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Kauffman ETF Report: Many Allegations, Many Holes

Kauffman ETF Report: Many Allegations, Many Holes
Ron DeLegge, Editor
November 24, 2010

SAN DIEGO ( – A scathing 88-page report authored by the Ewing Marion Kauffman Foundation warns that ETFs have introduced a bevy of new risks that could cause the financial system to tip and sink like the RMS Titanic.

The foundation is a Missouri-based organization that attempts to further economics education. 

Let’s dissect a few of the arguments levied against ETFs by quoting directly from the report:

“The proliferation of ETFs also poses systemic risks similar to those that were briefly manifested during the “flash crash” of May 6, 2010.”

ETFs pose a systemic risk? Give us some perspective. Are they a greater or lesser threat to the financial system than hapless regulators? Again, give us some perspective.

For the record, blaming ETFs for the “Flash Crash” on May 6 or even linking them to this event is a popular argument usually made by individuals that don’t understand how ETFs really work, have a bias against ETFs and/or all of the above.

While it’s true that a disproportionate number of ETFs were entangled in the trading mess of that historic day, ETFs were victims of a temporary systemic breakdown not the root cause.*

“Without significant ETF-related reforms, the authors contend, more flash crashes and market instability are highly likely.”

This particular statement incorrectly and unfairly insinuates that ETFs are guilty of destabilizing the financial markets. The fact is ETFs, while quite popular, still command “less than 10% of the $11.26 trillion mutual fund industry and an even smaller percentage of the total market capitalization of the underlying securities,” according to BlackRock. Are investment products that represent a drop in the bucket compared to the $11 trillion mutual fund business and the $600 trillion derivatives business really an acute threat to the financial system?

Besides that, arguing for more ETF rules and reforms is another way of saying let’s create more red tape for already heavily regulated financial products in an already heavily regulated business. Three cheers for more bureaucracy!

“ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future.”

Really? If a small company grows its business to the point of becoming a significant component of the investment universe, its stock gets included as a member of small-cap index (NYSEArca: IWM). If the same company continues to grow its business it becomes a mid-cap stock (NYSEArca: MDY) and joins a mid-cap index. And if it grows even more then it becomes a large company stock (NYSEArca: VV) and joins a large-cap index. In each instance, the stock price may rise in value because of its inclusion within the index but that’s not an ETF’s fault. The ETF is merely doing what it’s designed to do which is to track the index as closely as possible. What’s wrong with that?

Withdrawn Arguments
Among the other wild claims made in the original Kauffman report dated November 8th, are that the proliferation of ETFs has contributed to a major decline in the number of initial public offerings. Really? What about the Financial Crisis and tightfisted capital markets? Have they had anything to do with this? Aren’t they a more direct and responsible cause for the declining number of IPOs? What do the investment bankers and venture capitalists have to say about all of this? How come they weren’t polled? Before that could happen, a revised report backing away from this argument was released by the Kauffman Foundation on November 12.

Besides having colorful accusations, the Kauffman report also has unresolved contradictions.

On one hand it rants against ETFs for allegedly creating systemic risks and then it goes on to defend high frequency trading (HFT) by asserting that “regulatory attempts to level the playing field between HFT and other traders are misguided.” Is that really so? Is the unfair advantage of HFTs over other market participants or anyone for that matter a healthy formula for the fluid and fair operating financial markets? If it’s true that HFTs put their competitors at an unfair disadvantage what do you think it means for mama and papa who trade 200 shares?

According to the Kauffman report, eliminating high frequency trading is wrong because it would be “benefiting old investment bank trading desks and large institutions that once received favorable treatment over lower-commission-paying competitors.” Isn’t this the same argument used by monopolists? Let’s defend one bureaucracy or monopoly to prevent another from taking over.

My final critique of the Kauffman ETF report is that it has many interesting exaggerations that have a Black Swan chance of coming true. That’s the bad news. Furthermore, I think the sincerity of its authors is overshadowed by way too many far-fetched, illogical and unsubstantiated arguments.

On a positive note, maybe the sequel to their horror movie will be better.

*For a deeper explanation (I said deeper, not believable!) of who was at fault for the “Flash Crash” please read “Findings Regarding the Market Events of May 6, 2010” published by the U.S. Commodities Futures Trading Commission and the U.S. Securities and Exchange Commission. I dare you not to fall asleep after the third page.  

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