Exchange-Traded Confusion: How Industry Practices Undermine Product Comparisons in Exchange Traded Funds

Despite their popularity[1] and growing importance in U.S. capital markets,[2] exchange traded funds (ETFs) are incredibly difficult (at times even impossible) to accurately compare side-by-side.  In a new article, I show how a variety of discretionary industry practices undermine simple “apples to apples” comparisons in ETFs. Comparative challenges are compounded by the limitations of disclosure and the ability of investors to understand the information disclosed.

For instance, there is significant diversity in the number of indices, and wide discretion in how an index is replicated. My article illustrates how similarly named ETFs often perform (and are constructed) very differently – complementing prior scholarship noting the proliferation of “custom” ETF indices and critiquing passive investing as “delegated management.”[3]

When an ETF deviates from the index it replicates it incurs a cost commonly known as “tracking error.”  Similarly named ETFs often exhibit very different tracking errors. Tracking errors are influenced by the way an index is replicated and adjusted, an ETF’s size, operational costs, how it is managed, arbitrage and settlement practices, and how its net asset value (NAV) is calculated.[4]

Tracking errors are an effective cost, which alongside other overlooked costs (like transacting in the secondary market at a price premium or discount to an ETF’s NAV) can materially erode investors’ expected returns.  These subtle, but often material, costs are difficult to assess when comparing ETFs side-by-side. Secondary market premiums and discounts largely emanate from instability in the ETF arbitrage mechanism.[5]  Yet ETFs tracking similar indices vary in their arbitrage robustness since stability of the arbitrage function is particular to a given fund.[6]  This can result in similar funds having different discounts or premiums at the same time.[7]

Such underappreciated costs are not the only factor obscuring ETF comparisons. Using numerous case studies, I show how discretionary ETF industry practices and factors make it exceptionally hard to accurately compare purportedly similar products. Those practices and factors include inconsistent NAV calculation methods; custom baskets in ETF arbitrage; product structural distinctions; variable trading expenses; marketing and fund naming practices; basket composition discretion in similarly named funds; hidden (like liquidity “rents”[8]) or contextual costs; and variation in securities lending, cash, and liquidity management practices.

The limitations of investors and disclosure also inhibit ETF comparisons.  My article surveys critiques of rational choice theory and applies numerous studies in judgment decision making (JDM) to the context of ETF investors making comparative product assessments.  Investors must navigate JDM challenges of an ever-expanding ETF product “paradox of choice”[9] and “information overload”[10] in the volume of accumulating disclosures.

JDM literature stresses that how information is presented is a critical factor in making rational choices.  To make informed decisions, disclosures must be effectively processed, and the use of reference points and anchors, relative assessments, comparative context, disclosure ordering, and attribute “evaluability”[11] can significantly improve judgments around indirect costs and otherwise difficult to understand fund characteristics.  My article shows how the current disclosure regime for ETFs falls short when viewed through the lens of JDM best-practices and may in fact be facilitating investor flows in favor of the largest incumbent ETF issuers.[12]

There is positive momentum around investor-focused reforms in ETFs.  Recent rule changes by the Securities and Exchange Commission (Rule 6c-11) help investors compare ETF product attributes and performance side-by-side.[13]  Yet Rule 6c-11 stops short of giving investors all the tools needed to accurately assess ETFs side-by-side.

Investor comparative assessments would be materially improved by standardizing the format and layout of ETF sponsor websites for information presentation; facilitating uniform calculation methodologies for key ETF variables (notably NAV); simplifying and providing greater comparative transparency around how indices are constructed and replicated; and creating an exchange traded product naming convention with standard terms for sustainable investing.

For maximum comparative impact, a systematized electronic reporting system, where ETF sponsors provide standardized data for key ETF variables to a freely accessible, centrally-controlled, public repository, should be considered – and my article shows how this idea is supported by numerous ETF industry stakeholders.[14]  Additional studies, aligned with JDM literature, are also worthwhile on how disclosures can be strategically ordered, digitally enhanced, and contextually supplemented (including visual displays) around ETF operational concepts like arbitrage instability and index composition methodology. Also, the emerging ETF “model portfolio” industry, and “cash-like” ETFs, should be assessed to reduce the opacity of information and make it easier for investors to compare them, and my article provides several suggestions to this end.

ETFs present a compelling case study to assess the effectiveness of a securities disclosure regime biased toward voluminous, text-heavy documents. Disclosure serves many worthy ends,[15] but when it comes to facilitating simple side-by-side comparatives for ETF investors, it falls short. While I don’t advocate uprooting traditional disclosure, a centrally-managed “aggregation” solution that facilitates easy product comparisons is warranted as a regulatory paradigm shift given the growing significance of the ETF market.[16] Such a mechanism was considered, but ultimately not required, in creating Rule 6c-11.[17]

ENDNOTES

[1] Recent estimates suggest that from 2008 to 2019 the number of ETFs globally increased from 1617 to 6940, while the ETF market grew from $716 billion to over $6 trillion.  See ETGFI, ETFGI report assets in the global ETFs and ETPs industry which will turn 30 years old in March started the new decade with a record 6.35 trillion US dollars (January 16, 2020), https://etfgi.com/news/press-releases/2020/01/etfgi-reports-assets-global-etfs-and-etps-industry-which-will-turn-30.

[2] Bloomberg reports that 70 percent of the exchange traded product market (the vast majority of which are ETFs) are U.S. products.  See Rachel Evans & Carolina Wilson, How ETFs Became The Market, Bloomberg (September 13, 2018), https://www.bloomberg.com/graphics/2018-growing-etf-market/. The importance to U.S. capital markets of ETFs (particularly credit variety) was prominently illustrated in the unprecedented recent purchasing of ETFs by the Federal Reserve in response to the coronavirus pandemic.  See Katherine Greifeld & Luke Kawa, Fed’s Historic Step Into Credit Markets May Cure ETF Dislocations, Bloomberg (March 23, 2020), https://www.bloomberg.com/news/articles/2020-03-23/fed-credit-backstop-fuels-surge-in-investment-grade-bond-etfs.

[3] Adriana Z. Robertson, Passive in Name Only: Delegated Management and “Index” Investing, 36 Yale J. on Reg. 795, 796-798 (2019).

[4] See Steve Johnson, Why ‘tracking difference’ is a vital metric for passive ETFs, Financial Times (July 27, 2020), https://www.ft.com/content/80917014-0d39-438c-b3b8-cb645d3c2a43; Edwin J. Elton, Martin J. Gruber & Andre de Souza, Passive Mutual Funds and ETFs: Performance and Comparison, NYU Stern School of Business Working Paper (April 29, 2019), at 3-6, available at http://people.stern.nyu.edu/eelton/working_papers/Passive_Mutual_Funds.pdf.

[5] See Ryan Clements, New Funds, Familiar Fears: Do Exchange Traded Funds Make Markets Less Stable? Part I, Liquidity Illusions, 20 Hou. Bus. & Tax L. J. 14, 25-26, 30-32 (2020).

[6] See Ben Johnson. Navigating ETF Discounts and Premiums During Turbulent Times, Morningstar (March 20, 2020), https://www.morningstar.com/articles/973313/navigating-etf-discounts-and-premiums-during-turbulent-times.

[7] Id.; see Henry T.C. Hu & John Morley, A Regulatory Framework For Exchange Traded Funds, 91 S. Cal. L. Rev. 839, 846 (2018).

[8] See Marta Khomyn, Talis J. Putnins & Marius Zoican, The Value of ETF Liquidity, European Finance Association 2020 Helsinki (March 26, 2020), available http://dx.doi.org/10.2139/ssrn.3561531.

[9] See Barry Schwartz, The Paradox of Choice, Why More is Less (2005); the Securities Industry and Financial Markets Association (SIFMA) has called the product selection in ETFs “the Baskin Robbins of choices,” see Securities Industry and Financial Markets Association, SIFMA Insights: US ETF Market Structure Primer, 5 (September 2018), available at https://www.sifma.org/wp-content/uploads/2018/09/SIFMA-Insights-US-ETF-Primer.pdf.

[10] See Troy A. Paredes, Blinded by the Light: Information Overload and Its Consequences for Securities Regulation, 81 Wash. U. L.Q. 417, 421 (2003).

[11]  See Christopher K. Hsee, The Evaluability Hypothesis: An Explanation for Preference Reversals between Joint and Separate Evaluations of Alternatives, 67(3) Organizational Behav. & Hum. Decision Processes, 247-257, 250 (1996).

[12] A host of concerns associated with the growth of the “giant three” ETF issuers (BlackRock, Vanguard, and State Street) have been noted recently in the scholarly literature, particularly economies of scale. See Lucian Bebchuk & Scott Hirst, The Specter of the Giant Three, 99 B.U. L. Rev. 721 (2019).

[13] U.S. Sec. & Exch. Comm’n, Exchange Traded Funds, Investment Company Act Release No. 33,646 (September 25, 2019), 84 Fed. Reg. 57,162, 57,166 (Oct. 24, 2019) (to be codified at 17 C.F.R. pts. 210, 232, 239, 270, 274), available at https://www.sec.gov/rules/final/2019/33-10695.pdf (hereinafter “Rule 6c-11”). Rule 6c-11 mandates a variety of standardized disclosures, including daily ETF portfolio holdings, but allows discretion in how ETF firms present the information on their websites.  See Rule 6c-11 at 187, 205.

[14] See Ryan Clements, Exchange Traded Confusion: How Industry Practices Undermine Product Comparisons in Exchange Traded Funds, Virginia L. & Bus. Rev (forthcoming, 2020) at pg. 54-56, 60-61 available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3680219.

[15] Disclosure serves many desired policy goals and is an alternative to ex ante merit review of investment products. Such goals include investor protection, efficient decision-making, capital formation, price discovery, the efficient distribution of risk, remedying informational asymmetries, directing incentives, correcting agency problems, ensuring fair dealing, and deterring fraud. See Michael D. Guttentag, Evolutionary Analysis in Law: On Disclosure Regulation, 48 Ariz. St. L.J. 963, 974 (2016); Michael D. Guttentag, An Argument for Imposing Disclosure Requirements on Public Companies, 32 Fla. St. U. L. Rev. 123 (2004).

[16] See Ryan Clements, Are ETFs Making Some Asset Managers Too Interconnected To Fail? 22(4) U. Pa. J. of Bus. L. 772 (2020).

[17] See Rule 6c-11, supra note 13 at 78.

This post comes to us from Professor Ryan Clements at the University of Calgary Faculty of Law. It is based on his recent article, “Exchange Traded Confusion: How Industry Practices Undermine Product Comparisons in Exchange Traded Funds,” forthcoming in Volume 15 of the Virginia Law & Business Review and available here.

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