2ND UPDATE: SEC Reviewing Effects Of ETFs On Volatility

The Securities and Exchange Commission is taking a close look at exchange-traded funds, including their transparency and impact on market volatility, a top SEC official said Wednesday.

The ETF review comes on top of a separate inquiry on mutual funds, exchange-traded funds and other investment companies that use derivatives announced in early 2010. Regulators are increasingly concerned about the risks to less-sophisticated investors of "leveraged" ETFs, which amplify investor bets often through the use of derivatives.

Eileen Rominger, director of the SEC's division of investment management, told a Senate Banking subcommittee Wednesday that the agency's wide-ranging review of exchange-traded products includes examining the adequacy of investor disclosure, liquidity levels and transparency of underlying instruments in which exchange-traded products invest.

She also said the SEC is examining ETF's "fair valuations, efficiency in the arbitrage process and the relationship between market volatility" and exchange-traded products.

ETFs, which typically track market indexes, function similar to mutual funds but trade on exchanges like stocks. ETFs have surged in popularity and now generate 35% to 40% of exchange trading volume, according to research company Morningstar Inc. Such funds sometimes are used by high-frequency traders, who buy and sell stocks and other assets at a rapid clip, making money on small price moves.

What are known as inverse ETFs, which also can be leveraged, are like mirror-image indexes, gaining if the underlying index falls and falling if the index gains.

The SEC inquiry into ETFs stems out of a broader look by regulators at the use of derivatives by mutual funds and other investment companies. As part of that broader inquiry, the SEC voted in August to begin a public dialogue on the issue, a first step in assessing the need for further regulation.

For nearly two years, SEC staff have been looking at whether investment companies that use derivatives should implement special protections for their investors.

In March 2010, the SEC put on hold requests by exchange-traded funds to invest in derivatives, pending the conclusion of its review. The agency is unlikely to close the review until it incorporates the comments it receives from its August "concept release" that is designed to spur public dialogue. Those comments are due by the end of October.

At Wednesday's hearing, Noel Archard, who heads product development at BlackRock Inc.'s (BLK) iShares unit, said there is a need for new standards for exchange-traded products to enhance transparency and investor protection, particularly to designate products with greater risk.

"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.

Rominger said BlackRock's labeling idea merited serious consideration.

Critics argue that ETFs contribute to market volatility when market makers buy and sell stocks or other underlying assets in ETFs, to rebalance their portfolios.

Rominger acknowledged ETFs might contribute to volatility, though she said the SEC is studying the matter and would reach a conclusion "in due course."

Eric Noll, executive vice president of NASDAQ OMX (NDAQ), who also testified Wednesday, said ETFs were a "tempting target" but downplayed their role in causing market volatility. He said the true drivers include the European sovereign debt crisis, imbalances in the U.S. budget or its high unemployment levels.

But Harold Bradley, the chief investment officer at the Ewing Marion Kauffman Foundation, noted ETFs have grown so fast in number and in variety that they now account for roughly half of all the trading in U.S. equities markets today.

"In the process, in our view, ETFs have increasingly distorted the role of equities markets in capital formation, while posing systemic risks from potential settlement failures," he said, referring to occasions when brokers fail to deliver shares to investors.

-By Andrew Ackerman, Dow Jones Newswires; 202-569-8390; andrew.ackerman@dowjones.com

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