commission proceed as it considers new rules for ETFs?

It could start with a fact-finding mission, as Stein suggested that many characteristics of ETFs are only beginning to be understood. She posed a series of questions that regulators and market participants should address as they look to balance transparency and accountability with the value that ETFs have created for investors.

She is concerned about the role of market makers and authorized participants in facilitating ETF trading, wondering if there is too much concentration in that area and worried about the potential risks for retail investors if market makers were to take a step back in times of volatility. And do retail investors understand the real risks associated with those products?

Stein also anticipates the conclusion of the probe into the Aug. 24 crash, suggesting that the review will help determine what course regulators should take.

"Perhaps such an analysis will lead us to the conclusion that ETFs should have different trading rules than equities," she said.

In evaluating the ETF phenomenon, Stein looks beyond equities and notes that an array of exchange-traded products holds very different investments such as commodities, currencies and derivatives.

As a class, these are fundamentally different from equities, she argues, questioning the basic logic of applying a regulatory framework for traditional stocks to exchange-traded products.

"These products are not traditional equity securities, and they do not always behave in the same manner as equity securities," she said. "The attempt to fit such non-equity products into the rules designed for traditional equity securities has left potential gaps in investor protection, and I think also raised questions about market integrity."


Stein's comments continue a theme she has argued forcefully, that changes are in order to ensure that funds remain a viable and reasonably transparent investment avenue for the retail community.

Stein has previously argued that some funds are moving away from the "bright-line protections" that investors have come to expect from the industry, particularly in the area of liquidity.

She has singled out the increasing popularity of funds that invest in bank loans, a segment that has soared nearly 400% since 2009, but that seems to stray from the liquidity requirements prescribed in the 1940 Act. Stein argues that since many of the bank loans underpinning those funds can take longer than a month to settle, "it is reasonable to wonder how the fund could possibly meet the seven-day redemption requirement in the Investment Company Act in times of market stress."

Likewise, Stein has warned about the increasing use of derivatives that has seen some funds take on more leverage than was intended by the 1940 Act.

"Unfortunately, this cornerstone principle appears to have gradually eroded as well. Derivatives usage by registered funds has skyrocketed in the past couple of decades," Stein said.

She has pointed out that in the run-up to the Great Depression in the 1920s, many of the investment companies and trusts that collapsed were heavily leveraged, "rife with abuse," and "were often receptacles for the unloading of worthless securities." She has cautioned regulators to recall that lesson and ensure that leverage within the fund industry is kept in check.

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