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Regulator puts uncertainty around Active ETFs & LICs

A couple of recent announcements by the corporate regulator, ASIC, have put LICs and Active ETFs on notice. With Active ETF Bid/Ask spreads twice that as Index ETFs and LIC sales commissions coming under the microscope. We take a look at their concerns.

By ETF Watch - Jul 30, 2019

Without a doubt, two of the success stories over the last 5 years in the listed funds space have been Listed Investment Companies (LICs) and Actively Managed ETFs.

In the last 5 years the LIC space has more than doubled, with the space particularly heating up from 2016-2018 where we saw dozens of LICs launch, most raising hundreds of millions of dollars.

In the ETF space, we’ve also seen a doubling in the number of ETFs since 2014. One of the key drivers of this growth in recent times has been the Actively Managed ETFs, who from almost a standing start in 2014, now boast 33 ETFs listed on the ASX, representing 17% of all ETFs listed on the ASX. The Active ETF launches have really ramped up in the last couple of years with many fund managers seeing this as a new distribution channel to access the burgeoning self directed investor and SMSF market.

A couple of recent announcements by the corporate regulator, ASIC, have put LICs and Active ETFs on notice. Below we take a look at what their concerns are and what this might mean.

ASIC gives Active ETFs a Yellow Card

Whilst not yet banned, ASIC last week asked the ASX to cease to admit ETFs who utilise internal market making mechanisms, of which most of the Active ETFs employ. ASIC has stated that they are considering appropriate regulatory settings for these funds.

Why the concern from ASIC?

All ETFs require market makers to turn investor buy orders into ETF units and vice versa, to close down ETF units. Essentially the market maker’s role is to buy or sell the underlying securities and turn these into ETF units. They earn a small fee for doing this through the Bid/Offer spread paid by investors, which is the difference in the buy and sell price of the ETF.

This works well for index ETFs, where the underlying portfolio constituents are freely available to market makers, and the market making process tends to be quite competitive, ensuring low bid/offer spreads. However, for Actively Managed ETFs, the underlying portfolio makeup is the one piece of Intellectual Property that the fund manager has. As a result, they choose not to release the underlying portfolio details to market makers, instead taking on market making responsibilities themselves.

ASIC is concerned about the lack of transparency around this internal market making responsibility and the possibility of the fund manager turning this into a profit generating exercise by offering large bid/offer spreads.

We took a look at the bid/offer spreads on offer for the 200 ETFs listed on the ASX last month, with an average bid/offer spread of 0.29%, the lowest spreads unsurprisingly go to the vanilla market cap weighted index ETFs at 0.23%. Not far behind them are the slightly more complex Smart Beta ETFs at 0.26%. Active ETFs, the concern area for ASIC have average bid/ask spreads of twice that of Smart Beta, at 0.52%. It’s clear to see why ASIC is concerned.

ASIC raises concerns with LIC sales commissions

ASIC doesn’t just have Active ETFs on their radar. They, as well as the Labor Opposition have recently raised concerns to the Morrison Government about LICs and the sales commission paid to brokers who promote these products.

What is the background on LIC commissions?

Labor’s Future of Financial Advice (FoFA) reforms in a bid to make the financial system more transparent, initially banned all commissions on financial products. This was later revised, with Company IPOs still able to pay commissions to the brokers who sell these products. As Listed Companies, LICs were able to benefit from this and LICs are now one of the last remaining investment products that pay commissions to the brokers who sell these.

It’s not surprising then, that LICs have boomed since the FoFA reforms were fully implemented in 2014, with brokers and financial advisers able to earn a nice 2-3% commission by selling LIC IPOs in their final remaining commission based investment (often called a ‘stamping fee’ in the prospectus).

The Banking Royal Commission findings backed up these concerns, and whilst not specifically calling out LICs, stated that it is time that the exemptions to conflicted remuneration (ie commissions) are reviewed. This potentially puts LICs under the microscope.

Labor has wasted no time in slamming LIC commissions after a number of high profile issues with LICs, including Dixon Advisory’s US Property Fund, marketed mainly to Dixon’s financial advice clients and L1 Capital’s L1 Long Short Fund’s losing 30% of is value after raising over $1 billion in its IPO based on being sold by brokers and advisers on the back of its previous strong performance.

Where to now for Active ETFs & LICs?

Active ETFs have made investment strategies previously not available to retail investors available for just a couple of clicks of a button. As a whole, they are creating a more fair and transparent investment market. However, the high bid/ask spreads are a concern, particularly as these fees are not well understood by investors. We welcome further regulation to place sensible caps on bid/ask spreads or force issuers to increase their transparency on these costs.

Commissions on the sale of LICs have long been of some concern, however without these commissions, we’d expect the number of new LICs coming to market to significantly fall. This will be a win/lose for investors, as whilst they may benefit from the abolition of stamping fees, the number of LICs available to invest in on the secondary market will reduce. This is a complex issue that will require consultation between regulators an the industry.

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