Exchange-traded notes to come under supervision similarly to mutual funds

The Israel Securities Authority approved an amendment to the mutual funds law on Monday that will impose regulation on exchange-traded notes. ETNs are Israel's predominant version of index funds.

Under the new amendment, exchange-traded notes will be supervised and regulated much as mutual funds are.

In addition, the amendment paves the way for launching exchange-traded funds in Israel, to compete with mutual funds that track indexes. ETFs currently do not exist on the Israeli market.

Like index funds or exchange-traded funds, exchange-traded notes commit to paying investors the return on the underlying index. Unlike these funds, however, exchange-traded notes do not actually have to own the assets they track.

Until now, mutual funds were subject to significantly more regulation than ETNs. The laws regarding mutual funds were precise, binding and relatively well-enforced. In contrast, ETNs were subjected only to disclosure obligations. As a result, many issuers preferred issuing ETNs, due to the lack of regulation and resultant savings on costs.

"The lack of regulation for one instrument and its existence for another creates differences in value between the products and drives issuers to shift to less-regulated, riskier products," explained a source at the ISA. "Therefore, the ISA initiated an amendment in order to impose regulation on ETNs similar to the regulation that already exists for mutual funds."

The amendment brings ETNs, and their issuers, under the auspices of the law governing mutual funds and subjects them to ISA regulation. ETNs will be defined much like mutual funds are, and ETN issuers will be regulated in much the same way mutual fund managers are.

Currently, ETNs are similar to promissory notes, legally speaking. They will now have a status similar to that of mutual funds, meaning investors will legally own the underlying assets. Like mutual funds, ETNs will be defined through an agreement between the fund manager and the trustee, and will be made up of units, each of which have an equal right to the fund's assets.

Unlike mutual funds, however, ETN issuers will be obligated to make up any difference in value between the sum the ETN holder is due upon redemption, based on changes in the price of the underlying asset, and the actual asset value of the note. Also, ETN managers may withdraw more money from the fund than it actually contains if the value of the assets is greater than the value of liabilities. The mechanism for such withdrawals is yet to be defined.

ETN managers and holders will also be subject to all the regulations currently facing mutual funds. These include licensing, definition of who may issue and manage ETNs, corporate governance policy, market share limitations, management policy, the option of issuing funds based on a given prospectus throughout a whole year (rather than a quarter), and restrictions on what assets, and what quantities of these assets, the funds may hold.

Another part of the amendment sets the stage for launching proper ETFs in Israel. ETFs are financial assets that track a given index, and are similar in many ways to mutual funds and ETNs.

Israeli ETFs will be designed to track a given index, responding either to changes in the index or in the value of underlying assets. They will be listed for trading in Tel Aviv.