Investors Shoulder ETFMG's Legal Costs

On Jan. 26, ETF Managers Group (ETFMG) revised the prospectus for five of its funds, raising their total annual fund operating expenses from 0.03% to 0.07% apiece, as a result of the company's ongoing legal woes. The changes went into effect Jan. 31.

The listed management fee for the funds won't change, but the new filing discloses additional "operating expenses" associated with five ETFs: the ETFMG Prime Cyber Security ETF (HACK), the ETFMG Prime Mobile Payments ETF (IPAY), the ETFMG Drone Economy Strategy ETF (IFLY), the ETFMG Prime Junior Silver ETF (SILJ) and the ETFMG Video Game Tech ETF (GAMR).

Fees for the other ETFMG-branded ETFs, as well as the company's white label funds, are not affected by the filing.

The cost increases, which come with a footnote stating they reflect "extraordinary legal expenses incurred in connection with" lawsuits filed by PureShares and Nasdaq, are as follows:

• IPAY: an increase from 0.75% to 0.80%
• HACK: an increase from 0.60% to 0.64%
• SILJ: an increase from 0.69% to 0.72%
• IFLY: an increase from 0.75% to 0.79%
• GAMR: an increase from 0.75% to 0.82%

Lawsuits Explicitly Mentioned

The five impacted ETFs once fell under the PureFunds brand, but ETFMG rebranded them in May 2017. This action, among others, sparked a lawsuit from PureShares (which does business as PureFunds).

Then in August 2017, ETFMG changed the index provider for several of the former PureFunds ETFs from the International Stock Exchange (ISE) to Prime Indexes. This instigated another, separate, lawsuit from Nasdaq, which had bought ISE in 2016.

ETFMG's newly revised prospectus inserts a "Litigation" section that explicitly notes the current status of these two lawsuits: PureShares LLC, d/b/a PureFunds et al v. ETF Managers Group LLC et al; and Nasdaq, Inc vs. Exchange Traded Managers Group, LLC et al.

This is the first time either suit has been mentioned by name in ETFMG's investor materials. However, investors’ risk as a result of this litigation is still not listed in the “Additional Risk Information” section or the “Fund Summaries” for any of the five funds.

Fees Begat ETFMG's Legal Woes

Ironically, ETFMG's current legal saga all started with a dispute over fund fees.

In March 2017, ETFMG's Board of Trustees voted to reduce HACK's expense ratio fee from 0.75% to 0.60% so as to make it more competitive with the First Trust NASDAQ Cybersecurity ETF (CIBR), which charged (and still charges) a 0.60% fee.

Complicating matters, however, was the fact that Nasdaq, which had purchased HACK's index provider in 2016, also provides the index for CIBR. Nasdaq protested the fee change, arguing that HACK and CIBR were not "substantially similar" funds and thus the slashed fee was unnecessary. ("Substantially similar" is something of a nebulous descriptor, given that, as of Jan. 30, all but four of CIBR's 35 holdings also appear in HACK's portfolio, though in differing weights.)

In May 2017, ETFMG went ahead with the fee change anyway, terminating its agreement with PureShares and rebranding HACK and the other PureFunds ETFs under its own name. Shortly thereafter, PureShares sued ETFMG for breach of contract, wrongful termination, defamation and emotional distress.

PureShares Suit Dismissed, For Now

That suit was dismissed without prejudice on Jan. 19, when PureShares failed to provide requested documentation to the court for discovery. ETFMG founder and CEO Sam Masucci released a statement that day saying that he was "extremely pleased" with the court's decision.

However, in an interview with ETF.com, PureShares CEO Andrew Chanin, who was ordered to pay Masucci's legal fees, described the motion as "procedural," adding, "Nothing merits-based has been decided at all."

PureShares still plans to submit the requested documents and revive the litigation, he says.

Nasdaq Hits Back

The second lawsuit referenced in ETFMG's revised prospectus remains pending.

In October 2017, Nasdaq sued ETFMG, accusing the company of failing to turn over its share of profits from HACK. Nasdaq also accused ETFMG of breaching a wholesaling agreement by hiring ETFMG Financial, an affiliate owned by Masucci, as the fund's distributor.

Just last week, ETFMG countersued Nasdaq for taking actions that favored CIBR over HACK, as well as for breaching the wholesaling agreement. ETFMG alleges that Nasdaq "flouted" its contractual obligations and tried to "bully" ETFMG into surrendering its existing contractual rights, because Nasdaq had a conflict of interest, being the index provider of CIBR.

ETFMG alleges that once Nasdaq took over ISE, "serious deficiencies" in the maintenance of HACK's index began to arise, including failure to meet minimum capitalization and tax diversification requirements; and letting HACK's implied liquidity fall, complicating market making for the fund.

ETFMG also makes the extraordinary claim that as retaliation for replacing Nasdaq as the index provider on the erstwhile PureFunds ETFs, Nasdaq intentionally cut off ETFMG's access to index data for GAMR and IFLY. The problem, which first arose on Aug. 4, 2017, according to court documents, persisted for several days, despite repeated requests from ETFMG for assistance.

ETFMG's countersuit of Nasdaq is not mentioned in the newly revised prospectus, even though the litigation was filed the previous day.

Legal Woes Stall HACK Flows

ETFMG's legal entanglements appear to have stagnated growth in the high-profile, $1.2 billion fund at the heart of the controversies.

The cybersecurity ETF HACK debuted with a bang in November 2014, swelling to $1 billion in assets under management in just seven months. Yet since mid-2017, HACK's AUM has remained relatively constant at $1.2 billion, and the fund saw net outflows for the five months after the PureFunds rebranding took place and the PureShares lawsuit became widely known (see Table 1).

In contrast CIBR—HACK's only direct competitor—has seen steady, if modest, inflows every month since October 2016.

Though CIBR receives a slight boost in net flows every time ETFMG's lawsuits make news, the ETF doesn't seem to be siphoning significant assets from HACK. Even CIBR's slight performance edge—the fund has returned 19.7% over 12 months, compared with HACK's 18.8%—has translated into little in the way of additional flows. 

Source: ETF.com

Data for January 2018 from Jan. 1 - Jan. 29

SILJ, GAMR, IPAY & IFLY Unscathed

On the bright side for ETFMG, the lawsuits appear to have had no impact on the other four former PureFunds ETFs that still trade today, even though they are shouldering the costs of HACK's legal battles (see Table 2).

Source: ETF.com

Data for January 2018 from Jan. 1 - Jan. 29. + IFLY and GAMR did not start trading until March 2016

These funds' asset-inflow consistency likely has to do with the fact that SILJ, IFLY, IPAY and GAMR are the only funds of their kind in their respective spaces. HACK is the only former PureFunds ETF with a competitor—which it now charges 0.04% more in fees.

ETFMG did not respond to repeated requests for comment in time for publication.

Contact Lara Crigger at [email protected]