(Dow Jones) With total assets in exchange-traded funds approaching $1 trillion, the rapid growth of these products is coming under fire from critics who contend that ETF proliferation has created new risks for investors.

In the aftermath of May's U.S. market "flash crash" and subsequent tremors in some mainstream ETFs, critics are especially concerned that the ability to bet against markets by short-selling ETFs could intensify a market meltdown or even cause individual ETFs to collapse.

"The ease of short selling ETFs makes them ideal potential triggers for market-wide free falls of the kind experienced on May 6 during the flash crash," a recent report from the Ewing Marion Kauffman Foundation concluded.

"The other, less well-recognized danger is that ETFs could be caught in a 'short squeeze' should investors, for any reason, decide they want to cover their short positions," the report added.

ETFs seem like relatively straightforward investment products: index mutual funds that trade on an exchange like individual stocks. Yet their day-to-day operations are markedly different from mutual funds.

Typically, when a traditional index mutual fund sees net inflows, it puts shareholders' cash to work in stocks, bonds or other investments. When the fund needs to raise cash to meet redemptions, the portfolio manager sells securities.

ETFs' inner workings are more complex because they trade in real time, while mutual funds price once a day at the market close. ETFs rely on specialist firms known as authorized participants to keep the price of a share in line with fair value. These ETF market makers profit by arbitraging away any price discrepancies.

But this process broke down during the May 6 flash crash as some ETFs saw their prices quickly plunge to pennies a share amid the confusion. When the damage was tallied, about 70% of the cancelled trades during the flash crash involved ETFs.

ETF sponsors claim they were victims of the chaos rather than the source.

"ETFs were impacted and not the cause," said Leland Clemons, director of the iShares capital markets group at BlackRock Inc. (BLK), the largest ETF provider, in an interview.

Clemons said the asset manager supported ETFs' inclusion in the circuit-breaker program designed to prevent sudden, big price swings in the future. 

 
Sharper Lens

It's not surprising ETFs are being put under a sharper lens. ETFs accounted for 28.2% of equity trading volume so far in 2010 on a dollar basis, according to BlackRock.

Securities firm Jefferies says ETFs represented 6.4% of total U.S. mutual-fund assets at the end of 2009, but market share is expected to rise as more asset managers enter the ETF business.

The Kauffman report and media scrutiny of ETFs' role in the flash crash have put the business in a defensive posture, but they haven't triggered an investor flight from ETFs. Investors pumped $80.6 billion into U.S.-listed ETFs this year through October, taking total industry assets to about $945 billion, according to investment researcher Morningstar Inc. (MORN).

"While long-term equity-mutual-fund flows have been slow to return, ETF flows continue to be robust," wrote Jefferies analysts Daniel Fannon and Surinder Thind in a report. "This is a reflection of favorable secular growth trends, expanding distribution channels and an increasingly diverse product suite."

From 2005 through 2009, ETFs attracted 42% of total long-term mutual-fund flows. Within the stock category, ETFs have captured an "astounding" 77% of inflows during the period, the analysts said.

Yet recent critical studies are a reminder that ETFs have complex inner workings which investors need to understand, and that the industry may need to step up its education efforts.

The Kauffman report published on Nov. 8 by Harold Bradley and Robert Litan, which has been revised, was a shot across the bow for the business, with its serious charge that ETFs are raising market risk.

BlackRock's Clemons said ETFs often have short interest greater than the number of shares outstanding. Unlike individual stocks, where there is a fixed amount of shares outstanding, authorized participants in ETFs-who must own the securities they plan to exchange with the ETF manager-can create or redeem shares to meet excess demand or supply.

In other words, even though an ETF might have more short positions than shares outstanding, the market maker should be able to produce enough shares for shorts who need to cover their positions. A short position is a bet a stock will fall.

"There has never been a short squeeze in an ETF," Clemons said.

Although he doesn't think an ETF can collapse from a short-selling squeeze, a rush to cover short positions can add fuel to rallies in the market an ETF tracks, said Matt Hougan, head of ETF analytics at IndexUniverse.

At the least, the negative commentary on ETFs recently has illustrated that ETFs' in-kind creation and redemption feature, and other inner workings, aren't easy to understand or explain.

The Kauffman report actually applauds the lower fees and tax efficiency of ETFs. "ETFs in principle are still a good innovation," said co-author Litan in a telephone interview.

However, the regulatory safeguards haven't always kept up with the rapid pace of development, added Scott Burns, director of ETF research at Morningstar.

For example, many investors are confused about leveraged and commodity ETFs. Some investors don't understand that leveraged ETFs reset on a daily basis, while commodity ETFs can suffer losses when futures markets are in a condition known as "contango."

Burns said being critical of the ETF industry is good when things can be improved, but he thinks ETFs' breakdown during the flash crash was a market-structure issue rather than a problem with ETFs. Circuit breakers for ETFs are a step in the right direction, he added.

Copyright (c) 2010, Dow Jones. For more information about Dow Jones' services for advisors, please click here.