Rebates, research and the hidden workings of the ETF market

There are some words in financial services – from “guaranteed” to “uncorrelated” – that should set alarm bells ringing. By David Batchelor

Historically, “rebate” has been one of them. Anyone who remembers the pre-Retail Distribution Review world of fund supermarkets, platform payments and distribution incentives could be forgiven for assuming that the investment industry had broadly learned its lesson: investors should know what they are paying, who is being paid and whether those payments could influence the products they are shown.

It is therefore striking that rebates and rebate-like arrangements are common in parts of the ETF ecosystem. This is not payment for order flow in the American sense, where a broker is paid by a market maker for routing client trades. Nor are UK investors being returned to the wild west of commission-driven fund distribution: in the UK and Europe, paying “kickbacks” in exchange for buying more expensive products is specifically outlawed. The issue is subtler than that and arguably more interesting.

The ETF market is built on a foundation of infrastructure that is largely invisible. Unlike a conventional open-ended fund, where investors typically subscribe and redeem directly through the fund platform at net asset value, ETFs trade throughout the day on exchange. A fund’s success therefore depends not only on the quality of the underlying strategy, but on liquidity, spreads, platform access and visibility. The largest global ETFs are so liquid, cheap and widely held that they effectively distribute themselves. Smaller, newer or more specialist ETFs do not have that luxury.

One of the major attractions of ETFs is their inherently low cost. However, delivering that cost advantage requires scale, meaning new products must build assets quickly to remain viable. This applies to active ETFs as well as passives. Unfortunately, a compelling active investment case is not enough on its own. A new fund can still fail if it sits unnoticed on an exchange, with limited trading volume, wide spreads and no clear route into model portfolios or adviser platforms. In Europe, where active ETFs are growing quickly but remain far less established than in the US, distribution is crucial.

In response, ETF issuers may spend money to support market-making arrangements or secure exchange visibility. It is widely understood that some issuers will enter into time-limited agreements with fund-of-fund operators to hold an ETF in exchange for a monthly payment, particularly for newly launched products.

Some of this is simply the cost of doing business in a competitive market. New funds need support, just as new investment trusts need roadshows, research and broker engagement. For ETFs, rebates can improve access, liquidity and competition. And if a commercial arrangement helps a new fund obtain broader platform availability or better visibility among professional buyers, investors may ultimately benefit.

Indeed, in a market dominated by a handful of enormous providers, anything that can help smaller managers bring different strategies to market could be seen as pro-competition. That is particularly true with active ETFs. If the category is to become genuinely useful in Europe, it needs more than “index plus” products from the global giants.

But the counterargument is equally clear. If a product is being selected or promoted because of a commercial arrangement rather than its investment merit, there is a real risk that the end investor will not get the best outcome. That matters particularly with ETFs, because the headline costs are often low enough for investors to forget the other economics at work. An ETF with a TER of 0.25% looks transparent, but the route by which it reaches an investor may still involve layers of commercial influence, including model-portfolio inclusion and access to mass market platforms.

The danger is that the market becomes self-reinforcing. Products launched by the companies with the deepest pockets get the best visibility, therefore the flows and therefore the liquidity – and products with the liquidity in turn look safer and easier to buy. At that point, the commercial advantage begins to look like an investment advantage, even if the original driver had little to do with portfolio quality or investment opportunity.

This should sound familiar to anyone who follows the active ETF market. JPMorgan’s dominance in European active ETFs has been built on strong products, scale, brand recognition and a serious commitment to the structure, but also on distribution muscle. New entrants, including UK asset managers trying to convert conventional active expertise into ETF wrappers, face a harder journey. They need to persuade advisers, platforms and wealth managers not only that active ETFs make sense, but that their specific product deserves attention.

The active ETF market therefore risks importing some of the least attractive features of the old fund world into a structure that is supposed to be more transparent. Investors could end up with a market that looks clean on the surface – daily pricing, exchange trading, UCITS wrapper – but is still influenced by opaque economics underneath.

The UK market has already been through a painful transition away from commission-led retail fund distribution. RDR may not have solved every problem, but it did establish an important principle: advice and distribution should not be quietly paid for, by product providers, in a way that biases recommendations. That principle should not be allowed to erode simply because the product wrapper has changed from a mutual fund to an ETF.

The answer is transparency and discipline. Not all commercial arrangements are inherently bad, and active ETFs in particular require education because they are still often misunderstood. But investors should know when an arrangement primarily buys favourable treatment that may not be justified by a fund’s fundamentals.

This is where research has an important role to play. Investors need to understand an ETF’s process, portfolio, liquidity, trading costs and how the strategy differs from cheaper passive alternatives or traditional active funds. At QuotedData, this is the role we think sponsored research should perform: giving issuers a credible independent route to explain their funds to the market, as an alternative to rebates.

Active ETFs are one of the most interesting recent developments in European asset management. They have the potential to combine the accessibility and efficiency of the ETF structure with genuinely active investment skill. But if the market is to earn investor trust, it cannot rely on opacity in the background while selling transparency in the foreground. The wrapper may be new, but the lesson is old: incentives matter.

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