ETP boom
The exchange-traded product (ETP) landscape is constantly evolving with new strategies such as cryptocurrencies and single stocks constantly being wrapped into the structure.
Despite the growth of ETPs, there are concerns a blow-up in a more esoteric part of the market could damage the reputation of the ETF industry.
ETFs have become a general term for any strategy that trades on exchange, however, there are significant differences between the varying ETP structures.
As a result, it is thought clearer classifications would provide investors with a better understanding of the risks of the different ETP structures.
In 2020, a group of leading US ETF issuers attempted to implement clearer categorisation of ETPs with the creation of four groups:
Exchange-traded funds (ETFs)
Exchange-traded commodities (ETCs)
Exchange-traded notes (ETNs)
Exchange-traded instruments (ETIs)
Confusion
While the first three categories are well known and understood, the ETI section was created for any ETP that did not fall into the other three such as short and leverage ETPs (S&L ETPs).
As BlackRock said: “While regulators have worked to promote transparency around these products, including disclosure requirements, they have not yet adopted a classification system that categorises the risks and characteristics associated with different types of ETPs.”
Despite the clear benefits a classification system would bring to the European ETF market, there are a number of stumbling blocks that would conflict with the existing UCITS framework which requires ETFs – as well as other investment vehicles – to be diversified and publish clear fee guidance.
The UCITS conundrum
The key problem is S&L ETPs can also be considered under the UCITS framework if they offer the right exposure. For example, the L&G FTSE 100 Leveraged (Daily 2x) UCITS ETF (LUK2) offers 2x exposure to the FTSE 100 and is UCITS compliant.
UCITS is the gold standard for investment vehicles globally and is the reason why many investors from Asia and Latin America choose to invest in Europe-listed products versus US ‘40 act’ funds.
Therefore, for the ETF industry in Europe to create a classification system to help investors in their decision-making, it must incorporate the UCITS framework. This will remain a challenge for the European ETF industry in the coming years.
For investors, they should look underneath the bonnet at the prospectus, especially when an ETP is not UCITS compliant.
ETP glossary
ETF: as built around a collective investment scheme, more commonly known as a “fund”, predominantly of the UCITS-type
ETC: as built around another debt instrument known as a certificate, albeit offering investors a narrow exposure to single commodities or commodity indices
ETN: as built around a zero-interest debt instrument intended to typically offer investors a narrow exposure to an underlying instrument or to a niche index
Source: EFAMA
Key takeaways
Confusion abounds: ETPs encompass diverse structures beyond ETFs, raising concerns about investor understanding and potential reputational risk for the entire market.
Classification efforts underway: Attempts have been made to categorize ETPs based on structure and risk, but a comprehensive system is lacking, particularly in Europe.
Balancing clarity with regulation: Regulatory hurdles exist due to the UCITS framework's requirements for diversification and transparency, posing a challenge for incorporating non-UCITS ETPs in a classification system.
