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Greenberg: New Report Blasts ETFs for ‘Systemic’ Risk

Monday, 8 Nov 2010 | 5:00 PM ET

A new study released this afternoon by the Kauffman Foundation says it believes ETFs (exchange-traded funds) hold systemic risk for the financial markets.

The report, co-authored by the foundation’s Harold Bradley and Robert Litan, pays special attention to the impact of heavily shorted ETFs.

Among its findings...

  • Index ETFs hurt the creation of IPOs (initial public offerings).
  • Ease of shorting ETFs makes them ideal potential triggers for "market-wide freefalls": like the May 6 Flash crash.
  • Contrary to popular opinion, ETFs are actually derivatives, because their value is derived form the value of securities that make up their baskets of stocks.
  • There has been lax regulatory oversight of the growth of ETFs.

The report drills into one ETF in particular: The I-Shares IWM, which tracks the Russell 2000 small cap index....

This heavily shorted ETF, according to the report, also happens to be:

  • One of the top five holders in 867 stocks.
  • And within the top 10 holders of nearly 2,000 mostly illiquid small-cap stocks.

That concentration raises a variety of issues, especially when it comes to buying in short positions in a heavily-shorted ETF. The industry claims this is not a problem, because ETFs can simply “create” new shares.

The report's authors argue otherwise, saying it could take months for some heavily shorted ETF short positions to realistically be covered.

“The sheer magnitude of the short interest in the Russell 2000 index ETF suggests that capital that should be finding its way to small capitalization companies in the public markets is instead trapped in the ETF ‘shadow securities system’,” the report says.

My take: Expect this report to make waves. To read the full report, click here.

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