ETFs By Any Other Name

May 18, 2020

On May 13, BlackRock, State Street Global Advisors, Invesco, Charles Schwab Investment Management and Fidelity Investments banded together in the name of "increased transparency" to propose new naming conventions for exchange-traded products.

Among other things, the new ETF classifications would break out leveraged, inverse and defined outcome funds into a separate category, despite those funds having little to do with one another.

While I do believe transparency is inherently good for investors, this proposal is anti-competitive, misguided and, at best, it confuses an already murky issue for investors.

What's In ETF Naming Proposal?

At first glance, the proposal itself sounds fairly reasonable. The “consortium” wants the three major stock exchanges to start using new nomenclature for exchange-traded products, by breaking out ETFs into four new product categories:

  • Exchange-traded funds (ETFs): These would be your typical open-ended investment companies operating under the ETF Rule, save for a few exclusions (listed below).
     
  • Exchange-traded notes (ETNs): ETNs are debt obligations issued by a bank or other financial institution to track a market index. Notably, however, the proposed redefinition of “ETN” would not include leveraged or inverse ETNs—and of the 185 ETNs currently trading, 80 are leveraged or inverse, or 43%.
     
  • Exchange-traded commodities (ETCs): ETCs would include pooled investment vehicles that hold physical commodities (like gold or other metals), commodity-specific futures contracts or commodity-specific total return swaps. Basically, this group would cover grantor trusts and commodity pools, which together represent the vast majority of commodity ETFs. (For more on grantor trusts, read "How Are Commodity ETFs Taxed?". For more on commodity pools, check out "K-1 Taxes Hurdle For Commodity ETFs.")
     
  • Exchange-traded instruments (ETIs): This classification would apply to any exchange-traded products—including those that otherwise would meet the criteria for one of the above three categories—that provide returns that aren't the unlevered return of an index or exposure. This means that the group would include any ETF that applies a leverage factor, such as inverse and leveraged ETFs/ETNs, or products that cap upside and downside returns, such as defined outcome products.

According to the release, most ETFs would still be called "ETFs": 77% of the roughly 2,400 exchange-traded products on the market would fall under the new "ETF" categorization. But about one out of five ETFs would earn a new designation, including about 250 products that would be rebranded as "ETIs."

6 ETF Issuers Decide For Everyone?

For what purpose, though? Set aside the fact that "ETI" sounds like something you should ask a doctor about; does calling a leveraged product an "ETI" instead of "ETF" truly solve an investor problem? Or is it simply creative marketing that makes it easier for the industry's largest issuers to sideline their competitors' products?

The industry group behind this proposal (which also includes Vanguard Group, though it is not listed in the press release) represents 90% of the total assets in the U.S. ETP industry, so it's easy to assume that its recommendation represents the will of the majority.

However, this consortium is only six members strong. By our count, there are 123 issuers now active in the ETF industry, the majority of whom offer just a handful of ETPs.

Most of those issuers are small-fry compared with BlackRock or Vanguard—but so what? Why should six big companies—who have diversified revenue streams beyond ETFs—speak for the entirety of the industry, including issuers whose only source of revenue are the funds they run?

Proposal Impacts ETFs Not Offered By Consortium

Furthermore, none of the six consortium members offers the sorts of leveraged and inverse products they're proposing to silo off into the "ETI" bucket. And of the six, only Invesco provides products that cap upside or downside return, though those funds represent only a tiny fraction of the company's total product offerings and invested assets.

Essentially, six of the biggest issuers in the market are proposing to rebrand certain types of ETFs that they don't even sell with a label that's unrecognizable to investors, all the while conveniently letting the vast majority of their own product lineups retain the language that's safer-sounding and more familiar to investors.

Gutsy marketing move, for sure. But the conflict of interest should be obvious.

Leveraged & Inverse ETFs Are ‘Real’ ETFs

Look, I get the desire to slap some sort of warning label on leveraged and inverse ETFs. I've written plenty about the dangers of these funds myself. (Read: "Don't Buy & Hold Leveraged ETFs.")

But rebranding them as not "real" ETFs is disingenuous. These are ETFs, structurally and mechanically. They hold a portfolio of securities; they trade on stock exchanges intraday; their share inventory is managed by the creation/redemption mechanism; and so on. Just because their returns are subject to a leverage factor along the way doesn't change the machinery of how the funds themselves work.

Besides, leveraged and inverse products are only dangerous when used improperly; namely, in a buy-and-hold context. At ETF.com, we've been shouting about this for years, but even the issuers themselves often warn against long holding periods. For example, both Direxion and ProShares run the numbers across various market scenarios right in the fund prospectuses to show how daily index resets impact returns over time.

If basic math embedded in the instruction manuals of the ETFs in question can't convince investors that leveraged/inverse products aren't meant to be held long term, then a name change certainly isn’t going to do the trick.

Buffered ETFs = Leveraged ETFs

It's also a strange choice to lump defined outcome ETFs in with leveraged and inverse funds, given that the raison d'etre of those products is risk management.

By capping potential return to both the upside and downside, defined outcome funds narrow the range of performance that investors can expect over a given time period. It's pretty much the opposite investor experience as leveraged and inverse funds.

Notably, however, it's in these types of risk-managed products where some of the most meaningful innovation in the ETF industry is now occurring. Consider the case of Innovator, the first issuer to package the concept of "buffered" defined outcome investments into an ETF wrapper. Since the firm launched its first buffered ETF back in 2018, its assets under management have risen to $3.2 billion—including $1.1 billion in new net cash this year alone.

That's small potatoes compared with BlackRock’s and Vanguard's assets. But maybe not small enough, if those two are suggesting that risk management strategies should be painted with the same brush as leveraged and inverse ETFs.

Don't Leave It Up To The Exchanges

Another critical issue with this proposal is that the burden of enforcing this new taxonomy would fall not on the Securities and Exchange Commission (SEC), but on the listing exchanges themselves.

The good thing about the SEC is that it’s an independent government agency not motivated by financial interest. Whether you agree with its decisions or not, its motivation is and always will be protecting investors, first and foremost.

Exchanges, meanwhile, are motivated by financial gain. They want to make money. And there's nothing wrong with that, but placing the duty of enforcing investor protection in the hands of a party with a financial stake in the matter introduces a conflict of interest, no matter how good the intentions are.

For what it's worth, the SEC already considered this question of new naming conventions while it was coming up with the ETF Rule last year. Ultimately, the agency decided against introducing new labels in its final rule—suggesting that, at the time, it didn't really see this as an imminent threat to investors.

Trying To Make Fetch Happen

Of course, the question this effort addresses is a good one: How do you get investors to understand that not every ETF is alike, and that just because they can invest in a product, doesn't mean that they should?  

It is a real and serious problem that investors—particularly self-directed retail investors—don't always understand the nuances of the vehicles they're investing in. But introducing a bunch of new acronyms is not the answer.

Changing the naming conventions feels like too little, too late. Different labels might have been useful two decades ago, as various classes of ETFs were first starting to be introduced. But introducing them now just feels like trying to make "fetch" happen.

So how do you fix the problem? I'm not sure this is a problem that can be fixed, because part of what makes ETFs so popular is how inherently accessible they are to the average investor. All you can do is educate folks about how their ETFs work, so they can make the best decisions possible.

However, education can't happen without a willing student. Investors first need to be willing to learn about the nuances of the products they're trading, or else we all might as well be shouting into the void.

And that's a step no amount of name changing can fix.

Contact Lara Crigger at [email protected]

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