Market volatility prompts calls for clear labelling of risky ETFs

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Wild stock market swings last month have sparked fresh calls for change in the way some exchange-traded funds are marketed to retail investors.

Several ETFs in the United States and Canada tied to the CBOE Volatility Index, known under the ticker VIX and referred to as Wall Street's fear gauge, saw most of their assets wiped out in less than a day when the Dow Jones industrial average fell 1,175 points, or 4.6 per cent, on Feb. 5.

Horizons ETFs Management (Canada) Inc.'s BetaPro S&P 500 VIX Short-Term Futures Daily Inverse ETF was one of those funds.

It halted trading twice last month and the firm is in the process of amending the fund's investment objective to reduce leverage.

ETF products tied to the VIX are extremely complex. Many are leveraged ETFs, which magnify exposure to an underlying index and typically aim to deliver two or three times the return.

The funds, as in the Horizons example, are designed to benefit from declining volatility.

Rising volatility results in losses. Even short bursts in market-moving trading, such as the Dow's move in early February, cause massive spikes in volatility.

The problem is some investors don't clearly understand the risks involved with such products, said Alan Green, the head of iShares Canada Capital Markets, a division of BlackRock Inc., the world's largest ETF provider. BlackRock has been asking regulators for years to reconsider the way certain funds are classified so as not to be compiled with more traditional plain-vanilla ETFs.

"In our view, [the VIX] episode highlights the need for clearer labelling of exchange traded products in order to make sure investors understand that certain ETPs come with greater embedded risks and more complexity than others," wrote BlackRock in an industry note last month. "The rapid price collapse of certain leveraged and inverse volatility related exchange traded products emphasized a need for a clear classification framework to help investors better distinguish more complex ETPs from traditional ETFs and risks across product types."

Regulators are taking note: leveraged and inverse ETFs were on the agenda when the International Organization of Securities Commissions met in early February – just days after the Feb. 5 plunge. A number of key global regulators from jurisdictions with exchange-traded funds (ETFs) heard from issuers, exchanges, index providers and market makers about the state of the ETF industry globally.

Horizons is the only provider of leveraged ETFs in Canada, with 25 leveraged funds on its shelf.

Horizons co-chief executive officer and president Steve Hawkins says the company has not heard any concerns from Canadian regulators around the labelling of the firm's leveraged ETF business; and says his firm goes above and beyond regulatory requirements by highlighting investor risks in large bold text that is boxed out on the top of all investment documents to warn investors using these products. In addition, Mr. Hawkins does not allow his wholesale team to actively promote or sell any leveraged products directly to advisers.

"These products are really designed for short-term day traders who are looking to access a very specific asset class," Mr. Hawkins said. "They are looking to make a high-risk, high-reward investment and we have been strong believers that investors should have access to trading vehicles to make those short-term investment decisions. These products have been around in Canada for 11 years and we have spent those 11 years on educating the public on how they work."

Kevin Gopaul, head of the industry advocacy group Canadian ETF Association, said these products should be identified differently as they are seen more as trading tools, rather than investing tools. "There is a definite need for greater education around these products," Mr. Gopaul said in an interview. "We can't just have a product on the exchange that is easily accessible by everyone and automatically think it's clearly understood. These products are constructed differently [than most ETFs]. I do think there needs to be a mechanism in place to identify these products on the exchange separately."

One scenario could look similar to the Hong Kong market.

Hong Kong is well known for taking its time to enter the leveraged ETF market, only launching products at the end of 2016. The Securities and Futures Commission in Hong Kong (SFC) was cautious and applied rules that would only allow for two times leverage and a distinct label added to each fund. Hong Kong regulators stated that to avoid confusion with more traditional ETFs, leveraged funds are not allowed to be named as "ETFs" but must be called "leveraged products" or "inverse products" instead.

Bloomberg ETF analyst Eric Balchunas says it would be a good idea to label the more exotic products that may be more difficult for investors to understand or have a higher level of volatility. Mr. Balchunas suggests using an easy-to-follow system, such as the movie ratings system.

"It sounds silly at first but when you really think about movie ratings, they are easy to understand and would alert an investor to look more closely," he says. "Some products – such as the leveraged – would be rated R while other products may not be deemed as dangerous but still need a PG-13-type warning on them. Also, you would see plain-vanilla funds that have a small nuisance to them and would bump them from a G rating to a PG for investors."