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Paul Britt
ETF.com Analyst Blogs

Truth In ETF Labeling

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Still, while the idea shined through the critiques from the Kauffman Foundation and others who worry investors don’t understand ETFs, designing and implementing a labeling system is probably unworkable.

To be clear, I’m not talking about a fund’s name, say, the Acme Large Cap Growth, but rather its suffix—ETF or ETN, as the case may be. Proponents of some kind of a new naming protocol argue that more expansive labeling might help investors know if they’re heading for a safe harbor or deep waters.

Seems like a no-brainer. But after a quick look at how this might play out over the roughly 1,300 funds, serious cracks appear.

Line In The Sand

Step one is identifying the best framework for separating exchange-traded products into naming buckets that help investors. But what’s the right screen to use? Asset type? Means of exposure? Legal structure? Risks? Let’s take a quick look at each of these.

Looking at asset type first, let’s start with the most straightforward—equities—and say we’ll put all equity funds into one bucket. And that bucket would get an innocuous-sounding name, which we’ll call “ETF” for now. Would a fund with a big basket of S&P 500 stocks make it in? Absolutely.

But, should a fund that tracks Chinese equities using swaps be in the same bucket? I’m not sure.

So how do we deal with the way a fund derives its exposure? Surely one that holds the underlying asset directly and doesn’t use any derivatives should a get a safe-sounding label, just as one that does should come with a warning or a disclaimer.

For commodity funds, those that hold physical assets would go in one bucket and those that use derivatives would land in another.

While I agree that investors in funds that use commodity derivatives need to know about the costs of rolling exposure into new contracts, I’m not sure new three-letter suffixes will get the point across.

Maybe a fund’s legal structure makes for a better vector for labeling.

After all, the ETN label is used broadly, too broadly maybe. ETNs cover just about everything: commodities, currency, equity, fixed income. True, ETNs carry unique credit risks to investors, but those risks are overlaid on top of the fund’s other traits.

In other words, the ETN suffix sheds little light on the differences between, say, an Italian sovereign debt ETN and one with VIX futures exposure. By the way, I don’t propose abandoning the ETN suffix—I’m just pointing out that it only conveys a limited amount of information.

More to the point, labeling commodity funds, for example, with a suffix for legal structure—whether they’re commodity pools or grantor trusts or ETNs—will only help if investors actually know what they mean. Legal structures matter, without question, but hanging an alphabet soup after the fund name won’t help much, in my view.

Lastly, labeling funds by their risks sounds logical. There is no shortage of factors: daily reset, geared, derivative exposure, contango, to say nothing of the direct risks of the underlying assets. The problem is where to stop.

Scarlet Letters

Even if a sensible naming solution could be designed, would it ever see the light of day?

Implementing the plan could be problematic. The labeling idea seems ripe for market-share battles between issuers, each attempting to brand an opponent’s funds with a scary or unfamiliar name.

Maybe the proponent with the deepest pockets would win. iShares has already staked out its position on the naming issue, and who can blame them?

The best course here may be “don’t just do something, stand there.”

Creating and implementing a naming system that will truly benefit investors seems too tall an order even now, and will only grow more difficult as ETFs carve the market into ever-finer pieces.

Better, instead, to push for greater transparency and more comprehensive education. The scope for confusion and mischief from new labels exceeds the likely benefits.

 

 

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