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ETFs Riskier to Markets Than Rapid Trading, Kauffman Study Says

Exchange-traded funds, not high- frequency trading, pose the greatest danger to stock-market stability and may trigger more disruptions like the May 6 selloff, according to the Kauffman Foundation in Kansas City.

The proliferation of ETFs presents “unquantifiable but very real systemic risks of the kind manifested very briefly during the ‘flash crash’” earlier this year, Harold Bradley and Robert E. Litan said in a research report published today. Potentially worse declines are “a virtual certainty” without ETF reforms, Bradley and Litan said.

The U.S. Securities and Exchange Commission blamed a mutual fund’s routine hedge against losses for starting a chain of events that turned an orderly decline into a crash that erased $862 billion in equity value in less than 20 minutes. Regulators also are investigating whether trading formulas, or algorithms, could “cascade,” triggering further action by computerized trading systems that would exacerbate market disruptions, Andrei Kirilenko, a senior economist at the Commodity Futures Trading Commission, said last week.

Unlike mutual funds, whose shares are priced once a day, ETFs are listed on an exchange where shares are bought and sold continually like stocks. Because ETFs are so widely traded, they, rather than the underlying securities they’re designed to track, “are effectively setting the prices of smaller-capitalization companies,” Bradley and Litan wrote.

ETFs are “undermining the traditional price discovery role of exchanges and, in turn, discouraging new companies from wanting to be listed on U.S. exchanges,” according to the authors.

The Kauffman Foundation, with about $2 billion in assets, provides research on entrepreneurship, innovation, education and public policy.

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