This afternoon, a consortium of the largest 5 ETF providers, plus Fidelity, sent notes off to the exchanges asking them to enforce an ETF taxonomy they’ve created. The Wall Street Journal covered this well, and you can read a copy of the press release here.
The proposed system creates four buckets, only one of which gets to call itself an ETF. In short, they’re proposing that only 1940 Act registered funds with normal creation/redemption activity get to be “ETFs.” Further, only such funds that are “designed to deliver full unlevered positive return of the underlying index or exposure” count. Exchange Traded Notes get to be called ETNs (Yay! We already do this!)
Any vehicle targeting commodities exposure (whether it’s a Grantor Trust holding gold, a ’40 act fund using the Cayman Islands, or a limited partnership holding futures or swaps) get to be called Exchange Traded Commodities (or ETCs). Everything else, gets to be an “ETI” or Exchange Traded Instrument.
The Backstory
This is far from the first time this kind of proposal has been floated. I don’t think I marked my calendar, but my first conversations with folks about coming up with definitions for different kinds of products was at least 10 years ago, possibly even predating the global financial crisis. In general, these efforts melded with many attempts to create ETF industry groups that could serve as educational institutions (Like the Options Industry Council does for the options market or the American Dental Association does for Dentists).
None of those efforts have been successful, and for pretty understandable reasons. The term “ETF” has become a genericized term, like Xerox or Frisbee. Your Bloomberg terminal responds to “ETF Go.” You’re reading this at a site called “ETF Trends.” We provide data at a website called “ETF Database.” So getting anyone who’s primarily in the business of manufacturing and distributing any product that wouldn’t be in the “ETF” bucket will likely be against any system that excludes them from the definition.
The Good
If for no other reason, I genuinely applaud the efforts of the six firms involved in this proposal, because I’ve toured the sausage factory in which these discussions must have been had. The expression “Herding Cats” comes to mind, but does a disservice to Cats’ ability to lie in the sun for 18 hours a day and let the world go by. Maybe it would be more appropriate to describe the effort as “herding cats that have had 5 double espressos.”
I also applaud part of the intent here. As their letter says, they’re trying to “categorize certain exchange traded investment products (“ETPs”) in a manner that more accurately reflects their inherent complexities, risks and structural features.” That sounds noble enough on the surface.
Last, the actual task of developing a taxonomy for ETFs is blisteringly hard and fraught with bad tradeoffs. I’ve built an ETF classification system (With Matt Hougan and Elisabeth Kashner, which now lives at FactSet) in the past, and it was some of the hardest work I’ve ever been involved with. I’m not going to claim I have a better mousetrap, because I’ve tilted at this particular windmill a dozen times in as many years, and I can’t construct a perfect system either. So I acknowledge that there’s real, thoughtful work behind this effort.
The Bad
So what’s not to like? Well this is just one dude’s opinion, but there are some real issues. Let’s start with the stated intent: to more accurately reflect complexities, risks and structural features. This sounds an awful lot like the Traffic-Light approach that my friend Eric Balchunas at Bloomberg implemented some time ago, which uses a scoring system to rate funds based on their complexity and risk. But it does so in a dynamic way, monitoring for creation/redemption impairment, volumes, discounts and so on. What’s proposed here is more one-and-done, and more monolithic.
It’s easy to understand the obvious base case: nearly all of the funds issued by those writing the letter will end up as ETFs, and they represent 90% of the $4 Trillion U.S. ETF market by assets. Sure, they collectively have a bunch of commodity products, but that’s not that controversial. Essentially none have any stake in the ETN market. Invesco has a handful of more obscure products that will likely get stuck in the “ETI” bucket – funds like the Invesco S&P 500 Downside Hedged ETF (PHDG). So by assets, most of the industry still gets to be ETFs.
But how, exactly? The coalition is asking exchanges to play hall pass monitor for the ETFs that list on their exchange, including looking through to the portfolio level. But absent a clear regulatory standard, this has all sorts of unintended consequences. I’m not saying these couldn’t get resolved, I’m just reacting to what’s being proposed:
- How can the exchanges agree on very clear shared rules so that issuers can’t “shop” for a listing venue that has the loosest “ETF” definition, without running into anti-trust issues? By definition, if this turns into an exchange rule, it gets bounced right back to the SEC, which has already thrown their hands up on this issue.
- As written, I feel like this is a gameable system. I could simply launch my fund as “go anywhere active total return” and then buy anything inside the four corners of my prospectus, creating far more complexity and risk than “vanilla” ETFs while retaining the title. The definition of an “ETI” suggested unmodified exposure to an index, but then I can just create a new index, decide that it represents it’s own unique Beta, and call it an ETF?
- None of this does anything to kettle “higher risk” funds, which is clearly the intent from the opening paragraph. While yes, this would scoop up the $50 billion or so of Leveraged and Inverse funds (1% of the ETF market!), it also scoops up some of the most exciting risk management products to be launched in the last 25 years – the risk-managed, defined outcome products (soon to be a very crowded playing field). So you’re taking funds that are smart about using options to mold returns and kicking them to the “weirdos” bucket? And plain old covered call strategies too? And the tail-risk strategies that saved a lot of investors a lot of money in March by lowering risk? That rubs me the wrong way, and seems counter to the stated intent.
- No matter what anyone says, if a system like this were universally adopted, I’m quite certain this would be used for gatekeeping. While Schwab and Fidelity would probably continue to let you buy “ETIs” they could and probably would put scary warnings ahead of every trade in the products, regardless of their actual risks. Larger advisory and brokerage firms with strict due diligence hurdles – already a big issue for small ETF shops – would like just exclude them, as they have with leveraged and inverse products already.
- More problematic is the confusion this would inevitably create in communicating with investors. Without a regulatory requirement from FINRA, it’s not even clear how compliance around communication would be enforced. NYSE, NASDAQ and Cboe might all agree that, say, the Global X NASDAQ 100 Covered Call ETF (QYLD) is an “ETI,” but when GlobalX runs ads calling it an ETF, who’s going to enforce this? FINRA reviews marketing materials, not exchanges. Is NYSE going to staff a marketing review office to ensure compliance with these labels, and then de-list “instruments” that are out of compliance? Is the entire support industry around data, analytics and content expected to rebuild their businesses in order to match what the exchanges dictate? Are hundreds of funds that currently have “ETF” in the literal names of their products expected to file new prospectuses with new names?
- Last, and perhaps most importantly, this feels an awful lot like “taxation without representation.” I get it – the top issuers pushing this currently have more about 90% of the assets. But a ton of the innovation in ETFs is coming from upstarts much further down the league table. Does First Trust not get a say in this, because they “only” have an $80 billion complex, vs Schwab’s $150 billion? What about Van Eck, Wisdomtree, PIMCO, Goldman, JPMorgan, DWS, ProShares and Direxion (and the next 50 or so firms in the league table?) These firms may not have a trillion dollars each, but they’ve still been incredibly beneficial for investors, not only in innovating, but in forcing things like disclosure and expenses to the front page. Competition is good for everyone.
Moving the Ball Forward
I don’t want to come across as overly negative here – and let’s be real clear, nobody’s giving me a vote. I don’t run an exchange, and I don’t run an ETF issuer. I’m just a guy on the neutral sidelines, trying to help investors and advisors make sense of ETFs. So in the spirit of trying to be constructive, here are some things that this gang-of-six (plus the 3 exchanges) could do if they’re serious about moving this forward:
- Broaden the representation. I’m not saying you need to get every firm on the same side, but you need to at least have a process for inclusion.
- Get a whole lot more specific about the bucketing, and publish exactly what that would look like fund by fund, for every one of the 2,310 funds on the market. Yeah, it’s work, but it’s not that much work. If you want everyone to accept this, then the details will really, really matter.
- Explain how investors are supposed to process this. If all of the sudden my ETF is now sending me a new prospectus telling me it’s an ETI, what am I supposed to do with that information other than panic. Education has to be the lead-dog here, not an afterthought.
But honestly …
My actual opinion is that this is trying to rebuild the barn long after it’s burned down and the horses are running wild. You can label these products anyway you want, and investors, and more importantly media, will continue to call them ETFs. At this point it’s like trying to get everyone to stop calling Police Officers “cops” or facial tissue “Kleenex” or plastic-air packaging “Bubble Wrap.” This is really about language (since its not regulatory), and language is always – always – decided by individual speakers, not by institutions, at least until we’re truly living in Orwellian times.
I get that people are shocked when something like USO has a bad day, or when a 3X fund has to close because of the math, but I also think brokers and advisors have done a very good job at effectively identifying these more complex products, and the industry has done a great job educating investors. This industry has thrived in part because of its big-tent inclusiveness.
I just can’t get behind something that backtracks from that.