Once again, exchange-traded funds (ETFs) are in the regulatory crosshairs. In mid-October, the US Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Market Microstructure: Examination of Exchange-Traded Funds.” Democratic Sen. Jack Reed of Rhode Island chaired the hearing and also happened to be the only Senator in attendance. Despite his senatorial colleagues’ absence, Sen. Reed conducted an excellent panel which included Eileen Rominger, director of the Securities and Exchange Commission’s (SEC) Division of Investment Management, Eric Noll, executive vice president of Transaction Services at NASDAQ OMX, Noel Archard, managing director of BlackRock and Harold Bradley, chief investment officer of the Ewing Marion Kauffman Foundation.

There’s no denying that a Senate hearing can be dull viewing, but if you’re inclined to watch it you can find the webcast archived here. If you don’t want to make that level of commitment, you can also find PDF transcripts of the panelists’ testimony at the aforementioned link.

Bradley offered the most compelling testimony, largely because his commentary was the most inflammatory. After all, his most recent claim to fame–at least with regard to ETFs–is his co-authorship of two white papers which made the case that ETFs pose significant systemic risks. To support his argument, Bradley’s papers cite settlement failures involving ETFs and the role ETFs played in the “flash crash” last year.

However, we disagree with those papers’ findings. In the paper about ETF settlement failures, the authors assert that ETFs account for a growing number of securities delivery failures following transaction settlement. Their data show failed-to-deliver ETFs amounted to $1 billion on the average trading day during 2010. But the authors’ other data show that the volume of failed deliveries in mortgage-backed securities (MBS) are a far greater risk to markets than ETFs at this juncture–the average daily failures in delivery of MBS amounted to $114.4 billion during 2010. And Bradley’s paper dealing with the “flash crash” was published before the joint findings of the SEC and the Commodities and Futures Trading Commission were issued–which essentially cleared ETFs–so the material is dated and debunked. Still, the two papers are interesting reading.

Despite Bradley’s contentious contribution to the panel, the hearing did yield a couple of positive outcomes. The SEC has announced that it will take another look at both ETF transparency and the impact ETFs have on market volatility. The agency will pay particular attention to leveraged ETFs, which make extensive use of derivatives.

While the investigation is nothing new–there’s been an ongoing review by the SEC involving the use of derivatives by mutual funds, ETFs and investment companies since early 2010–we believe it could lead to sensible regulatory oversight.

In general, we believe most investors are not well served by leveraged ETFs. Such ETFs’ use of leverage magnifies losses in ways most investors don’t fully appreciate until they experience it for themselves.

Aside from our concern for the plight of the individual investor, we haven’t seen any hard data that clearly demonstrate leveraged funds play any role in higher market volatility. Despite the lack of such evidence, we expect the SEC will take some sort of action on leveraged ETFs to pacify the investing public. Among its options, the SEC could adopt the European approach of limiting trading in leveraged products to institutional or other sophisticated investors. While that type of rule could negatively impact some ETF sponsors’ bottom lines, we think such a curb would be positive for the average investor.

If the SEC doesn’t go to that extreme, we think they’ll be receptive to the uniform naming scheme for products proposed by Noel Archard of BlackRock. Archard said that ETFs should simply state their investment focus in their actual names.

While many ETF sponsors already do that, a surprisingly large number still don’t and they’re not eager to do so since it might make it more difficult for them to market their products. Nevertheless, Archard’s proposal would provide greater clarity for investors navigating a cluttered ETF market.

We’re generally leery of government investigations since the regulations that typically result from them are onerous. But we think a broad review of ETFs could lead to necessary oversight, as well as the possibility that the unwarranted and unsubstantiated concerns about ETFs are finally put to rest.

What’s New

The Royal Bank of Scotland launched RBS Global Big Pharma ETN (NYSE: DRGS), the only new exchange-traded product to hit the market last week.

The exchange-traded note (ETN) tracks an equally weighed index comprised of 16 global large-cap pharmaceutical companies. Its top holdings include Bristol-Myers Squibb Company (NYSE: BMY), Novo Nordisk (NYSE: NVO) and Teva Pharmaceutical Industries (NSDQ: TEVA). Geographically speaking, the US receives the heaviest weighting at 50 percent of assets, followed by the United Kingdom with an 18.5 percent allocation, while Switzerland, Denmark, France, Israel and Canada each receive 6.3 percent allocations.

Aside from this being the first ETN devoted to the health care space, there’s nothing particularly unique about it to warrant its 0.60 percent expense ratio. If you want to add pharmaceutical exposure to your portfolio, we would suggest SPDR S&P Pharmaceuticals (NYSE: XPH). This ETF is not quite as global in scope, but it significantly overlaps RBS Global Big Pharma ETN’s holdings while charging a low 0.35 percent expense ratio.

Portfolio Roundup

Over the trailing week, the MSCI EAFE Index declined 2.7 percent while the S&P 500 lost 0.9 percent. As has been the case for months now, Greece was at the heart of the market’s decline. After a brief shot of exuberance following the announcement of European leaders’ tentative plan to resolve the Greek sovereign debt crisis, Greek Prime Minister George Papandreou said he intends to offer Greeks the opportunity to vote on the deal via a national referendum. Greek public sentiment has been notoriously volatile during this crisis, so European leaders are concerned that such a vote could scuttle the deal even though they believe it’s the only way to resolve the crisis.

While this news roiled the market, the Global ETF Profits Model Portfolio still managed to gain 0.2 percent for the week.

• State Street Global Advisors’ licensing agreement with KBW has expired, so SPDR KBW Regional Banking ETF (NYSE: KRE) is getting both a new name and a new underlying index. The ETF’s old index used a market-cap weighting scheme, which meant the largest regional banks received the heaviest weighting. Under the new scheme, all holdings will be equally weighted so small- and mid-cap banks will now comprise the bulk of the portfolio. The ETF is also less concentrated now with its allocation to the top five stocks in the index falling from around 20 percent to just over 10 percent. While the move has spooked some investors, we view the change as a positive development since the smaller banks were the ones to which we sought exposure. Still, the shift toward smaller-cap holdings could result in greater volatility in the fund going forward. Continue buying SPDR Regional Banking ETF under 31.