The Name Game (Part 1): What Makes an ETF an ETF?

May 24, 2020

“What’s in a name? That which we call a rose. By any other name would smell as sweet.”

Romeo and Juliet, William Shakespeare

What’s in a name indeed. Does a name truly define the substance of an object? Or, as the great bard suggests, is a name simply a label which distinguishes one thing from another without enhancing its worth or meaning? Not a question one might associate with asset managers and mutual funds, but one that is under greater industry scrutiny. It holds true that a catchy name makes a fund stand out in a crowded marketplace and, ultimately, helps it to sell. So, it’s natural that regulators and others would want to ensure that the name of a fund is truly indicative of how it invests and is not misleading.  

The latest ‘naming’ controversy has popped up in the world of exchange-traded funds (ETFs). A few weeks ago, some of the largest US ETF issuers banded together to ask that the major exchanges no longer allow leveraged or inverse products to carry the name “exchange-traded fund” on their offerings. Why? Because the group claims that certain leveraged and inverse products aren’t actually ETFs. Sure, they are freely exchanged on secondary markets, like a stock or traditional ETF, but that’s where the similarity ends. Chief among those differences (and risks) is that leveraged ETFs use derivatives in order to amplify the daily return of the underlying index. And unlike traditional ETFs, leveraged ETFs are rebalanced daily, making them exclusively short-term by nature – which is largely antithetical to the “buy and hold” ethos of many broad-based index ETFs.    

As part of its letter to major exchanges, the band of US issuers suggest a new naming regime, which distinctly separates different exchange-traded financial products by type. This large and influential cohort feel that misnomers in naming could result in investor confusion and undue risk. All products that carry “exchange traded” in their name, after all, may be perceived as  in the single bucket of seemingly homogenous products. By designating ETFs by type, the US market would align itself with existing regulations in the EU where there are very distinct rules about funds who may and may not name themselves ETFs.

This is not the first time this debate has arisen.  It tends to flare up every few years with prominent voices from the more traditional ETF providers calling for change and then factions from the innovative ETP sector leading a counter-offensive, before things die down and the status quo remains.  However, latest wrangle reached a turning point in March as a result of pandemic related commodity market turbulence, where certain exchange-traded commodity products (namely oil ETNs) closed.

In the proposal, the ETF label would be exclusively reserved for registered open-end management investment companies as defined under the ’40 Act. Such companies issue and redeem creation units to and from authorized participants, and their shares are listed on a national securities exchange and are traded at market-determined prices. As such, while the proposal is addressed explicitly to the securities exchanges, if accepted, it raises the possibility of the Securities and Exchange Commission having to address the issue also.  Interestingly, the SEC have only recently recast their own exchange traded funds rules and are in the midst of assessing the existing “Names Rule”, as such they may feel these issues are in hand already.

If the ETF naming proposal is approved by the exchanges, more than 550 products that currently carry the ETF moniker would no longer be allowed to do so.  

Other products would be categorized under a set naming convention which aims to better reflect the products’ underlying strategies, as follows:

  • Exchange-Traded Notes (ETNs)
  • Exchange-Traded Commodities (ETCs)
  • Exchange-Traded Instruments (ETIs)

There are, however, dissenters to the proposal, many of whom are issuers of these types of products. This group argues that the parsing out of the exchange-traded universe will only add further investor confusion and reduce choice and competition. 

No Sure Thing

Clearly the naming point has been made loudly and clearly by a large cohort of influential providers, but the path to concrete change remains uncertain. There is no guarantee that the stock exchanges nor the SEC will take up their calls for change. If the exchanges do accept the suggested reclassification system, it might compel the SEC to address it with new rules, but it seems unlikely that the exchanges themselves wish to wade too strongly into this debate or indeed monitor new categorization guidelines or be involved in potentially delisting of products that don’t comply. Given that the SEC has already addressed risk disclosures in their ETF rule without addressing the classification issue and are currently already focused on enhancing its broader Names Rule, it does appear less than certain that it will have the appetite to step in and completely recast the naming conventions for the US ETF market.

So, the US ETF market is hyper focused on names, so too are the SEC in broader terms.  Later this week we will delve into more detail on the SEC’s Name Rule consultation in “The Name Game (Part 2): SEC Seeks to Purge Misleading Names

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