BlackRock Seeks Ban on ETF Label for Funds Using Derivatives

BlackRock Inc., the world’s biggest provider of exchange-traded funds, urged U.S. lawmakers to bar products that rely on derivatives from being marketed as ETFs to avoid confusion with their traditional counterparts.

BlackRock Chairman and Chief Executive Officer Laurence D. Fink compared ETFs to the market for mortgage-backed bonds, which began with a simple product and evolved into complex variations with risks that investors didn’t understand.

“That was a failure of the mortgage market,” Fink said during a conference call with investors following the release of the New York-based company’s third-quarter earnings. “We need to be very assertive as a firm and outspoken that we will not allow, at BlackRock, the lack of disclosure on these products.”

ETFs, which hold $1.43 trillion in assets worldwide, have drawn scrutiny from regulators since 2009. The Securities and Exchange Commission has examined whether ETFs contributed to equity-market volatility in August and the intraday plunge on May 6, 2010. European ETFs that generate returns through derivatives add a layer of complexity and risk to financial markets, the International Monetary Fund said in April.

Most ETFs track an index by holding a basket of securities. Unlike mutual funds, which can be purchased or sold once a day, they trade throughout the day on an exchange, like stocks.

Some complex and risky funds “should not be labeled ETFs,” BlackRock’s Noel Archard told a Senate subcommittee in Washington today, according to a copy of his prepared remarks.

Promoting ‘Own Agenda’

BlackRock’s research doesn’t suggest that heightened stock-market volatility over the past year was spurred by ETFs, according to Archard’s remarks. Still, the firm believes greater regulation of ETFs is required to make sure investors have a clearer understanding of risks and costs involved in investing in the products.

Michael Sapir, chairman and CEO of ProShare Advisors LLC in Bethesda, Maryland, the largest provider of leveraged and inverse ETFs, criticized BlackRock in a statement today for using the hearing “as a platform to promote its own agenda.”

Archard, head of product development at iShares, testified before the Senate Committee on Banking, Housing and Urban Affairs’ subcommittee on securities, insurance and investment. Eileen Rominger, head of the SEC’s division of investment management, and Harold Bradley, chief investment officer at the nonprofit Ewing Marion Kauffman Foundation in Kansas City, Missouri, also spoke at the hearing.

Leveraged, Inverse ETFs

Funds that rely on derivatives include commodity-based ETFs that own futures contracts instead of the physical product, as well as leveraged and inverse ETFs. The majority of U.S.- registered ETFs hold all or most of the underlying securities that make up the index they seek to track.

The SEC said in March 2010 it wouldn’t approve new ETFs that make substantial use of derivatives. That followed a warning to investors and brokers in 2009 that leveraged and inverse ETFs weren’t appropriate for long-term investors who may misunderstand how they work.

From Dec. 1, 2008, to April 30, 2009, one ETF seeking to deliver three times the daily return of its index declined 53 percent while the index gained 8 percent, according to the SEC.

Leveraged ETFs use total return swaps to multiply daily index returns, as do inverse funds designed to move in the opposite direction of their benchmark. Derivatives, including swaps, are financial contracts tied to an underlying stock, bond, index or event, such as the default of a company.

Proposed Labels

Because of compounding, the returns of leveraged and inverse ETFs can veer from their targeted return if the fund is held for multiple days without rebalancing. Leveraged and inverse products in the U.S. held about $33 billion in assets as of Sept. 30, according to data compiled by State Street Corp.

BlackRock, which broke into the business with its acquisition of Barclays Global Investors and its iShares unit in 2009, manages about $538 billion in ETF assets and accounts for about 38 percent of the market worldwide. The firm doesn’t offer any leveraged or inverse ETFs.

The term “ETF” isn’t sufficient to encompass the range of products that subject investors to varying levels of risk, according to Archard’s testimony. He proposed that “exchange-traded product” be used to describe all strategies that trade on an exchange, with only the simplest products still classified as ETFs. Any fund backed by the credit of their issuers should be called an “exchange-traded note,” one that holds physical commodities should be called an “exchange-traded commodity” and any others should be labeled an “exchange-traded instrument,” according to BlackRock.

‘Byzantine’ Classifications

ProShares’ Sapir called BlackRock’s proposed classifications a “side show” and a “distraction that’s not going to serve investors.”

“Every fund sponsor should be focused on investor education and not on some Byzantine classification system,” he said in an interview.

ProShare’s leveraged and inverse funds manage $25.9 billion, according to data compiled by Bloomberg.

Bradley of the Kauffman Foundation said ETFs contributed significantly to market volatility and to the increased correlation between the movement of indexes and individual stocks. He also said he believed volatility caused by ETFs discouraged companies from publicly listing.

“ETFs carry big risks when they are carried too far, and that is where we are today,” Bradley said.

The SEC should adopt a consistent set of ETF rules that tightens disclosure requirements for more complex products, Archard said. Like mutual funds, the majority of ETFs are currently regulated under the Investment Company Act of 1940. The SEC provides what is known as “exemptive relief” to ETF providers that want to open the products in the U.S.

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