As the market for exchange traded funds becomes larger and more complex, there’s a need for more transparency of product structures, fund holdings and fees, along with various other market reforms, according to investment manager BlackRock Inc.
In a report released this week, BlackRock and its ETF provider, iShares, address growing concerns that investors don’t fully understand ETFs or appreciate the risks and costs associated with them.
“While the first ETFs were straightforward, tracking relatively broad benchmarks such as the S&P 500 or individual country indexes, today the sector has become more complex and sometimes confusing,” the report says.
To address this confusion, BlackRock proposes five regulatory and market reforms to improve the marketplace for ETFs.
1. Clear labeling of product structure and investment objectives.
While ETFs all share certain characteristics, the products in this category boast a wide range of different structures, and BlackRock argues that this has led to confusion among investors.
To ensure investors understand what they are buying, the company recommends establishing a global standard classification system with clear labels to clarify the differences between products. For instance, it suggests that exchange traded notes, exchange traded commodities and exchange traded instruments should all be clearly differentiated from exchange traded funds.
“Investors need better clarity to understand various structures,” the report says. “Clear labeling combined with disclosure of risks is a critical starting point.”
2. Frequent and timely disclosure of all holdings and exposures.
To ensure investors are completely clear on what they’re investing in, BlackRock recommends a requirement for sponsors to fully disclose an ETF’s holdings and financial exposures.
It says that ideally, the goal should be daily disclosure of holdings and exposures. But the report acknowledges that various practical, technical and legal constraints may prevent full disclosure of all portfolio holdings in some products.
3. Clear standards for diversifying counterparties and quality of collateral.
BlackRock recommends that standards be established regarding counterparty exposure and the quality of collateral posted by counterparties.
For instance, it suggests that ETFs engaging in securities lending be required to fully disclose all fees paid in connection with earning revenue from this practice, and that independent risk managers be required to oversee credit risk with respect to counterparty risk, collateralization levels and cash collateral issuer risk.
4. Disclosure of all fees and costs paid, including those to counterparties.
As some funds have become more complex, BlackRock notes that in some cases, the fees have also become more complex.
It calls for complete clarity regarding all costs and revenues associated with a fund, so that investors can clearly establish the total cost of ownership.
“In addition to clearly stating the management fee paid by the fund to the sponsor, the disclosure should include any costs or fees that affect the investors’ holdings, including those paid to companies related to the fund provider such as swap counterparties and securities lending participants,” the report says.
It suggests establishing uniform global standards that determine which specific fees and expenses are included or excluded from a fund’s total expense ratio.
5. Universal trade reporting for all equity trades, including ETFs.
Lastly, BlackRock calls for ETFs to be subjected to standardized transaction reporting, as part of the broader push for over-the-counter derivatives trading to move onto an exchange with a central clearing party.