We have repeatedly called for both the regulator and providers to differentiate between ‘simple’ and ‘complex’ Exchange Traded Products. We consider that ETFs are commonly perceived to be simple, low-cost tools for tracking well-established indices but recently, more complex structures have emerged. These products have similar names but may use leverage, sell short, track illiquid underlying assets or use active management techniques which add unexpected risk. In particular, some Exchange Traded Products may not hold proper collateral to secure the investor’s funds.
We have called for this second group of products to be clearly labelled to inform investors of the difference in structure. Internally, we already classify Exchange Traded Products as either ‘simple’ or ‘complex’ and would like this approach to be adopted in the marketplace for the benefit of all investors.
ETFs have seen significant growth by offering high quality, transparent, and liquid exposure to an index or asset class. ‘Simple’ or ‘non-complex’ ETFs offer performance close to the index, and greater liquidity than many active funds; they seek to match an index by replicating the assets of the index, and to provide the investor with a share in a portfolio of assets, like that of a unit trust.
The truth is non-complex ETFs are essentially UCITs III funds with the same protections as unit trusts. They offer two levels of liquidity, and when the markets are open, ETFs can be traded. If the market is losing value the fund will buy or sell the underlying securities, creating or redeeming shares accordingly. The holding is literally as liquid as the index and asset class being purchased.
ETFs which use a swap contract or synthetic element to match the index may still be classified as ‘simple’ in our view, provided that they hold a high level of collateral assets to protect the investor’s funds. Under UCITS III rules these ETFs must hold collateral assets equal to at least 90%of the value of the fund, but EPA’s preferred providers maintain over 100% collateral assets at all times.
In 2008, when some hedge funds and investment banks faced difficulties, ETFs remained strong. However, regulators are right to raise concerns about the risks involved and we believe that the first step towards this should be a clearer, less confusing classification between the various types of Exchange Traded Product.
It would assist potential buyers and holders of ETFs, who do not otherwise have the benefit of professional advice, to know that there are regulatory guidelines in place to ensure that non-complex or ‘simple’ ETFs are a liquid and a cost efficient way to buy into an asset class. It would also help investors to have the riskier and more complex products renamed and given an appropriately higher risk rating.
