Prompted by a delay in a big trade at a popular ETF, the U.S. Securities and Exchange Commission is taking a closer look at a possible connection between high-frequency traders and hedge funds jumping in and out of ETFs, and instances where ETF trades fail to settle on time, this person said.

The SEC's inquiry is part of a wider probe that began last year and focused on complex ETFs that allow investors to magnify returns or bet against stock indexes.

U.S. and UK regulators are concerned that so-called settlement fails - when trades are not completed on time - could contribute to volatility and systemic risk in financial markets.

The probe's main focus is on illiquid ETFs, but regulators are now also examining popular ETFs and failed trades, according to the person.

An SEC spokesman confirmed that the agency is looking into failed trades and ETFs, but declined to elaborate.

The SEC's inquiry comes amid greater scrutiny of the ETF industry, which has surged in popularity since the early 1990s. It is still unclear how settlement delays might affect retail investors in ETFs.

ETFs are baskets of securities that, like mutual funds, give investors exposure to a pool of assets. But unlike mutual funds, they trade throughout the day. Early ETFs were created to mirror benchmarks such as the Standard & Poor's 500 index. ETF assets have doubled since 2007 to about $1.3 trillion, according to Deutsche Bank AG. Some of the most popular ETFs are those that use derivatives to give investors exposure to commodities, high-yield bonds or ETFs that own other ETFs.

'SHORT' IMPACT

Hedge funds often "short" ETFs, or make a bet that the price of the ETF will fall. In such a trade, the fund sells borrowed ETF shares in hopes of profiting by buying them back later at a lower price. The SPDR S&P Retail ETF, for instance, has a short interest of nearly 200 percent, meaning short investors' bets amount to three times the total number of shares outstanding for the ETF. That is possible because traders lend ETFs to other investors or traders. These ETFs can be lent again to others, and show up on the books of multiple parties.

ETF experts discount criticism of ETFs. In a recent report, State Street Corp, a Boston asset manager that created the first ETF in 1993, said that "short interest theoretically should have no impact on an ETF's performance."

State Street created the SPDR S&P Retail ETF, which is often the most-traded security on U.S. equity markets, outpacing daily volume of large-capitalization stocks like Microsoft Corp and Apple Inc.

State Street said its analysis of SPDR S&P Retail and 19 other most-shorted ETFs, including popular names like SPY, IWM and QQQ, found that high levels of short sales did not affect the ETFs' ability to track their corresponding index.

However, 14 of the 20 most-shorted ETFs on State Street's list also ranked highest in total value of reported settlement fails across all equity securities for 2011, according to data published by the SEC.

The overlap "deserves further exploration," said John W. Emerson, a statistics professor at Yale University. He said, though, that "some of the reason for the coincidence might be a simple association with volume."

On an average trading day in 2011, failure to deliver shares amounted to 4.3 percent of the total volume of shares traded that day, according to a Reuters analysis of settlement fail data published by the SEC. The impact of failed settlements on investors remains unknown. ETFs account for about 30 percent of the value of U.S. equities traded daily, according to a recent report by Credit Suisse.

ETF industry leaders say the data on ETF trade failures does not account for the fact that market-makers, the firms that do the bulk of ETF trading, have seven days to clear trades. The data assumes that all market participants must clear in four days, and any trade that settles later is counted as a failed trade by the National Securities Clearing Corp, a trade processing subsidiary of the Depository Trust & Clearing Corp.

"The main issue is bad vocabulary," said Dave Nadig, director of research at San Francisco research firm IndexUniverse, referring to the fact that any trade that settles between the fourth and sixth day is considered a fail.

Even if ETFs did fail to settle on time, investors would not be on the hook because the NSCC, which clears all of the trades, guarantees the delivery of the shares. "There is no possibility for a trade to truly fail," Nadig said. "That is why the NSCC exists."

LARGE, FAILED TRADE SPARKS REVIEW

The SEC's decision to widen its review came after a sizable trade in a large, liquid ETF failed to settle within the four days, said the person familiar with the inquiry. The specific ETF is not known.

Regulators want to better understand whether high-speed trading can contribute to settlement fails. They also are studying links between ETF prices and the value of securities underpinning an ETF.

"If you can't figure out what price a stock is at because there are multiple high-frequency traders using ETFs to trade in and out," then when a sudden, unexpected shock occurs in the market, "no one is going to know what caused it," said Joseph Saluzzi, co-founder of Themis Trading, a Chatham, New Jersey brokerage.

The SEC began looking at ETFs following the 2010 "Flash Crash" in which the Dow Jones industrial average plunged 1,000 points in minutes, only to rebound quickly.

The agency again raised concerns about ETFs last October when the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing on ETFs. An SEC official said a number of the SEC's divisions, including enforcement, were charged with oversight of ETFs.

"This proliferation (of ETFs) has been accompanied by product innovation, giving rise to new and increasingly complex products," said Eileen Rominger, director of the Division of Investment Management.

Rominger, who joined the agency from Goldman Sachs Group last year, added that investors might not understand the risks of complex ETFs such as those that traders are prone to using for short sales.

(By Jessica Toonkel, Carrick Mollenkamp and Cezary Podkul in New York; Editing By Alwyn Scott and Matthew Lewis)

• A Permanent Economic Emergency