Exchange-traded products (ETPs) are a disorganized mess. The industry needs standardized product groupings so that investors have an easier time sorting and comparing funds. I propose a “first cut” classification method that sorts ETPs into four basic categories.
Figure 1 illustrates the four proposed groupings by their investment objective: benchmark, strategy, hedge and active. All ETPs fall into one of these categories. They do not overlap.
Figure 1: The Four Basic ETP Types
More than 1,400 ETPs traded on U.S. exchanges and over 800 new funds are in government registration. Most of these products are exchange-traded funds (ETFs) registered under the Investment Company Act of 1940. Other products include exchange-traded notes (ETNs), grantor trusts, and unit investment trusts. I’ll lump everything under the heading of ETFs for this article because that’s the term most people use, even though it’s grossly inaccurate.
The proliferation of ETFs has led to a very confusing environment for investors because the industry has not come together to decide what to call various strategies. Trying to get the index products and fund companies to agree on classification terminology has been a challenge.
I proposed a two-state classification system for ETFs several years ago in the first edition of The ETF Book (now in its 2nd edition) where funds are divided based on the index type they followed.
ETFs can follow either benchmark and strategy indexes. Benchmark indexes track broadly diversified, capitalization-weighted indexes and include size, style and industry components. The ETFs that follow benchmarks are also known as “beta” or “plain vanilla” products. In contrast, strategy indexes intentionally do not track cap-weighted benchmarks. The ETFs that follow strategy indexes employ restrictive security screening methods, alternative weighting methods, or both. Strategy index ETFs are often referred to as “alternative” beta products, an oxymoron which I consider akin to alternative water.
The ETF industry has expanded beyond benchmark and strategy classifications in recent years. Two new groups that have emerged are “hedging” and “active” investment products.
Hedge ETFs are short-term investments that can be quite complex. The first funds were introduced by ProShares in 2006 when they launched leveraged and inverse funds. These products seek a return that is 2x or -1x the return of popular market benchmarks for a single day. The company has since expanded their fund lineup to include 3x, 2x, -1x, -2x or -3x of the return of style, sector, industry and country indexes and benchmarks. All leveraged and inverse funds are for short-term speculation and hedging.
Additional hedge ETFs have been introduced that are more complex. These include market neutral funds and volatility funds. Market neutral funds zero-out market risk by shorting an equal amount of securities as they purchase. Volatility funds move up and down in value based on market price fluctuations. A long-only volatility ETF will increase in value when market prices begin to fluctuate more and decrease in value when markets become calm. These hedge examples are the tip of the iceberg. The complexity of hedge ETFs is only limited to the imagination of their creators and demand in the marketplace.
Actively-managed ETFs are the new kid on the block. They made their way into the marketplace in 2008 when Investco PowerShares introduced the first funds that did not track rules-based indexes. Active ETFs are subjectively managed by individuals or investment teams who select securities and assign weightings based on research. PIMCO’s new Total Return Exchange-Traded Fund (BOND) created a buzz in the marketplace when it was launched this February. The fund is overseen by legendary bond manager, Bill Gross.
Actively-managed ETFs have not attracted much capital aside from a couple of bond funds. That might change soon. Several traditionally active fund companies are stepping into the marketplace. Firms that have filed for permission to develop actively-managed ETFs include Fidelity, Legg Mason, T. Rowe Price, Eaton Vance and John Hancock.
ETF issuance continues unabated and assets continue to climb while leaving investors on their own to sort out the maze. It’s my hope that the industry can work together on standard terminology and classification methods so that investors can better understand and compare products. Perhaps the new National Exchange Traded Funds Association (NETFA) will put this important item on their agenda since it is in their best industry to do so. Grouping of ETFs into four categories of benchmark, strategy, hedge and active is a good place to start the dialog.
