We would be remiss if we didn’t address some of the arguments a recent industry report makes about exchange traded funds (ETFs) and why they’re just flat-out incorrect.

The Kauffman Report basically dings ETFs, saying that they’ve made the markets worse, threatening their stability and impacting stock prices in the way they’re structured. Matt Hougan at Index Universe also gave a well-written rebuttal to the report’s arguments today.

The ETF industry has weighed in on the study. Invesco PowerShares‘ Managing Director Ben Fulton appeared on CNBC this morning to refute the study’s assertions.

Vanguard‘s Head of ETF Product Management Rick Genoni had this to say, “Our view is that the Kauffman Report is a sensational attack on ETFs and is factually incorrect on many fronts.  The report seems to conclude that ETF creations are done in cash when in fact, for the vast majority of products, securities are delivered in-kind through the creation redemption process.

“As far as claims that ETFs played a role in the flash crash, we agree with the SEC’s assessment that the flash crash was a market structure problem and not a product structure problem.  We further believe that ETFs are the model of transparency and that they play a key role in price discovery and market liquidity.  Claims around the impact ETFs are having on the ability of small companies to access capital are also completely unfounded.”

Among the points made in the report include:

ETFs are to blame for the May 6 Flash Crash, instead of high-frequency trading. This is not true. ETFs were a victim of the crash, not the cause, because underlying securities were mispriced. This forced authorized participants to widen the bid/ask spread in order to keep ETFs trading. Because ETFs trade like stocks, it’s important to understand that limit orders always trump market orders.

What’s more, ETFs have withstood extreme volatility in the markets in other periods, including the dot-com bubble in 2000, the housing crisis of 2007 and the credit crisis of 2008. Through all of these periods, ETFs delivered consistent price discovery for the markets and liquidity for investors who were seeking it.

ETFs are distorting the markets by threatening the growth of new companies by curtailing their access to capital. All this talk about ETFs would suggest that it’s a much larger industry than it actually is. ETFs currently represent less than 10% of the $11.2 trillion mutual fund industry. While it’s a growing industry, blaming them for everything wrong with the markets is a bit of a stretch.

ETFs do favor the underlying stocks making up the ETF, but IPOs wouldn’t benefit from ETF flows because they’re not in any of the currently available indexes. And furthermore, free markets should set proper pricing on IPOs based on the current demand. This argument also suggests that the study’s authors think there are many small U.S. companies that would go public if the markets were tweaked in some way.

ETFs are used so heavily that they’re effectively setting the stock prices of small-cap companies. Again, not true. Interest in certain asset classes effectively drives demand for underlying stocks. Investors looking to buy small-cap stocks, for example, may want the diversification ETFs offer at a reasonable price. The Russell 2000 market cap is $1.34 trillion vs. the Russell 2000 ETF (NYSEArca: IWM) has $15 billion in assets. This represents 1.1% of the market cap of the underlying stocks – clearly not as impactful a ratio as the authors would like us to believe.

ETFs pose hidden risks to investors, based on high short interest positions relative to shares outstanding. There can’t be a traditional “short squeeze” in ETFs. Unlike in single stocks, where short covering triggers buying pressure for shares outstanding, short covering in ETFs would cause a creation of new shares to meet the demand.

As with single stocks, short sellers of an ETF don’t have any claim on fund assets; they’ve borrowed shares from someone to express a bet that the price will go down. The only party with a true claim on fund assets is the beneficial owner of those shares, and the ETF assets back those investments.

It seems pretty clear from this report that its authors simply don’t understand how ETFs actually work or the creation/redemption process. If they had, they would see that ETFs have brought more investors into the markets to invest in previously unavailable asset classes in a cost-effective way. This has had a positive impact on the liquidity and transparency of the markets.

ETFs are a relatively new product – they’ve only been around since 1993. The industry recognizes that and readily acknowledges the need for more investor education, and has already made great strides in informing investors of how ETFs actually work.

False, inaccurate or otherwise misleading reports only set the educational efforts back further.

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