SEC conducting sweeping regulatory review of ETFs

The U.S. Securities and Exchange Commission has launched a broad, agency-wide review of exchange-traded funds to ensure they are adequately transparent and not fueling market volatility, a top agency official told lawmakers on Wednesday.

"Commission staff is currently engaged in a general review of exchange-traded products in connection with, among others, the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments in which ETPs invest, fair valuations, efficiency in the arbitrage process and the relationship between market volatility and ETPs," SEC Investment Management Director Eileen Rominger said in prepared testimony.

The review also entails "gathering and analyzing detailed information about specific products," she said.

The news of the SEC's general review of exchange-traded funds came at a Senate Banking subcommittee hearing on Wednesday that was called to examine potential regulatory issues arising from ETFs, which have attracted more SEC scrutiny in the past several years.

It also marks the second investment company-related review that the SEC has undertaken, after the agency voted in late August to seek comments from the public on the potential risks of derivatives use by mutual funds, ETFs and other similarly structured funds.

Exchange-traded funds such as those managed by BlackRock, State Street and the Vanguard Group, generally track market indexes and trade on exchanges. They have grown to account for roughly $1 trillion in assets since their inception in the 1990s, and have some similarities to mutual funds in how they are structured and managed.

In recent years, however, certain kinds of ETFs and major market events such as the May 6, 2010, "flash crash" have raised concerns by regulators that they may be contributing to market volatility or pose risks to less savvy investors.

During the flash crash, for instance, ETFs experienced massive intraday price swings and made up 70 percent of all canceled trades. The event led the SEC and the exchanges to implement circuit breakers to help prevent another major market drop.

Then earlier this year, 10 new exchange-traded funds suffered a mini "flash crash," forcing Nasdaq OMX to cancel trades.

The SEC has also been closely looking at leveraged ETFs, which can be used to magnify returns, and inverse ETFs, which deliver the opposite of the performance of the underlying benchmark index.

The SEC, along with other regulators, has issued warnings to investors about the risks surrounding these kinds of ETFs, especially because many of them reset on a daily basis, making it harder to judge long-term performance.

Back in March 2010, the agency also suspended all exemptive requests from exchange-traded funds seeking to invest heavily in derivatives pending the outcome of its review into derivatives use by investment companies. Public comments on that issue are being accepted until November 7.

Noel Archard, a managing director at BlackRock in charge of product development for iShares, plans to tell lawmakers on Wednesday that there needs to be better disclosures and descriptions of ETFS for investors.

For instance, he said, any inverse, leveraged or derivatives-based funds should not be labeled as ETFs. He also is calling for better disclosure of financial holdings and fund fees.

"Clear labeling combined with disclosure of fees and risks is a critical starting point to achieving the better clarity investors need to understand various structures," he said.

(Reporting by Sarah N. Lynch; Editing by Maureen Bavdek)