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Do ETF Managers Eat Their Own Cooking?

Few exchange-traded fund managers own any of the funds they manage.

Dan Culloton, 09/12/2006

Exchange-traded fund families urge you to join the ETF revolution, but many of the people managing their own funds are sitting the uprising out.

I recently looked at the regulatory filings of some of the largest and fastest-growing ETF families to see how ETF managers are compensated and if they are investing any of their own money in the funds their employers are hawking so aggressively. This information can help investors figure out how much ETF managers really believe in the funds they run.

The result was disappointing.

For most of the funds I checked, few of the managers had anything more than a token amount invested in the ETFs they ran, according to their funds' most recent disclosures with the Securities and Exchange Commission. The managers of Barclays Global Investors' iShares and State Street Global Advisors' streetTracks and SPDR ETFs had no money in their funds as of their most recent disclosure, while managers at Vanguard and PowerShares had at least some money invested alongside their shareholders. Of those firms, only Vanguard linked manager bonuses to the performance of funds they ran.

Should this matter? After all, most ETFs are market (or market segment) tracking index funds that are extremely tax efficient on their own, so it's not like an ETF skipper needs incentive to beat the market or manage taxable distributions.

I think it does matter, though, for the same reasons it matters for conventional open-end funds. Simply put, the interests of managers who are compensated based on how well they run their funds, and who have significant sums of their own money invested in their portfolios, are more aligned with their shareholders. Whether a fund is active or passive, exchange-traded or traditional, managers are more likely to ensure a fund delivers what it promises for a reasonable fee if their own wealth is on the line.

Manager compensation seems like a particularly important factor to consider as more and more new ETFs flood the market touting paradigm-shifting methodologies and strategies. Looking at where ETF managers invest their own money can help investors discern which funds are based on legitimate investment cases and which are hyped-up asset-gathering vehicles.

Granted, it isn't as dangerous for index funds to pile up assets because their low turnover and limited mandates allow them to run a lot of money without compromising strategy and performance. But ETF managers usually are intimately involved in their firms' product development efforts, and if their pay is tied to sales or if they have no intention of using the funds themselves, they may be more likely to acquiesce to dubious fund ideas, such as ETFs that track narrow benchmarks or illiquid securities.

Furthermore, as ETFs continue to adopt more active strategies and expand into more illiquid asset classes, such as micro-cap stocks and commodities, asset growth could become a much bigger issue. That's why we like to see managers' incentive pay based on the performance of their funds relative to an objective yardstick over time. We also typically like to see managers invest more than $1 million or more than a third of their liquid net worth in the funds they manage.

Morningstar doesn't give ETFs and their families Stewardship Grades like we do for mutual funds (we do grade Vanguard's conventional funds). If we did, though, none of the organizations I looked at would pass the manager compensation and ownership component of the score with flying colors. Here's why.

Barclays Global Investors bases the iShares ETF managers' bonuses on the profitability of the firm and business unit, according to regulatory filings. An assessment of individual performance also factors into the calculation.

None of the listed equity iShares managers invested in any of the firms' more than 100 stock ETFs, and just one of the listed bond managers owned any of the six fixed-income iShares, as of the most recent SEC filings. The only investments on record were small--fixed-income manager Lee Sterne had between $10,000 and $50,000 in iShares Lehman 1-3 Year Treasury SHY and between $1 and $10,000 in iShares Lehman TIPS Bond TIP as of Feb. 28.

There's not a lot of evidence that managers' interests are aligned with those of shareholders.

State Street Global Advisors
Managers at the home of streetTracks and SPDRs didn't have any skin in the game, either. None of the five listed members of State Street's ETF team owned any streetTracks or SPDR ETFs, according to recent filings. Neither did any of the managers who subadvise the streetTracks Dow Jones Wilshire REIT RWR.

Furthermore, State Street bases its managers' bonuses on the performance of the business group and the individual, but it's not "directly tied to the investment performance or asset value of a product or strategy," according to regulatory filings. There's not much to go on here, either.PAGEBREAK

Vanguard ties its ETF managers' bonuses to how well their portfolios track their benchmarks over a one-year period. More subjective factors, such as contributions to strategic planning and staff development, also are considered. The short performance measurement period seems appropriate for index funds. It's also better than no performance assessment at all, as is the case with iShares and State Street. Vanguard's board of directors also awards annual long-term incentive payments based on how efficiently the firm serves shareholders and how all of its funds have done relative to rivals.

Manager ownership at the firm's ETFs and conventional index mutual funds has been spotty, though. It's hard to tell if Vanguard's index fund managers choose the ETF or conventional share classes of their offerings because Vanguard just discloses investments in the overall fund. (Vanguard's ETFs are structured as share classes of the index mutual funds.)

Even if Vanguard broke out its managers' ETF ownership, though, I doubt it would be impressive. Vanguard maintains that its managers invest all their money across the family's funds, but few of the index fund managers invest much in the funds they directly run, according to regulatory documents. For example, none of the index fund managers own any of the sector funds, and Vanguard Total Stock Market Index VTSMX manager Gerard O'Reilly had between $100,000 and $500,000 in the fund at the end of 2005, which seems slight for an experienced manager of a core stock fund.

There's evidence that the managers are more aligned with shareholders here than at other firms, but it could be better.

This firm has a lot of incentive to grow fast. The firm pays John Southard, the lead manager of its rapidly growing stable of ETFs, a fixed salary and a year-end bonus that isn't based on the performance of any of the funds he manages.

But the biggest motivator for PowerShares' management is probably the firm's pending merger with AIM Funds parent Amvescap AVZ. Amvescap is supposed to pay PowerShares $60 million in cash when the deal closes this year, and half of that payment will go to firm founder Bruce Bond, while 12.5% of it goes to Southard, according to SEC filings. PowerShares also could get another $670 million in three payments out of the transaction if it hits management fee growth targets set by Amvescap over the next five years; Bond and Southard would get big slices of the last two payments as well.

This helps explain why the firm has been so intent on growth. Indeed, PowerShares seems eager to have a fund for every trend. Most of the 38 funds it has launched in the past three years have been sector or industry offerings, including ETFs tracking water, nanotech, and clean energy stocks. The firm has more than two dozen more ETFs in the works tracking more sectors, industries, and indexes that push the envelope of passive investing.

With all these funds to choose from, where do PowerShares principals put their money? They have chosen the more diversified offerings in the lineup. Southard had between $10,001 and $50,000 invested in just one of the firm's funds: PowerShares Dynamic Market PWC, which tracks an index that uses computer stock selection models to beat the broad stock market. He has nothing in the more specialized ETFs. Bond has more than $100,000 in the same fund and between $10,000 and $50,000 in PowerShares Dynamic OTC PWO, a fund that seeks to outperform the Nasdaq Composite. The incentives seem unbalanced here.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior analyst with Morningstar.

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