The SEC’s Fixed Income Market Structure Advisory Committee (FIMSAC) approved two draft recommendations prepared by its ETFs and Bond Funds Subcommittee. The first recommendation outlines potential classifications of exchange traded products (ETPs) aimed at establishing clarity around the term "ETF" by categorizing the risks associated with different ETPs. The second draft letter recommends that the Commission form an industry-wide group to promote investor education and create a centralized and widely accessible database that can be used to compare and analyze ETFs.
Classifications. The subcommittee’s classification recommendation notes that while ETPs share certain characteristics, the term "ETF" is currently used to describe many products that have a wide range of different structures, investment objectives, and risk profiles. Citing "truth in labeling" as its guiding principle, the subcommittee stated that proposed Investment Company Act Rule 6c-11, which was issued for comment in June and would establish a framework for certain ETFs to operate without applying for individual exemptive orders, offers a timely opportunity to consider more consistent terminology for ETPs. To avoid potential problems of investors assuming that all products referred to as ETFs are structured like Rule 6c-11 ETFs, the subcommittee recommends that the Commission amend Rule 35d-1 to require that a registered investment company with "Exchange Traded Fund" or "ETF" in its name comply with Rule 6c-11.
The use of a more clear-cut and consistent naming convention for ETPs can better serve retail investors, according to the subcommittee. The draft letter recommends a superset classification for ETPs with four subsets: ETFs, exchange-traded notes (ETNs), exchange-traded commodities (ETCs), and exchange-traded instruments (ETIs). ETP would be a generic term for any portfolio exposure product that trades on an exchange.
ETFs would be registered investment companies required to comply with Rule 6c-11 and whose underlying securities include stocks, bonds, futures, or other investment instruments (such as bank loans and exchange-traded options). The ETF category would exclude funds with embedded leverage or inverse features. The subcommittee recommends that existing ETFs that were structured as Unit Investment Trusts or share class ETFs be grandfathered into this classification.
ETNs and ETCs are not registered investment companies and, thus, would not be subject to Rule 6c-11. ETNs would be debt instruments that provide an index-based return and may or may not be collateralized. As its name suggests, ETCs would include commodity futures and physical commodities listed under different Exchange Act rules than Investment Company Act funds.
The term ETI would refer to a registered investment company that seeks to provide a leveraged or inverse return, a return with caps on upside or downside performance, or "knock-out" features. ETIs could include products designed to outperform a specific index (such as active funds) but not by a particular multiple of a period’s return.
Subcommittee member Lynn Martin of ICE Data Services noted that ETFs have become increasingly popular with retail investors, but as the markets have developed, so has the complexity of the instruments. The classification system recommended by the subcommittee attempts to take into account how the market has evolved as well as considering future developments, Martin said, adding that as the complexity increases, ETPs have embedded risk characteristics that deviate from the original ETFs that gained popularity among the retail segment.
FIMSAC member and former SEC Chief Economist Larry Harris, now at the University of Southern California’s Marshall School of Business, inquired why the proposed classification does not identify a difference between actively and passively managed funds. According to Professor Harris, there is a simple way to differentiate between the two: actively-managed products involve ongoing judgment, whether it is human or machine-based; while passive funds involve criteria that can be easily enumerated, even if the criteria are complex.
Ananth Madhavan of BlackRock, who chairs the subcommittee, noted that the active versus passive distinction is increasingly hard to make. There is a blurring of the lines where many index products have features that could be considered active, such as intelligent currency hedging, he explained. He did agree with Harris that there is room in the education component of the subcommittee’s recommendations to help investors make these distinctions.
Education and data. The subcommittee’s recommendation on education and data advised that an investor education group should address the education of financial advisors, including robust and detail training modules within existing required certifications; adapt financial advisor education content to suit a retail audience; and identify standard information concerning ETFs, focusing on common data and formatting standards with key information regarding ETF portfolio and trading data. To facilitate availability and standardization, a centralized and widely accessible database should be created to host these key data elements, the subcommittee recommended.
Subcommittee member Kumar Venkataraman of Southern Methodist University's Cox School of Business advised that in the subcommittee’s discussions with industry participants, academics, and regulators, the members found that it is frequently difficult for investors to compare even structurally similar ETPs because various market data services, broker-dealers, and ETF issuers have historically used metrics derived from their own methods, making it difficult to compare fixed-income ETFs with other fixed-income investments, he said. With this in mind, the industry-wide group described under the education component of the recommendation should create a primer presenting the most basic elements for analyzing ETFs, focusing on identifying key data aspects along with common definitions for the use of investors, regulators, and academics.
The Rule 6c-11 proposing release outlined specific potential areas for consistent disclosures, which the subcommittee believes will be effective in improving investor awareness, Venkataraman said. The subcommittee also supports the proposal to expand disclosure of historical bid/ask spreads associated with ETFs and would also like the Commission to consider disclosure of additional historical information.
FIMSAC member Sonali Theisen of Bank of America Merrill Lynch asked how the group would track active authorized participants, who would provide the information, and whether it would be made available publicly and with what frequency. Venkataraman replied that perhaps the ETF issuer could collect the data because they have the information and the expertise. Regarding the dissemination of the data, he understands that some of the information could be sensitive, and the public availability of this information could be delayed for a year or 18 months.
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