Wary observers are concerned that a small ETF issuer might be tempted to accept less-than-ideal securities from authorized participants – the group behind efficient creation and redemptions of ETF shares – in exchange for assets. Additionally, another could be persuaded to deliver more attractive securities from the fund to a broker that it relies on for business in what is known as “dumping” or “cherry picking.”
Controls in Place
“They are concerned about situations where an authorized participant exerts power over an ETF,” Jane Heinrichs, associate general counsel at the Investment Company Institute, an industry association for mutual funds and ETFs, said of the SEC. “But there are enough other belts and suspenders that take care of that. If you show favoritism to one authorized participant, it’s not going to be a long-term game.”
The potential for abuse is limited since any bad behavior would translate into higher tracking errors, which could dissuade investors from investing, and a manager’s compensation is usually tied to how closely an ETF mirrors its underlying index.
Related: Bond ETFs Are Starting to Turn More Heads
Regulators may also nip this in the bud by introducing measures like requiring ETFs to spell out their policies on flexible baskets.
For more information on the ETF industry, visit our ETF performance reports category.