When An ETF Changes Its Exposure

On Oct. 27, ETF Managers Group (ETFMG) filed for a new ETF, the Alternative Agroscience ETF, a first-of-its-kind fund to track the burgeoning legal marijuana industry.

Except the Alternative Agroscience ETF isn't precisely a new fund.

Instead, ETFMG is retrofitting an existing ETF, the Tierra XP Latin America Real Estate ETF (LARE), with a new strategy. Effective Dec. 26, LARE's index will change from a Solactive benchmark that tracks mostly Mexico and Brazil REITs to a Prime Indexes benchmark tracking cannabis cultivators, producers and distributors, as well as cannabinoid drug makers, fertilizer producers and tobacco companies.

The Alternative Agroscience ETF would be the first marijuana ETF to come to market in the U.S. As such, its first-mover advantage could be significant.

"As an issuer, we've seen increasing demand from investors looking for solutions to gain access to this space," said Sam Masucci, chief executive officer and founder of ETF Managers Group, the fund's investment advisor.

But the index transition also means radically altering LARE's focus and risk/return profile, as well as eliminating the market's only pure-play Latin American real estate fund.

The move has left some investors fuming.

"I think it's a little scummy what they're doing," said Peter DeCaprio, portfolio manager and principal at Crow Point Partners, in Hingham, Massachusetts. Crow Point is the largest investor in LARE, owning a 22% stake, according to most recent 13-F filings.

"But as long as they have support at the board level, if they want to change up the strategy, then they can," he added.

Changing Indexes Not Uncommon

This isn't the first time an issuer has changed the index backing one of its funds. It's not even all that uncommon. ETF.com lists hundreds of such instances since 2003.

"Index changes aren't as rare as people think," said Kris Monaco in an email. Monaco is managing partner of Level ETF Ventures, which owns and operates Prime Indexes, the index provider of the new Alternative Agroscience ETF. "It demonstrates the robust nature of the industry, and the need for both issuers and index providers to continue to innovate."

Typically, issuers attempt to maintain some consistency between an old and new index. Though index providers may change or the securities universe may be tweaked, a small-cap ETF will generally remain a small-cap ETF, a tech fund a tech fund, and so on.

But not always. Sometimes changing a benchmark effects dramatic change on the ETF, transforming large-cap ETFs to small-cap ones; or switching focus from one single-country market to another; and so on.

One of the most radical changes was in 2013, when Exchange Traded Concepts made an index change to its Canadian oil sands ETF that transformed it into an income-focused fund-of-funds. The ETF gained a new name, the YieldShares High Income ETF, and a new ticker, YYY (see: "First Yield-Focused Magoon ETF Goes Live"). Monaco was also involved in the YYY change.

Low Assets Can Prompt Change

Usually, the ETFs chosen for change tend to be extremely low in assets and average trading volume. For example, the YieldShares Canadian oil sands ETF had less than $1.5 million in assets when it transitioned into YYY in 2013 (today it has $207 million).

LARE has also failed to gain significant market traction. As of Nov. 1, it had $6.0 million in assets and an average daily volume of $90K.

"There's a need to make sure a fund resonates strongly with investors, that it's solving a portfolio allocation problem," said Masucci by email.

Track Record Stays

Despite its low assets, however, LARE had its user base.

"It's a one-of-a-kind product, which is what we liked," said DeCaprio, whose firm typically maintains an allocation in emerging markets between 13-16%. "It was a good diversifier inside the key EM bucket. I'm surprised there aren't more assets in it, frankly."

Meanwhile, ETFMG will be able to point to LARE's current track record in the prospectus and marketing materials for the new fund. This is misleading, says DeCaprio, since the Alternative Agroscience ETF is untested, whereas LARE has seen stellar performance. Year-to-date, the fund is up 24%.

"The only reason to keep this shell of the ETF alive is to capitalize on the existing track record," said DeCaprio. "If they can do that, then the ETF marketplace has bigger problems than I thought."

Preserving the old track record is standard practice for ETFs that change their indexes, however. "The track of the security is historical," said Masucci in an email. "[Overtime] the historical returns will be attributed to the portfolio based on the new index."

Many considerations go into the choice to convert an ETF to a new benchmark instead of closing it, says Masucci, chief among them cost.

Launching a new fund via retrofitting an old one with a new index is "less expensive and faster to market" than filing a new prospectus and registering a brand-new fund, he said, adding: "To construct a new prospectus typically runs anywhere between $75,000 to $100,000. This way costs about half that."

No Sponsor Input

Interestingly, the brand behind LARE, Tierra Funds, had no decision-making power over the fund's index switch.

Tierra Funds, a private fund manager of Latin America real estate, served as LARE's sponsor, a role with limited involvement in day-to-day decisions. According to the prospectus, Tierra's job was primarily to pay "certain expenses" of the fund and to "provide marketing support." As such, Tierra had no direct input into which index or index provider ETFMG as investment advisor chose to use, even though Tierra's name was the brand on the fund (see: "Who Actually Owns Your ETF?").

If this sounds familiar, it's because this is the same sponsor relationship PureFunds had with ETFMG, before being ousted from the PureFunds ISE Cyber Security ETF—now the ETFMG Prime Cyber Security ETF (HACK)—earlier this year. PureFunds has filed a lawsuit against ETFMG over the termination (see: "ETF Shakeup: PureFunds Brand Name Ousted").

"Tierra agreed that, through no fault of theirs, the fund didn't really resonate with the greater investor base," said Masucci. "Tierra Funds has a financial obligation to support funds. If you go two years, as we have with LARE, without attracting enough assets to be self-supporting, then obviously that's a concern of theirs as well."

Tierra Funds declined to comment on the nature of the termination of its relationship with ETFMG.

Fundamental vs. Nonfundamental Changes

Neither did LARE's investors have any input over the index switch. Nor would any investor in any such change, due to the procedures outlined in the Investment Company Act of 1940, which governs investment policies of registered investment companies, including mutual funds and ETFs. (A fund's investment objective, which often states its index by name, is an example of an investment policy.)

According to the '40 Act, there are "fundamental" and "non-fundamental" investment policies. The distinction between the two is somewhat circular, in that a fundamental policy requires shareholder approval to change, while a nonfundamental one does not. (Nonfundamental policy changes require at least 60 days' written notice to investors.)

Funds have the discretion to decide for themselves which policies are fundamental, and therefore require a vote from shareholders. And they use it. Scan any SEC filing, and you'll see plenty of investment policies defined as "non-fundamental"—including ETFMG's post-effective amendment filing the new Alternative Agroscience ETF.

It's all legal and by-the-book. But that doesn't necessarily mean it's a good thing for investors, says Elisabeth Kashner, director of ETF research and ETF analytics for FactSet.

"It seems to us to be an unfriendly move from an investor’s point of view," she said.

‘Lack Of Recourse For Investors’

Kashner also expressed concerns over "the lack of recourse for the investor," citing a September court case decided in BlackRock's favor.

In this class-action lawsuit, ETF investors sued BlackRock for losses incurred during the Aug. 24, 2015 "flash crash," stating that BlackRock had failed to clearly state the risks of trading using certain order types. The judge, however, ruled that investors who'd bought ETFs after they'd first been issued to authorized participants were unable to sue the issuers for misrepresenting risks in the registration statement.

Though the decision is likely to be appealed, it could make it harder for investors to sue issuers over risks not included in the fund prospectus—such as the risk of their fund completely changing its exposures through a new benchmark.

That leaves investors with the only recourse they've ever had to express displeasure over an index change: pulling their money from a fund.

Once LARE switches to a marijuana stocks ETF, "there is zero chance we will stay in this fund," said DeCaprio, whose largest client is a manufacturer of medical marijuana.

Unintended Exposures

Dave Nadig, CEO of ETF.com, weighed in on the controversy: "With any investment, knowing what you own is always the most important guidepost. Anytime you see even a subtle change in a fund's investment objective, I worry existing shareholders can end up with unintended exposures. And this hardly seems like a subtle change."

Interestingly, neither the website for LARE nor the Tierra Funds website mentions the impending index change. While recent SEC filings do reflect the impending change, the websites investors often turn to when researching a fund are silent on the matter.

"Woe be to any investor who stumbles on the Tierra Funds website right now," said Nadig. "They'd have no reason to believe that the fund will invest in anything other than Mexican and Brazilian REITs for the foreseeable future." 

Contact Lara Crigger at [email protected]