What are the limits for ETFs?

Ben Johnson shares his thoughts on how the constant innovation of ETFs is leading to increasingly complicated products

February saw the launch of Pimco Source’s active short maturity ETFs. Previous to that and further down the active end of the spectrum, Source launched its MAN GLG Europe Plus ETF. These strategies and others like them are pushing the envelope in terms of what is available within the ETP wrapper with increasing regularity. 

From a legal perspective, there are no real boundaries as to what constitutes an ETF; any that do exist come from investor perception. Providers are guided by what we expect of an ETF and generally speaking the largest products are still those that track liquid, broad and familiar benchmarks. 

The question of what those limits might be, however, is important to surface because ultimately an exchange-traded product, whether a fund, certificate or note, is just a delivery vehicle for any number of different strategies. 

Much of the confusion involved herein arises from the fact that we are dealing with a young industry and one that is plagued by a host of semantic issues. We still do not have a broadly accepted definition of any number of terms, the first and foremost one being: what is an ETF? The industry should work organically towards a standardised dictionary, but it will take time. Meanwhile different conventions are embedded in languages as you move across borders and exchanges. 

Transformation
The development of ETCs and ETNs complicates the issue further and there is still a long way to go to increase understanding of the differences between these products.  These various structures are distinct in a number of aspects, including investor protection. Within the universe of synthetic ETFs, each separate manager employs a distinct model; they may appear virtually identical, but at a granular level collateral policies are very different across providers.

So far, the industry has done a fairly good job of self-regulating. We have seen a number of initiatives over the past 12 months to increase transparency, including the use of very explicit warning labels and making information on some of these products simply unavailable to a retail audience. 

One of the efforts that is already underway to increase transparency is coming from iShares on the issue of securities lending activity. More often than not, investors are unable to make much sense of a daily snapshot of collateral exposure, precisely because it will not look like the portfolio they are seeking to replicate, but what is significant is the gesture that shows an industry committed to transparency and the best interests of investors.

This is not just an issue that effects large institutions. There is a pioneering albeit limited group of retail investors who are actively engaged in this industry. This sort of innovation is important at the very least to create a sense of goodwill.