Even before a recent delay in a popular Exchange-Traded Fund (“ETF”), the Securities and Exchange Commission was already investigating ETFs. The recent news has only led the SEC to ramp up its investigation and expanded its inquiries into the operation of multiple ETFs.
The SEC began the initial investigation last year in an attempt to keep a closer eye on complex ETFs, which can allow investors to magnify returns and bet against stock indexes – a winner-takes-all style of investing that could result in huge profits or astronomic losses. But now the SEC is focused on a reported connection between high-frequency traders and hedge funds and so-called “settlement fails.” Settlement fails occur when ETF trades are unable to settle on time, and can dramatically increase volatility and risk in various financial markets. It is speculated that high-frequency trades interfere with the ability of the ETF to accurately track share values which could potentially complicate the settlement process.
This report surfaced in Reuters after unconfirmed unnamed sources leaked information about the expansion of the SEC investigation. The SEC confirmed the investigation but declined to elaborate on its exact nature.
The investigation was likely spawned by the fear that high-frequency trades in an ETF would shock the market by interfering with proper valuation of the ETF shares. Theoretically, when the smoke cleared, investors could be holding piles of worthless shares.
ETFs have gained popularity since the early 1990s because they offer an opportunity for tremendous gain. More and more investors have looked to ETFs to achieve a return on their investments in the perpetual low interest rate environment spurned by the financial crisis.
However, engaging in ETF trading comes with tremendous risk. In April of this year, VelocityShares Daily 2x VIX Short-term ETN (TVIX for short) lost 29% of its value in one day of trading. That one day contributed to month-long losses amounting to over 60% of the ETF’s value.
Still, in spite of the risk, the ETF market is booming. Assets have tripled since 2007 to nearly $1.3 trillion and short-term, high-yield ETFs are among some of the most popular.
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