When An ETF Changes Its Exposure

November 08, 2017

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.


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