Cross your ‘F’s and mind your ‘P’s
The last two weeks, contrary to pre-conceived notions put forward by those who have the most to lose, exchange traded funds (ETFs) did not exacerbate the market fluctuations, nor were they to blame for falls. In an effort to support this narrative some media outlets mistakenly referred to a derivatives-based exchange traded note as an ETF. However, such exchange traded notes, also referred universally under the umbrella term 'exchange traded products' (ETPs) are not ETFs. The differences are important to understand as the consequences for investors, as we've seen, can be severe.
The world of financial products can be very confusing not only for investors but also, based on recent reporting, sections of the media. ASIC has recently sought to clarify the naming conventions in its Information Sheet 230, Exchange traded products: Admission guidelines (INFO 230), which is a welcome move. ASIC acknowledges that the information sheet largely reflects market practice and some elements may need to be altered over time as the market continues to grow and innovate.
INFO 230 sets out the standards for defining exchange traded products (ETPs) including exchange traded funds (ETFs), exchange traded managed funds (ETMFs), hedge funds and structured products, each of which can be traded on the Australian Securities Exchange (ASX). For investors, the impact of INFO 230 can be identified by the ETP's full legal name which should alert you to potentially hidden risks.
According to ASX data, as at 31 December 2017, there were 175 ETPs on ASX with a combined market capitalisation of $35.7 billion, representing a jump of 39% compared to 12 months earlier.
ETFs make up the bulk of this market, representing 92% by market capitalisation. ETFs have driven the growth of the ETP market because investors like their benefits: low cost, transparency and liquidity.
But not all ETPs offer all these benefits, as ASIC's paper confirms.
Products that can be referred to as an 'ETF'
Passive investment strategy funds
According to ASIC, a fund can only be described as an 'ETF' if it is a passive investment strategy, that is, one that seeks to replicate or track the performance of an index or a combination of multiple indices, or other widely regarded/available benchmark (e.g. currency pair or commodity), the value of which is continuously disclosed or can be immediately determined.
Smart beta products
ASIC separately recognises 'smart beta, factor, multi-asset and quantitative or rules-based ETPs'. ASIC recognises that these products are increasingly common and may seek to provide additional diversification or enhance returns compared to traditional market capitalisation based index tracking ETFs by involving strategies that are a hybrid between active and passive investment management.
Those products that seek to replicate or track the performance of an index, albeit a smart beta index, the value of which is continuously disclosed or can be immediately determined, can be referred to as ETFs.
VanEck's own smart beta ETFs all track rules-based indices while retaining the low costs, transparency and ease of trading associated with ETFs.
ASIC's recognition of smart beta ETFs is welcome as they are making up an increasing proportion of the ETF market. In Australia, almost one in three ETFs listed on the ASX is now smart beta. That growth will likely continue this year as more investors turn to smart beta ETFs for the first time seeking low-cost targeted investment outcomes. Globally, smart beta is the fastest growing segment of the investment management industry, with over 1,200 products listed with US$592 billion of funds invested in smart beta ETFs (ETFGI, 2017).
But not all smart beta products qualify as an 'ETF'.
ASIC confirms that if funds do not meet the ETF labelling criteria, they must be labelled as 'managed funds' or 'hedge funds' and they may (where not misleading) be labelled as 'active ETFs'.
Active managed funds (products must include the word 'active' before ETF and be identified as a 'managed fund')
In contrast to an ETF, an 'active ETF' is a fund that buys and sells investments based on an active investment strategy or which seeks to outperform a benchmark (as opposed to replicate or track it). According to ASIC, these funds must not be labelled ETFs without also including the word 'active' and should also include the words 'managed fund' e.g. ABC Active ETF (Managed Fund).
Where the label 'active ETF' is used, ASIC says the fund must be marketed as having an active management investment strategy and the impression should not be given that it has a passive management investment strategy or that it aims to track a benchmark. This is an important requirement: active ETFs should not be marketed as having similar qualities as an ETF.
Because they don't. In a nutshell an 'active ETF' is an active managed fund that is traded on ASX.
Indeed, ETFs offer several advantages over 'active ETFs'. These include greater transparency of holdings, which must be reported daily. In contrast, 'Active ETFs' only need to report their holdings every quarter. Also, ETF management costs are a lot lower than those of 'active' ETFs.
Arguably, even calling a product an 'active ETF' could convey the message that the product brings the benefit of low cost as ETFs do. However, 'active ETFs' charge relatively high fees, often the same as the unlisted actively managed funds on which they are based, including performance fees, which ETFs do not charge.
So there are significant differences between ETFs and active ETFs, about which investors need to be better educated. 'Active ETFs' would be better described as 'exchange traded managed funds' (ETMFs) or 'active managed funds' so that there would be no confusion with ETFs. We see this as an area that is likely to see some alteration in future to provide further clarity for investors and facilitate ASIC's goal of 'promoting fair and transparent' markets.
Hedge funds including leveraged and inversed (cannot have ETF in its name)
ASIC also distinguishes hedge funds, which are a subcategory of managed funds, as opposed to ETFs. Hedge funds use alternative investment strategies, often including debt (leverage) or derivatives that can expose investors to more diverse and complex risks than other types of managed funds. ETPs that meet the hedge fund criteria need to use the words 'hedge fund' in their name e.g. ABC Fund (Hedge Fund). A hedge fund cannot use the ETF designation.
Structured products (cannot have ETF in its name)
ASIC also distinguishes structured products. A structured product is a security or derivative which gives financial exposure to the performance of underlying instruments. These type of products need to use the words 'structured product' in its name e.g. ABC (Structured Product). Types of structured products include exchange traded commodities (ETCs), exchange traded certificates and exchange traded notes (ETNs). Quite rightly, a structured product must not use the label 'ETF'.
Leveraged and Inverse ETPs (cannot have ETF in its name)
Finally, ASIC also distinguishes leveraged and inverse ETPs. A leveraged ETP is constructed using various derivatives and debt to amplify the returns of an index, likewise an inverse ETP uses complex financial instruments such as derivatives except these are constructed with the purpose of profiting from a decline in the value of a benchmark. ASIC has avoided many of the complex versions of these products that have been launched in other markets however there are some on ASX that do provide leveraged/inverse exposure to the performance of a benchmark. These types of ETPs must be labelled 'managed fund', 'hedge fund', or 'structured product' as appropriate.
INFO230 classifications are welcome moves by ASIC to define a rapidly growing ETP market. Whereas some ETPs can be very risky their subset, ETFs are tried and tested and have opened transparent, low cost and targeted investment opportunities to Australian investors. It's important investors understand the differences between the various ETPs. ASIC is concerned enough to ensure that product names more clearly reflect the nature of the product to assist in alerting retail investors to the type of product and associated risks.
As a result of ASIC's paper, other more complex and costly investment products should now be more easily identifiable for what they really are, whether they are actively managed, synthetic, hedge funds, or structured products.
VanEck has long supported a classification and naming system for ETPs that investors can easily understand. However, it still remains vitally important investors fully understand the ETP they are investing in and read beyond the ASX ticker. The full 'legal' fund name should at least alert you to potentially hidden risks. Naturally, you should read the product disclosure statement too.
This information is issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 ('VanEck'). This is not a solicitation to buy or an offer to sell shares of any investment in any jurisdiction. It is general information only and not financial advice. It does not take into account any person's individual objectives, financial situation or needs. Before making an investment decision in relation to any VanEck funds, you should read the relevant PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. PDSs are available at www.vaneck.com.au or by calling 1300 68 38 37.