Investment giants try to reshape ETF market

Smaller companies are pushing back, arguing the big players are just trying to cement their dominance

An effort by investment giants including BlackRock Inc. to redefine the $4 trillion universe of U.S. exchange-traded funds has the industry’s smaller players bristling.

The push to reclassify funds into four separate categories looks like a move by the biggest providers to further cement their dominance, the critics argue, and risks confusing retail investors in the ever-more complex world of passive markets.

Under proposals sent to exchanges this week by a coalition of the largest asset managers, a host of products would lose their ETF designation, becoming instead exchange-traded instruments, notes or commodities.

“They’ve decided they want to monopolize the ETF label for only uses they declare,” said Rob Nestor, president of Direxion, one of the largest issuers of leveraged and inverse ETFs, which would become ETIs if the plan succeeds. “It’s just going to sow confusion for investors and basically serve the interest of the largest providers in the space.”

The consortium pressing for the changes — which in addition to BlackRock includes Street Corp., Vanguard Group, Charles Schwab Corp., Fidelity Investments and Invesco Ltd. — says the four distinct categories will boost investor awareness of the different risks.

The six firms together make up more than 90% of the U.S. ETF market, according to data compiled by Bloomberg.

The industry has come under scrutiny in recent months as the coronavirus pandemic roiled markets. Regardless, this long-standing push — which would result in the vast bulk of funds from big issuers retaining their ETF classification — is leaving the smaller players up in arms.

“What they’re trying to do is corner the market on the ETF brand,” said Alfred Eskandar, co-founder of Salt Financial. “It’s just the big trying to get even bigger.”

‘Needlessly confuse’

BlackRock has been an advocate of reclassification in the ETF industry for several years. The world’s largest asset manager put forward a list of suggested categories in 2017 that mirror those in this week’s letter.

The following year, the Securities and Exchange Commission’s Fixed Income Market Structure Advisory Committee — of which BlackRock is a member — submitted a similar proposal to the regulator.

But the SEC declined to implement the proposed naming system when it passed a long-awaited rule streamlining the process for launching funds in 2019. Instead the agency encouraged issuers to engage with their investors and each other on ETF nomenclature.

“This proposal, a retread of a scheme by BlackRock that has failed to gain traction numerous times in the past, would reverse 27 years of the common use of the term ETF,” said Michael Sapir, chief executive of ProShares, another heavyweight among leveraged ETF issuers. “It would draw arbitrary lines that would needlessly confuse investors, squash innovation, and further entrench the dominant financial players who are proposing it.”

BlackRock itself maintains the drive is an attempt to simplify things, however.

“ETF has become a blanket term for a range of products that can lead to significantly different outcomes,” said Samara Cohen, co-head of iShares global markets and investments at BlackRock.

The goal of the proposal “is to have a shared language to promote clarity and provide compass points to navigate the ETP landscape,” she said.

Retail complaints

Leveraged funds in particular have come under fire after the virus spurred turbulence in the first quarter.

In April, the SEC said it received numerous complaints from retail investors about leveraged products, revealing a “widespread lack of understanding” about how the funds were intended to operate.

Similar concerns were stoked just weeks later when the United States Oil Fund (USO) was forced to take a series of unusual actions as crude prices plummeted. Retail investors had piled into the $4 billion fund just before the turmoil.

If the reclassification is adopted, USO would likely fall under the umbrella of an exchange-traded commodity rather than an ETF. John Love, president of USO issuer USCF, said in an email that the firm has no objection to the proposal.

Still, there’s no shortage of market participants worried that reclassifying funds will only add to the complexity in this booming corner of the investing world.

“The $4 trillion industry already uses hard-to-follow jargon, such as smart-beta and semi-transparent active, to describe existing products,” Todd Rosenbluth, CFRA Research’s head of ETF and mutual fund research, wrote in a note Thursday. “A new system could lead to more confusion.”