FAIR Canada continues to call for improved regulation of exchange-traded funds (ETFs) (and ETNs (exchange-traded notes) and other exchange traded investment products) in order to protect Canadian investors. BlackRock, an international investment firm, in a report released in the fall of 2011, recommended five regulatory and market reforms to address ETF customer confusion resulting from product innovation. The report states: “[w]ith the proliferation of these new products, critics have questioned whether existing regulations ensure that investors fully understand what they are buying and fully appreciate the risks and costs”. FAIR Canada also has brought such issues to light, particularly in our call for Canadian regulators to conduct a review of investments in derivatives and our reports about leveraged, commodity and inverse ETFs.

BlackRock’s recommendations include:

• Clear labeling of product structure and investment objectives
• Frequent and timely disclosure for all holdings and financial exposures
• Clear standards for diversifying counterparties and quality of collateral
• Disclosure of all fees and costs paid, including those to counterparties
• Universal trade reporting for all equity trades, including ETFs

In the USA, FINRA (the Financial Industry Regulatory Authority) issued an investor alert on ETNs on July 10, 2012, following an investigation after sudden swings of the Credit Suisse and Barclays ETNs earlier in the year.

Dan Hallett in “Covered-call ETFs: Beware the gap between expectation and reality” and Tom Bradley in “Covered Call ETFs: Are they for you?” have highlighted for Globe and Mail readers the risks to investors of covered call ETFs which were introduced in Canada in the last year and have generated large retail investor sales. Both point out that investors will be giving away upside potential in exchange for current income and that the odds are against a covered call strategy being a long-term success.

In Australia, ASIC (Australian Securities and Investments Commission) is working with the Australian Securities Exchange and product issuers to develop clearer labels and appropriate naming conventions for ETFs to increase investor protection, such as prohibiting structured products from being called ETFs. FAIR Canada has recommended clear labeling of investment products in Canada so as to prevent investor confusion and protect investors.

Another issue that should be scrutinized by regulators is one noted by Vanguard in a recent press release. Vanguard notes that the rapid growth in ETFs has coincided with the proliferation of target benchmarks.  More than half of the indexes that ETFs track in the U.S. have been in existence for less than six months before the launch of an ETF that seeks to track it. In addition,  these indexes use back-tested performance data (that is, data which is based on applying the index methodology to historical data) in the place of live performance data. Vanguard notes that the research shows that back-tested performance data may not be a reliable indicator of how an index will perform after it is launched. They found that while 87% of the indexes outperformed the broad US stock market for the time in which back-tested data were used, only 51% did so after the index was launched. U.S. Securities regulators prohibit the use of back-tested performance for most US mutual fund and ETF providers, but index providers are not held to the same rules. The concern is that recent index creation may be more about marketing and promoting new ETF products and jump-starting their acceptance and viability rather than providing investable benchmarks for market segments.  To read the Vanguard research paper click here.