New Wrinkle To Marijuana ETFs

December 03, 2018

Broker-Dealer As Custodian

Innovation Shares is proposing a different approach. The proposed fund would use a broker-dealer for its custodian instead of a bank. (No custodian or transfer agent is listed in the Innovation Shares prospectus, but Innovation and its subadvisor confirmed to ETF.com that several broker-dealer firms have expressed serious interest. No names appear because the agreement has not yet been finalized.)

Most ETFs rely on banks to custody stocks, in part because of their existing custody infrastructure for other investment vehicles. Banks also offer one-stop shopping, often providing a fund with custody services, fund accounting and administration, and transfer agency all at once (read: "How The ETF Sausage Gets Made").

Yet a broker-dealer is also capable of holding stocks on behalf of a registered investment company, such as a mutual fund or ETF, making them a "perfectly legitimate custodian," says Kip Meadows, CEO of The Nottingham Company, which is listed as the proposed ETF’s administrator and is affiliated with OBP Capital, LLC, the listed fund advisor.

Furthermore, says Meadows, broker-dealers have more flexibility to hold marijuana stocks on behalf of their clients, because they have no need to satisfy federal banking laws.

"The broker-dealer community is more comfortable [holding cannabis stocks] because they already do so" in other contexts, said Meadows. "It would be a blatant hypocrisy for the SEC to say they can't custody stocks [for a '40 Act fund] that they've already approved under a '33 Act filing."

Higher Costs … Maybe

The downside of using a broker-dealer to custody stocks is that doing so may require an additional audit with the SEC, if that broker-dealer is a private entity.

Under the so-called custody rule, the SEC requires custodians for pooled investment vehicles (such as ETFs) to undergo an annual "surprise" audit of the assets within those funds, unless they are already subject to an annual audit by the Public Company Accounting Oversight Board. As such, publicly traded banks would be exempt from the surprise audit, but privately traded broker-dealers wouldn’t.

That can increase the costs of annual audit requirements by roughly 50%, says Meadows.

However, he added, "It's a manageable fund expense. We feel that we can save on other fund expenses to offset," including by splitting up custody services, transfer agency, fund accounting and administration across several smaller entities, including affiliates of Nottingham, to reduce cost.

But the audits are "just the cost of doing business, and the investor will either understand that or not," said Meadows, adding that ultimately the end investor may not even see much impact, given that many ETFs have an expense cap. (He did not specify whether the proposed marijuana fund would have an expense cap.)

It is unclear whether using a broker-dealer to custody stocks would make the Innovation Shares' proposed fund more or less expensive than the existing ETFMG fund. MJ costs 0.75% annually. No expense ratio is yet listed in the prospectus of the Innovation Shares filing.

Contact Lara Crigger at [email protected]

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