Exchange Traded Funds (ETFs) have enjoyed a meteoric rise over the past two decades, reaching more than $1.5 trillion in assets under management in Europe alone. This success has been largely down to the fact that they offer unparalleled levels of access to investors and are relatively ‘simple’ products to understand. But soon this may no longer be the case.
Some definitions
First, let’s step back into the world of Exchange Traded Products (ETPs). This is a term that describes a wide range of very different investment vehicles listed and traded on a stock exchange. There are several categories of ETPs, but they broadly fall into two buckets: ETFs or Exchange Traded Notes (ETNs). ETNs (or ETCs for commodities) are essentially debt instruments issued off the balance sheet of a special purpose vehicle. They do not have to comply with the investor protection regulations we see in the funds industry. ETNs are only limited by the imagination of the issuer. In other words, an ETN is a broad category that will often mean anything that would not typically be allowed within a mutual fund structure.
ETFs, on the other hand, are highly regulated mutual funds. However, the ETF acronym is sometimes used, some might say intentionally, when talking about ETN/ETC products. This presents a real risk to investors, who could be confused into thinking they are getting the same level of protection from an ETN as they would from a traditional ETF. In fact, in an attempt to deal with this issue, in 2014 the European Securities and Markets Authority (ESMA) produced specific ETF guidance where they created and defined the term ‘UCITS ETF’. All ETFs that are UCITS funds must now contain this term in the fund name.
Global inconsistency
While this guidance certainly went some way to clear up any potential misconceptions, it has not eliminated the issue entirely. The definition of what a UCITS ETF is, still does not define what an ETF is not. It also does not prevent someone from using the term outside of the UCITS framework. This has created a number of exceptions where some products that do not offer the same level of protection as a UCITS fund are still using the term ETF. For example, in Switzerland, their locally domiciled and regulated ETFs can hold a single commodity, unlike a UCITS product. In the US, the term ETF continues to be widely used when referring to ETNs.
If investors are not already a bit confused by the different definitions, there’s now another new entrant to contend with: the non-UCITS ETF. In the race to get the first bitcoin products to the market, Alternative Investment Funds (AIFs) are now being approved as ETFs in Europe. While these products meet the criteria to be defined as funds, they will not be considered ‘UCITS ETF’ funds, as they do not offer the same level of diversification and are not intended for retail investors. Will this distinction be clear enough to potential investors? Does it matter?
Buyer beware?
One could argue that all the relevant investor information is made available to investors, should they care to review it. Perhaps most investors will recognise the importance of avoiding the pitfalls of such complex products, or at least go in with their eyes open. But the biggest risk to the ETF industry has always been the ETF brand. Despite numerous attempts over the years by vested interests to create negative sentiment towards ETFs, they have continued to deliver to investors time and again. The more successful they are, the bigger the risk for the ETF brand if investors find themselves in complex products that fail to deliver and bear little resemblance to their other ETF holdings. By allowing the ETF name to be used for complex AIFs, we run the risk that investors may not fully realise the risks involved with buying ETF shares on an exchange. This is where the simplicity of an ETF may prove its Achilles heel.
What’s the solution?
While it might not be the answer we want to hear, it’s time for clearer regulations –and more international regulatory alignment – on the taxonomy of all ETPs and the labelling they use. It’s not a question of limiting the access of an exchange listing to UCITS ETFs. There is no reason that the benefits of the ETF ecosystem should not be shared with all product types, including complex AIFs. However, if AIFs are going to be put on the shelf beside a UCITS product, investors need clearly labels to avoid any potential confusion.
Will we all be taking about the world of Exchange Traded Complex Funds (ETCFs) in the future? I hope so, as this could also be the catalyst for the next stage of growth for the ETP industry.
Rob Rushe, Senior Expert – ETF Solutions
CACEIS Ireland Limited
