ETF Education A Moving Target

[This article appears in our January 2021 issue of ETF Report.]

Innovation is the lifeblood of ETFs, driving  their creation and ongoing evolution. But the key to innovation adoption is education  on the part of issuers and practitioners. How else were the originators of the SPDR S&P 500 ETF Trust (SPY) going to convince investors to put their money into a brand new product that offered a bold twist on the ho-hum mutual fund structure?

If you don’t understand a product, don’t invest in it. Seems simple enough, but with innovation a constant in the ETF space, an educator’s job is never done in this industry. 

The problem is that the goal posts keep moving. With almost all of the low-hanging fruit in the plain vanilla space long plucked from the tree, most of the product development we see today comes with added layers of complexity, and complexity means more homework.

Misunderstood Leverage
When leveraged and inverse ETFs first hit the market in 2006, the issues of erosion, compounding and daily resets were confusing to many investors. That led to multiple lawsuits against issuers of such funds, despite the ETFs behaving exactly as promised in their prospectuses. There was an ignorance gap that ended up in courts.

Is there actually a “problem” with leveraged and inverse ETFs? No, they do exactly what they’re designed to do, for better or worse. The issue is in understanding the structure. When you’re dealing with 300%/-300% exposure, just one day of adverse conditions can largely wipe out an entire investment.

The March 2020 market crash made that lesson abundantly clear.  The education hurdle in this part of the market is always critical.

Today’s Biggest Concern
Right now there are two new and novel parts of the ETF market that are crying out for additional investor education: nontransparent active ETFs and defined outcome ETFs.

Portfolio nontransparency in an otherwise massively transparent ETF industry is innovation enough, but it’s come to market through no less than five different models currently available from the NYSE, Fidelity, T. Rowe Price, Precidian and Blue Tractor. All have different strategies and subtleties embedded in their methodologies, raising the bar on the due diligence that’s needed to understand what each type of active ETF a product is.

Once you nail down the mechanics of each model, you still need to determine whether you’re comfortable with the level of disclosure the model offers, and given that it’s early days for these products, you should monitor how they trade. There’s a lot to learn about this latest innovation before committing assets to the strategy. 

Defined Outcome Education
With defined outcome ETFs, there are several issuers offering such funds: Innovator, First Trust, AllianzIM and TrueMark. There are subtle differences between the different approaches, but they all use flexible exchange-traded options. Most look to re-create the performance of the S&P 500 Index within ranges established by upside caps and downside buffers, thereby offering a smoother ride. 

What’s not to like about a more predictable outcome in an otherwise volatile market? But again, the expected outcomes and the inner workings of these funds can be complicated, especially if the options market isn’t your typical terrain. The SEC requires issuers to show on their websites what outcomes to expect when the ETFs are bought outside the reset days—that’s an investor protection mandate aimed at education. 

But as we well know, the educational burden doesn’t rest only with regulators or issuers. It rests with everyone involved with any part of the ETF ecosystem, including the end investor.

The good news is that information is typically readily available in this part of the financial world. But the ever-shifting sands of innovation in the ETF space and the constant influx of new-to-ETF investors mean that educational efforts will always be ongoing.