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Industry Coalition Advances ETP Classification
Since State Street launched the first exchange traded fund (ETF) in the United States in 1993, ETFs have become an increasingly popular investment vehicle. Today, the more than 2,000 ETFs listed on US exchanges1 provide all investors efficient, cost-effective and transparent access to markets.
ETFs’ exponential growth has sparked the proliferation of more structurally complex exchange traded products (ETPs), including exchange traded notes (ETNs) and levered and inverse ETPs. Yet, while these products pose very different risks to investors than do traditional index or basket-tracking ETFs, many ETPs have been categorized—by investors, the press and exchanges—as ETFs.
On May 13, 2020, State Street Global Advisors was proud to join BlackRock, Charles Schwab Investment Management, Fidelity Investments, Invesco, and Vanguard in asking the exchanges to implement a classification system that categorizes different types of ETPs in a way that more accurately reflects their inherent complexities, structural features and risks.2
Recent market events underscore the need for investors to understand the greater risk posed by some ETPs:
- April 2020: The dramatic decline in oil prices resulted in a 3x levered long crude oil-linked ETN being delisted with an expected value of zero dollars per note.3
- February 2018: A steep drop in equity benchmarks coinciding with a large one-day increase in the VIX resulted in several inverse VIX ETPs suffering declines in excess of 90%.4
To help ensure that investors understand that complex products or those with more narrowly tailored investment objectives can have greater embedded market and structural risks than do others, the industry coalition has asked each US stock exchange with ETP listings—NYSE, Nasdaq, and Cboe—to implement more consistent identifications and categorizations of ETPs.
By providing investors with a high-level view of products’ varying characteristics and risk, the coalition’s ETP classification system supports due diligence from a common starting point.
We have asked the exchanges to use these definitions to categorize the different types of ETPs at the data-feed level:
A registered open-end management investment company under the Investment Company Act (operating under Rule 6c-11 or an applicable SEC ETF exemptive order) that: (i) in the normal course issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount (if any); and (ii) issues shares that are listed on a national securities exchange and traded at market-determined prices. ETFs include funds that transact on an in-kind basis, on a cash basis, or both; and exclude ETNs, ETCs and ETIs.
A debt security issued by a corporate issuer (i.e., not issued by a pooled investment vehicle) that is linked to the performance of a market index and trades on a securities exchange. An ETN may or may not be collateralized, but in either case, depends on the issuer’s solvency to deliver fully to expectations. ETNs exclude products that seek to provide a leveraged or inverse return, a return with caps on upside or downside performance or “knock-out” features.
A pooled investment vehicle with shares that trade on a securities exchange that invests primarily in assets other than securities and financial futures. The primary investment objective of an ETC is exposure to traditional commodities and non-financial commodity futures contracts; and may hold physical commodities (e.g., precious metals) or invest in non-financial commodity futures or commodity-based total return swaps.
Any pooled investment vehicle, debt security issued by a corporate issuer, or similar financial instrument that trades on a securities exchange that has embedded structural features designed to deliver a return other than the full unlevered positive return of the underlying index or exposure (for example, products that seek to provide a leveraged or inverse return, a return with caps on upside or downside performance or “knock-out” features). All products not captured by the ETF, ETN or ETC classification fall under ETI.
This classification system will help investors understand the varying outcomes a fund might have, based on what it holds, or other relevant features of the construct. Longer term, the proper identification and categorization of ETPs will help investors to make more informed investment decisions.
1 Morningstar, as of May 15, 2020. Excludes exchange-traded commodity, exchange-traded note, exchange-traded mutual fund and NextShares assets.
2 The SEC chose not to include an ETP naming convention in Rule 6C-11 (the “ETF Rule”); however, the Commission encouraged ETP market participants to “continue engaging with their investors, with each other and with the Commission on these issues.”
3 The price decline reflected the embedded economics and risks of this ETN; it performed as expected but with volatility and market risks significantly different than unlevered index tracking ETFs. Barclays exercised its issuer call option, which allows the issuer to call the ETN at its discretion. See Barclays Press Release (April 20, 2020), Barclays announces the redemption of the iPath® Series B S&P GSCI® Crude Oil Total Return Index ETNs (“the ETNs”) and the suspension of further sales and issuance of the ETNs, available at https://barxis.barcap.com/file.app?action=shared&path=iPath/US/Press/Barclays%20suspends%20further%20creations%20for%20OIL%20ETN.pdf
4 While these products performed as designed, the dramatic jump in the VIX prompted the closure of an inverse VIX ETN by its sponsor under the terms detailed in the ETN’s prospectus (a so-called “event acceleration”). See Credit Suisse AG Press Release (Feb. 6, 2018), Credit Suisse AG Announces Event Acceleration of its XIV ETNs, available at https://www.credit-suisse.com/corporate/en/articles/media-releases/credit-suisse-announces-event-acceleration-xiv-etn-201802.html