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ETFs And Skewed Incentives
By Paul Amery | 06 September, 2012   

We all know what it is like to walk into a bank to do something simple, like pay a credit card bill, only for the person behind the counter to ask if you would like to extend your credit, take out more insurance or look at their competitive mortgage rates,” notes Martin Wheatley, managing director at the UK regulator, the Financial Services Authority, in a speech made this week.

An obvious reason for this behaviour is that people within financial institutions are encouraged to sell to us through incentive schemes, Wheatley says.

The FSA is not against staff bonus schemes per se, but they need to be structured and managed in a way that treats the people they will affect fairly, he adds.

That means performance incentives should be shared equitably between all stakeholders, including customers, owners, bank employees and taxpayers (as the underwriters of last resort of the financial system).

Dodgy, unfair incentive schemes proliferate across finance and society. Do hedge fund managers take a fair share of the returns they earn for investors, given the way their reward/risk ratio is skewed massively to the upside? Should Mitt Romney pay an effective tax rate that’s nearly two-thirds less than the rate for people earning a small fraction of his annual income? Is it fair that a low earner in the UK has to pay several percent of salary a year to his local government as a property (council) tax, while rich landowners actually get paid rebates by the EU?

On the face of it, a focus on skewed incentives in the financial products business should benefit ETFs. They don’t pay the heavy commissions to intermediaries that characterise the traditional, active funds business. And they don’t charge option-type hedge fund fees—their fees are flat, and some of the lowest available on investment funds.

But ETFs do carry potential conflicts of interest, implying costs that can easily go well beyond the total expense ratio. And, unfortunately, it’s very difficult to quantify those costs. We’ve explained in a recent webinar that the lack of transparency into the financial engineering techniques some ETFs carry out behind the scenes (via the use of derivatives or through stock lending) is the prime cause.

Worse, some people’s proposed measures of the “total cost of ETF ownership” are based on a fund’s ex-post tracking ability against an index (i.e., once the returns from ancillary activities like stock lending or dividend tax optimisation are thrown in). This approach is inadequate and potentially highly misleading if the risks incurred when producing the tracking performance are not also measured.

And I’ve heard that ETF providers are not beyond offering commission-type rebates to clients themselves (for example, by offering those clients a better post-tax rate on equity dividends via a payment made outside the fund).

As ESMA, the European financial services regulator, has recently picked up on, there are also plenty of opportunities for the designers of index trackers to embed hidden costs within fund benchmarks. The body is pushing for much greater index transparency to address this potential concern.

So while the worst recent examples of financial product mis-selling (here’s a list compiled by Citywire) come from outside the tracker funds business, there’s little room for complacency for those within it.

Over time, the alignment of financial firms’ pay structures with longer-, rather than shorter-term performance should reduce the worst incentives for mis-selling. But for regulators this is likely to be a long and controversial struggle against powerful and deep-pocketed vested interests. Arguably, until the riskier bits of the financial industry are entirely separated from the basic banking and custody functions, ample scope will remain for things to go wrong.

In the meantime, we should all keep a close eye on the structure, management culture, and the remuneration policies of the firms from whom we buy investment products.


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