The general rule of thumb for most investors when it comes to exchange-traded funds (ETFs) is that the bigger they are, the cheaper, better performing, and more liquid they are likely to be. But with any kind of rule-of-thumb investment strategy, investors should always be wary of the exceptions. So-called branded or in-house ETFs are a prime example, carrying potential added costs and risks that might not be obvious to the average investor, according to a recent story in Barron’s.

Key Takeaways

  • Large ETFs often viewed as cheaper, more liquid, and better performing.
  • Branded ETFs may be large due to being largely owned by the issuer.
  • Branded ETFs suffer from a conflict of interest. 
  • Branded ETFs exhibit low daily trading volumes, leading to less liquidity.

What It Means for Investors

Branded ETFs are generally large because their issuer is steering its own clients into them, a recent trend referred to as BYOA, standing for “bring your own assets.” For example, ETFs issued by JPMorgan Chase & Co. (JPM) raised $15.6 billion in 2018, and most of that came from the bank’s affiliates. As of early March of this year those affiliates owned as much as 53% of JPMorgan’s ETF assets, and the No. 1 shareholder of 23 of the bank’s 31 ETFs was the bank itself, according to The Wall Street Journal

That’s a lot different from an ETF that grows its assets by attracting investors on the basis of merit, such as offering low management fees and superior performance. An ETF exhibiting those characteristics should, in theory, attract a varied mix of unaffiliated investors in a more organic fashion. In a competitive market, one would expect the funds that offer the best reward relative to risk to rise to the top and attract more investors.

From this perspective, ETFs such as the John Hancock Multifactor Emerging Markets ETF (JHEM) appear as anomalies. The fund carries a 0.55% management fee that is five times above its lowest-cost competitor, the SPDR Portfolio Emerging Markets ETF (SPEM), has lagged the performance of its peers in 2019, and yet has managed to amass $809 million in assets after only one year in existence. 

However, the seeming paradox of attracting investors despite high fees and underperformance is explained by the fact that 97% of the assets in the fund are owned by John Hancock’s parent company, Manulife Investment Management. Similar to JPMorgan, Manulife is effectively steering its clients into the ETFs issued by its subsidiaries.

But such practices expose investors to subtle risks for which they may incur unexpected costs. For one, there is a clear conflict of interest since financial advisors know that their employer will be more profitable if they favor the ETFs issued by their employer as opposed to others. Those incentives don’t match up well with the interests of the investors, who care more about performance rather than supporting their financial institution’s bottom line.

“An independent ETF strategist doesn’t have those conflicts,” Rusty Vanneman, president and chief investment officer of CLS Investments, told the Journal. “They have open architecture and more choices.”

Further, branded ETFs whose issuers own the majority of the funds’ assets are subject to less liquidity, which could make it more difficult for investors to unload their shares in times of market stress. Such funds are more likely to have lower average daily trading volumes. The lower turnover is an indicator that an ETF’s shares are far less liquid than ETFs with higher daily trading volumes.

For example, 98% of the $602 million in assets that make up the Hartford Total Return Bond ETF (HTRB) come from Hartford Funds Management. But, the fund has a daily trading volume of less than 10,000 shares, significantly less than its slightly larger competitor, the $812 million Fidelity Total Bond ETF (FBND), which has a daily trading volume of over 100,000 shares. 

Looking Ahead

To be sure, not all in-house ETFs are more expensive than their peers and many employ multifactor strategies that simulate active management, which could justify higher fees. However, most of these in-house multifactor ETFs have failed to outperform more traditional index funds, according to Barron’s.