Know what you own: advancing ETP classification

As the number of exchange-traded products (ETPs) in the U.S. has grown over the past two decades, so too has the number of products with different features and varying degrees of complexity. While “ETF” has become a blanket term for any product that offers exchange-tradability, many products labeled as “ETFs” have distinct elements, like the use of leverage to deliver a return that is a multiple of the index the fund tracks or, in the case of exchange-traded notes, exposure to the creditworthiness of the issuer of the underlying debt. As such, we believe that requirements should exist that constrain the application of the term “ETF” to a specific subset of ETPs (Figure 1).

A clear categorization of the different types of ETPs will help investors and the professionals who engage with them (including advisors and broker-dealers) complete a more thorough due diligence process when investing in these products.

A real-life example of the importance of clarity

Recent market events have demonstrated the need for clearer distinctions between different types of ETPs. In April 2020, a dramatic decline in oil prices resulted in a 3x levered crude oil-linked exchange-traded note being delisted with an expected value of zero dollars per note.1 While the decline in value was extreme, this product actually performed as designed.

The call to action: a recommended ETP classification system

While regulators have worked to promote transparency around these products, including disclosure requirements, they have not yet adopted a classification system that categorizes the risks and characteristics associated with different types of ETPs.2

To help advance clearer classifications, on May 13, 2020, an industry coalition of leading ETP sponsors, including BlackRock, Charles Schwab Investment Management, Fidelity Investments, Invesco, Vanguard, and State Street Global Advisors, submitted a letter to each U.S. stock exchange with ETP listings—NYSE, Nasdaq, and Cboe—to enlist their support implementing more consistent identifications and categorizations of ETPs (Figure 1) .

Figure 1: Recommended Categories of Exchange-Traded Products

Exchange-Traded Products (ETPs)

Exchange-Traded Funds (ETFs)
  • 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;
  • Includes funds that transact on an in-kind basis, on a cash basis, or both; and
  • Excludes ETNs, ETCs and ETIs.
Exchange-Traded Notes (ETNs)
  • 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;
  • May or may not be collateralized, but in either case, depends on the issuer’s solvency to deliver fully to expectations; and
  • Excludes products that seek to provide a leveraged or inverse return, a return with caps on upside or downside performance or “knock-out” features.
Exchange-Traded Commodities (ETCs)
  • 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.
Exchange-Traded Instruments (ETIs)
  • 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); or
  • All products not captured by the ETF, ETN or ETC classification fall under ETI.

Many players in the ETP ecosystem, from issuers to exchanges, are well-positioned to help advance ETP classifications. Incorporating consistent ETP nomenclature at the exchange data feed level would not only benefit investors by providing more clarity into specific product characteristics, but also assist brokerage platforms in implementing point-of-sale guardrails to better protect investors.

This initiative is one of the ways in which BlackRock continues to be committed to investor advocacy and education. Click here for more on the latest ETF industry trends.