Label This 'Controversial'

May 27, 2020

A group of six ETF issuers recently announced an initiative to better label exchange-traded products. The coalition includes iShares, Vanguard and State Street (the “Big Three,” who control 80%+ of the ETF market), along with Invesco, Schwab and Fidelity.

The basic idea is that not every product should be called an “ETF.” Instead, some should be labeled differently to reflect their “structural features” and risks, which might better inform investors.

 

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Under the proposal, ETF issuers would rely on stock exchanges (Cboe, Nasdaq, NYSE) to implement these labels. Since ETF issuers must apply to have products listed on an exchange, the thought is this would be a natural point of “enforcement.”

This isn’t new. iShares, the largest ETF issuer, pushed for better labeling several years ago, and even attempted to include a similar proposal as part of last year’s ETF Rule, which cleaned up the ETF regulatory framework.

In a 2018 comment letter to the SEC, iShares laid out its case by citing the VelocityShares Daily Inverse VIX Short-Term ETN (XIV):

“The equity market sell-off and heightened volatility during the first week of February 2018 highlights the different risk profiles associated with different types of ETPs. Specifically, a steep drop in equity benchmarks on February 5, 2018 coincided with the largest one-day percentage increase ever recorded in the VIX level. During the week of February 5th, ETFs experienced more than $1 trillion in US-listed exchange trading volume, roughly double normal trading volumes. This episode demonstrated the resilience of the traditional ETF market in a time of market stress. However, after the closing bell on February 5, 2018, several inverse VIX ETPs suffered declines in excess of 90%. These price declines reflected the embedded economics of these ETPs, as a fall in the VIX increases the value of the inverse ETP while a rise in the VIX decreases the value of the ETP. In our view, this episode highlights the need for clearer labeling of ETPs in order to make sure investors understand that certain ETPs have greater embedded risks and more complexity than others.”

Ultimately, the SEC passed on including this proposal in the Rule.

ETFs have been a boon for investors by offering lower costs, greater tax efficiency, more transparency, trading flexibility and easy access to nearly every asset class or strategy. It’s the last point that is the driving force behind this labeling proposal.

As the ETF universe has ballooned, complexity has also increased. With nearly 2,400 products available, every investor can now buy anything from oil futures to leveraged products to volatility, all with the click of a button. Predictably, that’s led to some retail investors getting burned, the most recent example being the United States Oil Fund LP (USO). It’s important to note products such as XIV and USO functioned properly. The problem is some investors didn’t understand the risks.

Investor Experience Matters
From the perspective of ETF issuers, a bad experience for investors—even if the products did what they were supposed to—might negatively impact future business. Try googling “XIV” or “USO” and you’ll see an endless stream of scary stories about how ETFs have blown up Grandma. iShares and other issuers don’t want these stories dissuading Grandma from buying say, the iShares S&P 500 ETF (IVV).

The bottom line is some issuers want to avoid having a few products give the entire industry a black eye.

So, where do I stand? I applaud this new initiative and actually suggested this be considered in the wake of the USO debacle:

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I also said BlackRock’s proposal was a step in the right direction two years ago … which is why I have been somewhat surprised to see the broader ETF industry’s reaction to this now. I would characterize the overall response to the latest initiative as lukewarm at best.

Issuer Concerns
It seems the biggest concern is this might further unlevel the playing field in an already top-heavy industry. A decent chunk of products that would be labeled “ETN,” “ETC” or “ETI” come from smaller issuers. The CEO of Innovator ETFs, who pioneered the highly successful defined outcome ETFs, recently told MarketWatch:

“This is just really big companies coming together to try to squeeze out competition and build wider moats. It’s un-American.”

Under the new proposal, Innovator’s defined outcome ETFs would be labeled “ETIs.” The fear is that being labeled “ETI” or “ETC” might cause further gating at brokerages and other distribution platforms, which is already an (unfair) disadvantage for smaller issuers.

In other words, if a product is labeled “ETI”, brokerages might exclude that product from being offered to investors altogether or, at a minimum, place warnings that dissuade buying. But, isn’t that the point? If an investor wants to directly trade options or oil futures or open a margin account, they have to go through an approval process. Why should it be easier to trade oil futures ETFs or leveraged ETFs?

Look, I’m a huge fan of Innovator’s defined outcome ETFs. But the fact is, it holds a customized basket of FLEX options based on price indexes, and have some complexities. Go poke around on Innovator’s website. You’ll find interactive pricing calculators, lengthy FAQs and other learning tools. Innovator has done a remarkable job on education. Why? Well, it has a disclosure front and center on its home page:

“The funds have characteristics unlike other traditional investment products and may not be suitable for all investors.”

“Unlike other traditional investment products.” If being labeled an ETI causes some investors to hit the pause button and explore Innovator’s website, isn’t that a good thing?

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