ETFs Aren't Always What They Seem

Here Today, Gone Tomorrow (Note: This column owes a large debt to "Who Actually Owns Your ETF?," from ETF.com's Dave Nadig. Although Mr. Nadig took the discussion in quite a different direction, most of the fact-finding is his.)

Some things about funds are abstruse, but not which company runs the show. If a fund is called Vanguard or Fidelity or T. Rowe Price, then Vanguard or Fidelity or T. Rowe Price calls the shots. It's really that simple.

Or so I had thought.

Last week, an exchange-traded fund lineup named PureFunds went poof! On Friday, the PureFunds ETFs existed. That afternoon, a press release announced that the PureFunds name would be no more, and that beginning Tuesday morning (not quite an overnight coup, but pretty close) that group would be called ETFMG instead.

I know what you're thinking. Datsun became Nissan. Jerry's Guide to the World Wide Web shortened to Yahoo. Brad's Drink was rebranded as Pepsi-Cola. A book with a new cover remains the same book, Rekenthaler. Except that … PureFunds is actually gone. There does exist a company called PureShares, which would love to run investments called PureFunds, and that firm was booted from the fund lineup that carried its name.

(Not happily, either--PureShares responded to the news by filing suit.)

Who's in Charge? It is not normal for the entity that lends its name to a fund to be removed from control. Quite the reverse. Typically, funds are named for their Advisors, and Advisors control the fund. Yes, technically, shareholders own the funds in which they have invested (just as stockholders legally own corporations). But the nine tenths of the law that comes from possession rests with Boards of Directors, and Boards work for Advisors. (That statement is not strictly correct, but it holds true in practice.)

Sometimes Advisors employ Subadvisors. That designation may be inconsequential, as when Fidelity appointed its corporate subsidiary Fidelity Management & Research Hong Kong as Subadvisor to assist on

Note that while Vanguard can eject Wellington, the reverse is not true. The subcontractor can't eject the general contractor.

Fund Sponsors Which brings us back to PureFunds. Was it not the funds' Advisor, and therefore was it not immune from attack? (Once again, the Board of Directors could revolt against its maker, but this is Investment Company Act of 1940 reality, not a Frankenstein film; that ain't happening.) Well no, it turns out, PureFunds was not the Advisor.

It was instead the funds' "Sponsor"--whatever that may be. It is not a term with which I am familiar. Nor, it appears, is it a term with which anybody else is familiar.

In PureFunds' case, the Fund Sponsor could be renamed the Fund Schlemiel. It was an entity that did all the apparent work, but which lacked the real power. PureFunds applied its brand to the funds, created and maintained the indexes that drove the funds, and was responsible for marketing the shares. In other words, it named the restaurant, prepared the food, and gathered the customers. But the company did not control the Board of Directors, and thus it was out.

However, that is not the only possible interpretation of the term Sponsor. World Gold Trust Services officially serves as the Sponsor for the ETF

Two Sponsors, two completely different uses of the term. In the case of PureFunds, the Sponsor's name was stamped on the tin, and its contents lay inside--but that Sponsor was powerless to prevent change. Its control was an illusion. With SPDR Gold Shares, the depth of State Street's involvement is an illusion. The final responsibility lies elsewhere.

As my high-school English teacher liked to say, if a word can mean whatever you would like it to mean, then that word has no meaning. The term "Fund Sponsor" has no meaning.

Wrapping Up As grand scandals go, this doesn't rate. None of the involved parties--from PureFunds to ETFMG to State Street to World Gold Trust--tried to fool investors. They went about their businesses in good faith. What's more, the problems are largely hypothetical. Investors who are displeased that their funds are not quite what they seem can easily sell their shares on the open market. Such trades are just about costless, aside from possible tax consequences for taxable accounts.

However, the situation needs addressing. These firms sowed their confusion honestly. The next ETFs to mislead their shareholders might do so intentionally. One needn't work too hard at imagining how the devil's shoes fit to envision how a firm with a questionable past might quietly control funds that are branded with a trustworthy label--a name that suggests integrity and stewardship.

This issue, I grant, is tricky; I'm not sure that I want regulators insisting that the organization that controls a fund (by appointing the Board of Directors) must place its name front and center in the fund's title. That has more than a whiff of overkill. Let's just say that I would like those who oversee ETFs to think about how investors might better be able to know where their bucks stop. It is their bucks, after all.

And fix this Fund Sponsor thing, OK? Whatever a Sponsor ends up being, per interpretation of the Investment Act of 1940, it should be just one thing. That doesn't seem too much to ask.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.