ICI Pushes Congress to Punish ETN Investors for Not Choosing Mutual Funds

by: ETN Expert December 27, 2007    

ETN Expert

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Someone alert the mainstream financial media. For anyone truly interested in the greed-fueled scandal of what the Investment Company Institute [ICI] is up to behind closed doors in Washington, check out the Dec 10 Investment News article by Jeff Benjamin -- "ICI seeks a protected market for mutual funds."

It's quite obvious that the monolithic mouthpiece of the $10 trillion mutual fund industry is working around the clock to destroy a competitive threat -- prepaid forwards generally and Exchange Traded Notes specifically -- before it takes root and swipes a few dollars from its fossilized business model. As you're reading this, the ICI is racing to erect anti-competitive barriers around its AUM before the investing public finds out about its secretive, back-room dealings.

You can picture ICI's Paul Schott Stevens and his henchmen smoking cigars in a plush, dimly-lit wood-paneled room, tut-tutting over filet mignon about how best to eliminate a competitive threat that is wildly successful in Europe (structured investments). Hey! Let's get Congress to impose a tax on any individual investor who invests in a non-ICI investment product! Hey, fellas, Representative Neal is just a speed-dial away!

What is so infuriating about the ICI's manipulation of the political process is that it is steadfast in its denial that it is the driving force behind the assault on ETNs. Its November 1 letter to Congress was full of intellectually dishonest screeds designed to push a politician's hot buttons ("Tax shelter!" "Dangerous derivatives being sold to retail investors!" "Lawyer-made financial trickery!") After ICI's devious starring role in the infamous market-timing scandals (see excerpt below) they've proven they can play dirty lobbying games as well as the tobacco industry once did. Still, it's certainly an astounding display of arrogance on the part of ICI for believing there will be no blowback from the financial media for its outrageous assault on the small investor who dares to divert a single dollar away from the fee-bloated mutual fund empire.

But wait. There's yet another intriguing nuance to this scandal: the ICI's own ambivalence about ETFs vs Mutual Funds. ICI has long been trying to wage a propaganda war against those who claim passive indexing is a superior, low-cost way of accessing the market opposed to the high-fee alternative of active investing. It's clearly a Sisyphean task. According to the annual Standard & Poor's SPIVA report:

Over longer time periods, Standard & Poor's continues to observe indices outperforming a majority of active funds. Over the past three years (and five years), the S&P 500 has beaten 64.9% (67.4%) of large-cap funds, the S&P MidCap 400 has outperformed 80.5% (83.7%) of mid-cap funds, and the S&P SmallCap 600 has outperformed 80.2% (79.2%) of small-cap funds.

The ICI despises the John-Bogle-inspired indexing phenomenon because studies like the SPIVA report blow the lid off the ICI efforts to get Mom + Pop Investor to drink the Kool-Aid that high-fee active management is a superior value proposition to "passive investing." Even ICI's own reports that suggest that "mutual fund fees are declining" admit that it's due to the paradigm shift of investors moving to no-load, low fee index funds, not active managed funds reducing their fees. Actively managed funds are still hosing investors with huge front loads.

Which brings us to the real story behind the headlines. ICI has no choice but to tolerate low-fee, zero-commission ETFs, even if it causes an erosion of AUM from mega-fee monsters like closed-end funds and actively managed funds. ETFs are creatures of the 1940 Investment Company Act, so it's a black sheep of the family -- but a member of the family nonetheless.

Not so for ETNs. ETNs form a significant competitive threat to the $590 billion ETF market, because ETNs offer no tracking error and may -- under some specific circumstances -- have a tax benefit over ETFs because of the long-established tax law regarding prepaid forwards. (Every one of the dozen top law firms in New York either have or are willing to write should-level opinions on the prepaid forward tax treatment of ETNs.)

ETNs are debt instruments issued by Goldman Sachs, Barclays, Bear Stearns and Merrill Lynch. Accordingly, ETNs are not creatures of the 1940 Act; they are debt instruments governed by the 1933 Act. Predictably, the ICI members-only club is attempting to kill off the $4 billion industry before the mass market recognizes ETNs as the most exciting low-cost, high-performing financial innovation for small investors since . . . well, since ETFs.

An unintended irony of this chocolate mess created by ICI? Its reckless button-pushing is acting full-force against the interests of several distinguished ICI members who actually are marketing ETNs: Nuveen, Claymore, and of course, Barclays. Moreover, the potential threat to prepaid forwards is a Pandora's box that will adversely impact ICI members already in the structured investments business or considering doing so: DWS Scudder, Fidelity, Schwab, ProShares, First Trust and Rydex, to name a few. ICI has also introduced a major threat to the largest investment banking firms and the reliable revenue-generation of their OTC derivatives business: Morgan Stanley, Goldman, Merrill Lynch, JPMorgan, Citi -- all could be adversely impacted by a misguided rush to impose a tax burden on prepaid forwards.

Wait until Michael Lewis, Floyd Norris, James Kramer, or Jonathan Clements gets their arms around this story.

====

Here's the ICI's role in the market timing scandal:

Early in October [2003], the volunteer Chairman of the Investment Company Institute [ICI], the mutual fund trade association, boldly proclaimed that "everything is on the table" to protect mutual fund shareholders ..... Unfortunately, no one can find the table.....The ICI announced the formation of two task forces to study market-timing and late-trading abuses, but the million-dollar-a-year president of the ICI, Matthew Fink, admitted to a reporter that the committees are essentially shams.....For example, Fink couldn't tell the reporter who was invited to join the task forces, or who attended a recent meeting of the late-trading group.....Fink, who's retiring this year, "bristles at suggestions that the ICI has reneged on its promise to look out for the nation's" mutual fund shareholders, but refuses to disclose any of the "20 or 30 things" the ICI is supposedly looking at related to the fund industry.....Allow us to guess one item on the ICI agenda: Hiring someone to replace Fink who doesn't actually hurt the industry every time he opens his mouth.

Source: "ICI task forces spark skepticism," Frederick P. Gabriel Jr., Investment News, October 20, 2003

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This article has 2 comments:

  •  
    Dec 27 12:38 PM
    does not seem possible.
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  •  
    Dec 27 04:08 PM
    I see no evidence that "ETNs form a significant competitive threat to the $590 billion ETF market, because ETNs offer no tracking error and may -- under some specific circumstances -- have a tax benefit over ETFs". First, ETNs most certainly can have tracking error. Barclays India fund IPN is a good example. It has deviated wildly just recently. Generally both ETNs and ETFs have good tracking, but it should be recalled that tracking error is not the primary goal, returns are. Sometimes perfect tracking is expensive. Second, ETNs have ownership risk that ETFs do not. ETFs are direct claims on stocks, whereas ETNs are debt backed by the issuer. Yes, they invariably have very high credit ratings but so, too, did mortgage bonds, so ETFs are always preferable, all else being equal. Third, as to preferential tax treatment, 95% to 99% have less than 1% capital gain distribution, so how much can you improve on that? I suppose in some cases it happens, but these are marginal instances. Fourth, ETNs are generally occupying those asset class niches where ETFs are impractical because a basket of common stock is difficult or impossible to assemble. So ETNs are quite welcome and useful for commodities, currencies, and highly regulated markets. Finally, as to their taking on ETFs, just look at assets under management. They remain tiny compared to the ETF juggernaut, especially in the broad asset classes.
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