The world of ETFs and their unique incentives is a fascinating, yet controversial, topic. Let's dive into the practice of rebates and uncover some intriguing insights!
Members of the European ETF industry often face a challenging battle when it comes to promoting ETFs. They compete against funds that offer inducements to intermediaries, which can be a significant hurdle. However, an interesting practice has emerged where ETF providers aim to attract large investors by offering cash rebates.
Inducements, or 'kickbacks', have long been criticized by ETF proponents. Advisors who accept these inducements from fund managers are essentially pocketing money for recommending costlier products, which provides no added value to the end client. This practice is banned in several countries, including the UK, Netherlands, and Switzerland.
But here's where it gets controversial... While asset managers avoid inducements for ETFs, the concept of rebates is gaining traction. As regulatory focus shifts towards fee transparency, the topic of rebates is likely to become a hot-button issue.
Several sources familiar with the practice revealed that large fund-of-funds operators often enter into agreements with ETF providers. These arrangements typically last one to two years, and in exchange for holding an ETF, they receive monthly payments for a pre-agreed amount. These payments are either reinvested or credited to the NAV of the unitized funds they manage.
Mutual funds have an advantage in terms of simplicity. They can easily launch institutional share classes with reduced fees and clear transfer agent registers, making it evident who holds a product and in what quantities. On the other hand, reducing fees for ETFs and proving an investor's holdings is a more manual and complex process.
A former UK-based fund-of-fund manager explained, "Before a rebate is paid, the ETF provider asks for a custody statement from the client's back-office, showing their holdings. The rebate is then calculated based on this statement. It's a bit more cumbersome than for a mutual fund, but it's manageable."
And this is the part most people miss... Rebates are a popular strategy for rapidly scaling new ETF products, especially when initial assets cannot be generated through captive distribution or asset managers' multi-asset offerings.
ETF Stream recently uncovered two instances where active ETF issuers secured orders worth at least $200 million by offering rebates equivalent to annual fee reductions of over 10 basis points.
An investor commented, "This is not so much an incentive payment as it is a reward for larger, more sophisticated asset owners who buy in bulk."
But ETF issuers don't stop at fee-cut-like rebates. Another common practice is covering the trading costs for large ETF orders.
A liquidity provider shared, "For certain issuers and products where we are the lead market maker, we can get discounted create fees or even a rebate on large trades. The issuer may be more open to negotiation, knowing it's a switch trade from a rival product."
A buyside trader added, "ETF issuers suggest getting the switching costs covered by a market maker, and then the issuer will pay for all the costs, making the switch flat for the client. This is quite common, as far as I understand."
So, are end clients truly benefiting from these commercial arrangements? There are valid concerns about whether clients are getting the best outcomes. Particularly, how are these rebate proceeds being utilized?
In the UK, intermediaries are forbidden from retaining inducements under the Retail Distribution Regime (RDR). However, ETF rebates are permitted as long as they are passed back to end clients.
A similar principle applies to rebates paid directly into the accounts of multi-family offices, which are treated like discretionary portfolio managers by the Financial Conduct Authority (FCA). But for single family offices outside the FCA's authorization and RDR requirements, it's harder to determine how rebates are handled.
Not all professional investors can access these lucrative cashback arrangements. Model portfolio providers, who already face challenges with ETF dealing on UK advisor platforms, struggle with rebates due to operational complexities.
A model portfolio provider stated, "From an accounting perspective, it's too complex, especially when considering how to distribute the rebate proportionately among all investors in the MPS. It's much simpler in a unitized fund structure."
Despite these challenges, ETF providers still have ample opportunities to use rebates to attract large wholesale and institutional investors.
Portfolio managers argue that such arrangements are only made when a product is already being considered and deemed suitable for their clients.
However, these schemes raise questions about the profitability of new asset managers entering the ETF space. With the asset-weighted average total expense ratios of passive and active ETFs in Europe already low (0.20% and 0.27%, respectively), it remains to be seen if these short-term costs will result in long-term, sticky assets once rebate agreements expire.
What are your thoughts on this practice? Do you think rebates are a fair way to promote ETFs, or do they raise concerns about transparency and potential conflicts of interest? Feel free to share your opinions in the comments!
