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Why 'Truth in Labeling' Matters for Exchange-Traded Products

Ben Johnson, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. A proposal before the Securities and Exchange Commission aims to help investors distinguish among various types of exchange-traded products. Joining me to discuss the proposal is Ben Johnson, he's director of passive strategies research for Morningstar globally.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's talk about what this proposal aims to address. What is the SEC trying to get at here?

Johnson: I think what the proposal aims to address is just to drive greater truth in labeling as it pertains to exchange-traded products, and important in that is the "P" in products. Oftentimes exchange traded products will be used interchangeably as a term with exchange-traded funds or ETFs. It's important to note that ETFs are really just a subset--albeit the largest most representative subset of what exchange-traded products are more broadly--but there are other types of exchange-traded products that fall under that umbrella, notably exchange-traded notes, which are not funds by a long shot, that have very different features, have very different levels of protection and regulation from exchange-traded funds which are funds proper, which are subject to 1940 Act.

Benz: Specifically what would this proposal require and how would fund labeling or ETP labeling change under the proposal?

Johnson: Labeling would require greater transparency around what is an exchange-traded fund, which again would account for by count backing into what we see in the 2,200-plus exchange-traded products today--80% of those would be exchange-traded funds proper. The next largest cohort would be exchange-traded notes, which are effectively just an IOU from a bank. There are no assets backing them. They are saying you are paying me a fee, I'm giving you the return of some index or a multiple thereof, you name it, which clearly is a much different proposition than having a real ownership stake in a basket of securities. 

I think its important. I think it's long overdue that we have this taxonomy. This way to differentiate among different exchange-traded product types so that investors can look at the tin have some semblance of an understanding of what are the regulations that are guiding the quality and the type of contents thereof, oversight of that process. Oversight of that portfolio, of that fundm versus what are other product types that might have less investor protection inherent within that structure.

Benz: Have you seen in your travels, in your interactions with investors in exchange-traded products, have you seen that they are legitimately confused about some of these features that go along with the various product types?

Johnson: I think its absolutely the case. People take what they see now in labeling at face value, and first and foremost might still to this date not necessarily know and appreciate the differences between even just exchange-traded funds and traditional mutual funds. This is another level of granularity deeper still where I think the stakes are even higher yet. At least with exchange-traded funds and traditional mutual funds we have a common set of regulations and guiding principles. Very different again when you move into other nonfund exchange-traded product types where you are going to forfeit some of your rights that you would have in the context of investing in a traditional fund.

Benz: Let's talk about what investors can do in the meantime. This is still a proposal. The SEC has not passed anything so there are no changes that are definitely taking effect. In the meantime, if I am transacting in exchange-traded products and I want to be a defensive driver and understand what I am getting into, can you make any recommendations for investors trying to navigate?

Johnson: First and foremost, it's easy to pull out some of these other subcategories. Notes will most commonly or almost always be labeled as such, as in exchange-traded note or ETN. Investors should understand when they are investing in an ETN that what they are promised in terms of oversight, in terms of accountability, in terms of protection, in terms of what they actually own, and the sponsor of that note's ability to call off the bet that they are taking the other side of it at any given point of time is very different from what they would expect in exchange-traded fund.

In other cases, it's a matter of, I think, understanding the underlying exposure. Part of this proposal would involve taking leveraged and inverse funds--which many investors have had some very bad experiences with, I would say owing chiefly to the complexity of the underlying strategy which is belied by a seemingly simple and straightforward labeling of the proposition--tose would be classified as exchange-traded instruments. So what would be ETIs investors can kind of suss out for themselves now in cases where there is a leverage component to the underlying exposure in question.

The next category would be exchange-traded commodities or ETCs. Really just about anything offering unlevered commodity exposure is going to be carved out into this separate ETC cohort. It really boils down to, first and foremost, is it a note or not and then what is the underlying exposure. Is it leveraged or inverse, is it some sort of commodity exposure? If any of those three apply, know that if this proposal does indeed go through--which I am fully supportive of a more clear, more consistent taxonomy for exchange traded products--that these sorts of products would be carved out separately in distinct cohorts from exchange-traded funds prope, which I think ultimately would be to the benefit of investors as they try to navigate what's an expensive menu now, as I mentioned before, of more than 2,200 different products.

Benz: Ben always great to get your insights. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.