Who Actually Owns Your ETF?

August 02, 2017

It would be easy to read the story we broke Monday about the seemingly un-amicable breakup of PureFunds and ETF Managers Group (ETFMG) and simply say, “Well, that’s interesting,” make some popcorn, put your feet up and watch.

However, the story brings to light so many interesting things about ETFs (and really all mutual funds) that I can’t help but use it as an opportunity to dig deeper.

Before I dive in, I should point out that I have no horse in this race. I know about as much about the specifics here in this particular case as you do, if you’ve read the article. The facts here are pretty straightforward for my purposes: a marketing relationship between the sponsor and marketing agent (PureShares LLC) of a 1940 Act Trust (whose shares used to trade under the brand “PureFunds”) was terminated by the advisor of that trust (ETF Managers Group LLC).

That sounds like a lot of mumbo-jumbo, honestly, so let’s abstract this for a minute. Who the heck are all these people, and what the heck do they do? The answer—like everything related to ETFs—is a bit more complex than it seems on the surface.

The Fund Itself

Let’s start with the fund itself (you can think of “fund” and “director” as generic, although technically most funds are “trusts” and are overseen by “trustees”). The vast majority of ETFs are organized as plain old mutual funds, registered under the Investment Company Act of 1940.

That act, which is long and mostly boring, sets forward a brand new kind of entity—the investment company—which, as long as it follows certain rules, allows you and me and everyone else to pool their money together for a common investment objective. That’s a good thing—it’s what brought us the mutual fund, and in turn, the ETF.

The most important part of the idea of an investment company is that it’s owned by its shareholders. Every individual who owns a share of an ETF or mutual fund has a direct ownership stake in all of the assets of the fund, and a vote in how that fund is managed, much like a corporate shareholder.

If you don’t like how a fund is being managed, you can call the board of directors of the fund, and if you rally enough shareholders, you can get the directors to fire the investment manager, or pretty much anything else you like.

 

Advisor

And then there’s the “advisor”—which, in this case, is ETFMG. The advisor of a fund has very specific responsibilities, notably, implementing the actual investment policy as outlined in a given fund’s prospectus.

This is a contractual relationship between a given fund and the advisor, and as such, what specifically they are on the hook for can and does change based on every fund’s unique quirks.

Sometimes the advisor has other roles—like, selecting and managing other relationships, like fund accountants or distributors. Sometimes the advisor is paid a set fee, sometimes the advisor is paid based on performance, and sometimes an advisor agrees to pay all of the expenses of a fund over a certain amount. It’s a huge variable.

Importantly, because “advisor” is just a contracted relationship, they can in fact be fired by the fund for all sorts of reasons, and the fund’s directors have a fiduciary obligation to monitor the advisor and make sure they’re doing their job.

Practically, this comes down mostly to fairly rubber-stamp processes like ensuring the advisor isn’t charging excessive fees—a topic thorny enough to have gone all the way to the Supreme Court back in 2010.

Sponsor Even Fuzzier

If “advisor” seems malleable, “sponsor” is even more vague. While the term is in the ’40 Act, the definition there is extremely broad and not that relevant. In practice, the sponsor is the entity that causes a given fund to be made in the first place. Generally, that’s someone we think of as being in the business of selling and managing funds: Fidelity, BlackRock and so on.

In this specific case, ETFMG, as the advisor, had an agreement with PureShares, the named sponsor, to provide various services. Here’s how it was filed: PureShares agreed to cover “certain expenses” of the funds, and PureShares “will also provide marketing support for the Funds, including distributing marketing materials related to the Funds.”

That’s it. That’s the only place the sponsor is even mentioned. And that’s a common relationship. Often, the brand we associate with a given fund is purely a marketing relationship.

 

There are some famous and huge funds out there that have this “marketing agent” connection. Take the SPDR Gold Trust (GLD), one of the largest and most liquid ETFs in the world. If you go to the SPDRs website, it says “State Street Global Advisors” right there on the page, right next to the ticker “GLD.”

But Google “GLD” and you’ll go to a website run by the World Gold Council. While a different animal (not a ’40 act fund, but a grantor trust), the relationship is the same: The World Gold Council oversees and effectively runs the product (and collects the fees), and SSGA is simply a contracted marketing agent.

Similar less-than-obvious connections exist in dozens of funds, from the Sector SPDRs to the PowerShares QQQ Trust (QQQ).

What’s This ’xemptive Relief’ Business?

One last point of deep nerdery: When a fund (or trust) is going about the business of being born, and it wants to be an ETF when it grows up, a special piece of paperwork must be filed with the SEC and approved, just once.

That magical document is called a “40 App” and what it is, essentially, is a giant note saying “you let all these other people break all of these rules inside the 1940 Act that allows them to be exchange-traded; may we please also do those things?”

These mother-may-I filings happen all the time—six happened last month. They don’t necessarily mean a product is going to be launched; it simply creates a framework for the funds to come into being, if approved.

You’ll hear a lot of talk about who “owns” exemptive relief, and I thought I’d just point out that ultimately, the fund itself owns its own exemptive relief. Sure, a sponsor’s or advisor’s or lawyer’s name may be on the filing, but the relief itself applies specifically to a given fund structure.

The advisor and the sponsor, as I’ve pointed out, serve at the pleasure of the fund’s board.

 

Three-Sided Coin?

There are more than two very distinct sides of the coin in this ETFMG/PureFunds story.

As an investor, it’s easy to look at the side of the story put forth by ETFMG here and say, “This is the 1940 Act doing its job.” After all, the dispute seems to be (again, according to the public statements) that the advisor and trustees decided to cut the fees on flagship fund PureFunds ISE Cyber Security ETF (HACK), which had its name changed Aug. 1 to ETFMG Prime Cyber Security ETF (same ticker).

That caused some consternation in the relationship between the sponsor and the advisor/trustees. It’s hard to side against “lower fees” if in fact that’s the entire story.

On the other hand, the “sponsor” in this case—PureFunds, which was connected with ISE’s indexing business—seems to have been cut out of a product it clearly had a hand in making successful. That could understandably make folks in the business of cooking up new ideas and new indexes a bit squeamish.

(And for a third hand—I guess this is some sort of mutant argument—the only piece of this story that will affect investors is the one not making the headlines: A very popular fund, HACK, is changing from one index provider to another.

That could have a meaningful impact on your performance, if you believe the new index is better or worse than the old index. (Those kinds of index changes happen with shocking regularity, and are almost universally underreported.)

Regardless, clearly the two sides disagree here; otherwise, the word “lawsuit” wouldn’t be in the article.

The Good News

But the good news here for investors is actually this …

If you own shares of HACK—or any of the other affected funds—you own those funds. Not only do you own the economics of the investment portfolios, you actually own the decision-making process around how the fund is managed, no matter how removed from it you might feel.

The interested parties can argue this in court all day long, and ultimately, it’s none of your concern. The legal fees involved are certainly not coming out of your pocket, and your investments will just keep chugging along.

Dave Nadig can be reached at [email protected]. He owns none of ETFs mentioned.

 

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