Open Letter to ETF Regulators
Dear ETF Regulators,
It is time to step up to the challenge of your job’s main mandate - protecting investors. Investor confidence in exchange traded funds (“ETFs”) and exchange traded notes (“ETNs”) is at a critical point. The abuses of a very small number of individual products flaunting regulatory holes can potentially cause irreparable harm to an otherwise beneficial and innovative industry.
I’m not talking about the use of leverage, derivatives, daily rebalancing, and other fully disclosed activities used by various product sponsors to meet their stated objectives. No, I’m talking about something far more serious – products that prey on investor perception of what constitutes a mutual fund, ETF, or ETN and the disclosures those products are expected to provide.
There are two major areas where regulators appear to be sleeping at the wheel. The first is in regard to appropriate disclosure of product expenses passed on to shareholders. The second is allowing broken products to continue to trade.
I provide three specific examples below, along with some potential solutions for you to consider. Before I get into the specifics, some background information may be helpful.
Ever since the passage of the Investment Company Act of 1940, investors have come to believe that mutual funds (and their ETF and ETN evolutionary offspring) are Regulated Investment Companies (“RICs”). Additionally, industry practice for most of the past 70 years has perpetuated the perception that these are “pass through” vehicles regarding income and tax consequences. Furthermore, there is an expectation that all product level expenses are disclosed as annualized expense ratios. Perhaps these are incorrect perceptions on the part of investors, but these are their perceptions nonetheless.
Another investor perception revolves around what it means for a product to be an ETF or ETN versus a traditional mutual fund or a closed-end fund. The industry has promulgated the idea that what makes ETFs and ETNs unique is their ability to create and redeem shares on demand through in-kind and cash exchanges with Authorized Participants. I, and the majority of investors, believe this feature constitutes the soul of an ETF, makes it a unique vehicle, and provides investors with the confidence that these products will trade at prices close to their net asset values.
Now, let’s look at three problem areas where these perceptions are shattered:
Problem 1: Product expenses disclosed in periods less than one year.
On September 8, 2011, UBS introduced six ETNs with annual expense ratios in excess of 5%. However, this fact escaped the general public and most professional analysts (even Morningstar lists the expense ratios at 1.35%). Regulators allowed UBS to state the majority of these fees as weekly expenses instead of annual ones. The products disclose an annual investor fee of 1.35% per annum and an Event Risk Weekly Hedge cost of 0.077%. The 0.077% per week works out to about 4% per year according to the small print buried in the UBS documents, making the total annual expense ratio about 5.35%. Allowing products to state weekly expenses is misleading. Since regulators have allowed this, what is to stop other products from stating expenses as daily or hourly rates? The solution to this problem is simple: Require expense disclosures in an annualized format.
Problem 2: Products that incur internal tax liabilities.
As of August 24, 2010, every ETF and ETN listed for trading on U.S. markets were structured as pass-through entities and therefore did not incur any tax liabilities at the product level. As previously stated, this is what investors have grown to expect during the 72 years since the passage of the Investment Company Act of 1940. All that changed on August 25, 2010. That was the day regulators allowed a listing for a product that called itself an ETF, even though it was structured as a C-corporation and liable for the 35% corporate tax rate on all capital gains and other taxable income.
That first C-corporation to be listed as an ETF was Alerian MLP ETF (AMLP). Even though AMLP incurs a tax liability in excess of 35% of the daily change of the underlying index, it does not report this as an expense. This future liability of AMLP becomes an immediate expense to every shareholder in the form of a daily adjustment to the fund’s NAV. Even though this expense exceeded 5% in calendar year 2011, AMLP reported its “total expense ratio” as 0.85%.
In some small-print footnotes, the AMLP disclosures go on to explain that its future tax liability is unknown and is therefore assumed to be zero. This is a ludicrous assertion because AMLP knows exactly how much to adjust the NAV each day to account for this liability. Hiding behind the mere fact that the total dollar amount of future liabilities might be unknown, while the daily impact is known, should not be justification for allowing an assumption of zero. The cost to shareholders now exceeds $122 million.
Those more knowledgeable of mutual fund accounting laws have suggested that fund level taxes are not required to be included in the total expense ratio. If that is true, then there is a very large regulatory hole here. As a result, many investors are unaware of the very high cost they are paying to own a C-corporation disguised as an ETF. On March 13, 2012, Yorkville High Income MLP (YMLP) became the second ETF structured as a C-corporation instead of a pass-through entity.
Possible solutions: Require all mutual funds, ETFs, ETNs, closed-end funds, and other pooled investment vehicles structured as C-corporations or other non pass-through entities to make it painfully obvious that investors are going to face double taxation. These corporations are liable for federal and state income taxes and then shareholders are taxed again on an individual level. Unknown total future dollar amounts are not a valid excuse. The impact for previous periods is known. The impact on future daily changes is known (process of adjusting NAV). If they can’t properly disclose the impact to shareholders, then don’t let these vehicles be called mutual funds or ETFs.
Problem 3: ETFs and ETNs without share creation and redemption.
As stated above in the background section, any product labeling itself an ETF or ETN is expected to have a functioning creation and redemption mechanism that helps to keep its trading price closely aligned with its NAV. That is one of the prime advantages touted by the industry.
However, investors are often not aware that it is even possible for this process to be broken. Furthermore, there is not an easy way to determine if a given ETF or ETN has a broken creation/redemption process. Investor perception is that ETFs and ETNs trade very close to their NAVs. As a result, investors can be caught unaware when these broken ETFs and ETNs are trading at premiums as high as 1,000% or more, as was the case for the former ELEMENTS MLCX Gold Index ETN (GOE) back in 2009.
More recent examples of ETFs and ETNs trading as closed-end funds with steep premiums include VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and iPath Dow Jones UBS Natural Gas ETN (GAZ). I believe many investors and traders purchased these products in recent weeks without knowing they were paying outlandish premiums.
Possible solutions: Halt trading in any “broken” ETF or ETN, where broken is defined as a non-functioning creation or redemption mechanism. This may seem extreme, but it will force sponsors to further consider the ramifications. Deutsche Bank and Invesco made the tough but correct decision to return $600 million to investors rather than allow the PowerShares DB Crude Oil Double Long ETN (DXO) to become a broken product. A less radical solution may be to use a ticker symbol suffix like the “.pk” designation used to identify pink sheet stocks. Some possible, currently unused suffixes include “.bp” (broken product) or “.tcef” (trading as closed-end fund) to properly alert investors that the product is not functioning as intended.
Ron Rowland, concerned ETF investor
Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.