Advisors question conflicts of interest in ETF vertical integration

Two recent deals demonstrate the Australian exchange-traded fund (ETF) sector is poised to enter a period of vertical integration but experts warn this risks conflicts of interest of which investors should be aware.

Online broker SelfWealth has recently joined forces with ETF Securities to launch an ETF. The new ETF, called the SelfWealth SMSF Leaders ETF (SELF), is managed by ETF Securities, while Selfwealth owns the index and distributes the ETF.

The index takes SelfWealth’s database of self-managed superannuation funds, and uses their best stock picks to build a portfolio of Aussie shares.

SelfWealth waives its $9.50 brokerage fee for members who buy the ETF on their trading account. ETF Securities and SelfWealth then charge an 0.88% management fee on assets in the fund.

SelfWealth has gained market traction by offering cheap, fixed-fee brokerage. It has tried to differentiate its offering by providing a community where it shares customers’ investment data on a deidentified basis.

Kyle Front, an independent financial adviser with Millennial Financial Advice, explains the ETF’s structure entices cost-conscious customers into the product in a similar way that Coles offers home-brand products.

“There is a conflict here, although it is not a massive one, as they are not advising customers to buy the SelfWealth ETF,” Front says.

“I hope customers recognise the relationship between SelfWealth and ETF Securities and make an investment decision considering all factors – that is, they are not just buying a long-term investment product to save a $9.50 broking fee,” he adds.

Front acknowledges regular investing is a cost issue with ETFs. While they typically attract a relatively small fee, the costs incurred rise each time someone invests, given brokerage is usually paid as these instruments are accessed through the public markets.

This is in contrast to unlisted managed funds, which typically do not attract brokerage. “Brokerage costs can work out to be large when you are making small, regular investments in ETFs. No brokerage solves this, but I would encourage investors to look at the bigger picture and consider all factors. The underlying investments and ongoing management costs of the ETF are likely to have a larger impact on your investment outcome than one-off brokerage savings,” Front says.

At 0.88%, the SelfWealth ETF management fee is higher than many other actively-managed ETFs, considering the decisions about what the ETF invests in are based on data rather than more costly analyst research.

Front says: “As low costs are one of the best predictors of performance, I would have liked to see the fee lower and hope it comes down if or when the product scales.”

He notes the index it tracks is new and, as a result, the product is genuinely different to the standard benchmarks ETFs track, such as the S&P ASX200. “The SelfWealth index is diversified and its makeup and weightings are quite different to standard indexes, so I expect it to perform differently. I do not have a crystal ball, but I would expect there will be times when it underperforms the market and times when it will outperform, potentially by some margin due to the differences in the portfolio.”

Self-Wealth’s issue of an ETF follows ratings house Morningstar’s release of its new ETF.

Commenting on Morningstar’s ETF, Front notes that issuing an ETF is new a front for Morningstar, which until recently has offered managed funds and managed accounts. “Entering the ETF space by offering a different structure for investors to access their already-available managed fund is an extension of a model they have had for some time.”

Morningstar’s core business is providing ratings on financial products. It does not provide recommendations on its own products as this would be an obvious conflict of interest.

The product is relatively inexpensive compared to other actively-managed ETF, with a management fee of 0.39 per cent, although it is more expensive than passive alternatives.

Conaill Keniry, a financial adviser with What If Advice, is one adviser in favour of vertical integration across the ETF sector.

“It is a good thing for the average investor. But when ratings houses like Morningstar throw their hat into the ring, questions around conflicts of interest should be asked,” says Keniry.

“At this stage I do not believe there is a conflict, as Morningstar’s ratings process is a quantitative one. But Morningstar and other ratings businesses need to make sure they remain impartial. As soon as their processes become qualitative rather than quantitative, an environment for conflict exists,” he notes.

Editor’s note (27/11/19): The headline was amended from “Investors concerned ETF vertical integration causes conflict of interest,” to more accurately reflect the piece.

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Image: Andrew and Louise Ward, SelfWealth founders, Source: SelfWealth

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