“To advise or sub-advise…that is the question.” William Shakespeare, outsourced compliance consultant, circa 1978.

Choosing an ETF white-label partner can be daunting, and the consequences of screwing it up can be stressful and expensive. First, while white-label relationships are not “till death do us part”, it can be difficult and expensive to get “divorced” (a $100k+ proxy is often needed – though if your firm gets acquired, the buyer usually pays for the proxy).  Second, you are buying into a package of complex services, each with its own nuance (trust platform, compliance, trading, custody, fund administration, technology, etc.). Finally, because of the steep learning curve, you are at a disadvantage with your negotiating counterparty (i.e., the ETF white-label firm). Our solution to these problems is to invest heavily in providing educational materials and maintaining transparency as one of our core beliefs. You can see our library of education materials here.

Today’s topic is one we regularly get asked by professionals looking to launch an ETF.

“What are the costs and benefits of being an advisor to an ETF versus being a sub-advisor to an ETF?”

Naturally, being an “Advisor” simply sounds better! The generic logic is that it is never good to play second fiddle to anyone! Of course, just because something sounds better doesn’t mean it is actually a rational decision. One needs to understand the costs and benefits of being an advisor vs. a sub-advisor. What are the different legal requirements? What are the risks? What are the costs? And so forth.

Here is the bottom line:

• Higher Risks – An Advisor takes on substantially more work and more tail risk than a typical Sub-Advisor.
• Higher Costs – Operating an Advisor is more expensive because they need more people, more process, and more tech to manage their risks.
• No Better “Control” – From a practical and legal standpoint, there are no differences in “control”.
• No Better Branding – For retail investors, there is virtually no difference.
• Harder Sell – For institutional investors, it’s harder to pass due diligence and open doors without scale, an operational track record, and established relationships.

We hope this piece will help dispel some of the myths we hear in our industry and ensure that you, the white-label consumer, are fully informed and can ask the right questions.

Boards are fiduciaries to ETF shareholders. Advisors or Sub-Advisors do not control them.

ETFs (each a “Fund” and collectively “Funds”) are governed by the Investment Company Act of 1940[1] (the “40 Act”). The Fund is governed by a Board of Trustees (a “Board”), and the Board is controlled by the Fund’s shareholders, much like how a public operating company works. Of course, running a Fund via thousands of individual shareholders is impossible. Enter the 40 Act. The 40 Act creates a framework whereby shareholders elect a Board and delegate responsibility for oversight of their Fund to the Board. These trustees are held to a fiduciary standard to represent the Fund’s best interests, and if they do not exercise reasonable care in conducting their oversight of the Fund, they can be held personally liable (i.e., not a smart role for slackers).

Boards can be comprised of “interested” and “independent” trustees. Whereas an independent trustee has no financial connection to the Funds, their advisor or a sub-advisor, an interested trustee can be affiliated. Typically, an interested trustee represents the firm that is paying for the costs of the Trust complex as a whole. This can be an executive from a large bank, an employee of the administrator, an Advisor employee, etc. In our situation, Wes serves as an interested trustee to our EA Series Trust, and he is deemed an “interested” trustee because he owns equity in ETF Architect, which serves as the Advisor to the Trust. Generally speaking, an interested trustee brings real-time knowledge and feedback from the entities supporting the Trust directly and helps connect the Board to the on-the-ground activities of the Fund. In contrast, Independent Trustees are expected to bring a level of objectivity to Fund matters because of their lack of any financial affiliation with the parties involved. In our case, we have 3 independent trustees: Mike Pagano and Daniel Dorn (both finance PhDs and tenured finance professors) and Emeka Oguh (a Harvard MBA, CEO, and serial entrepreneur). Team Bios. Be sure to evaluate a white label’s trust and understand who the independent and interested trustees are.

Interested Trustees, despite being on a Board, have diminished powers compared to their Independent Trustee counterparts. That’s because some of the most important items on which the Board votes (like your advisory or sub-advisory agreement) are required by the 40 Act to be approved by a majority of the Independent Trustees in addition to the overall Board. Interested Trustees may also be excluded from certain “Executive Sessions” of the Independent Trustees, a private, independent trustee-only forum to discuss Trust business. Independent Trustees often retain their own counsel (who they select), insurance, and other supporting infrastructure as they see fit to ensure they can effectively carry out their fiduciary obligations. In short, interested trustees can provide input and feedback as board members, but the key decisions pertaining to ETF governance largely reside solely with the Independent Trustees.

For a white-label trust, the Trustees are part of the package and have already been vetted and elected by the Trust’s previous shareholders. That’s a huge benefit because it means they have a proven history of ETF board experience and a track record of factors you can review (e.g., how they like to engage, areas of interest, and pain points). What you see is what you get. If you have your heart set on nominating Trustees to a Board as a new (or established) ETF issuer, you should be prepared to launch your own Trust (and enjoy the cost and operational complexities thereof).

The bottom line is that nominating trustees to a board drives extra costs and complexity. Most importantly, don’t expect to establish a “controlled” board because the 40 Act insists that they control you!

ETF Boards transfer key liabilities to the Advisor

The Board is responsible for the proper operation of an ETF. Full stop. Of course, Board members can’t operate an ETF themselves, and thus, boards are in the business of delegating and outsourcing. Boards will nominate a Chief Compliance Officer (“CCO”), hire an Advisor, hire Sub-Advisors, hire a Custodian, etc. Each Trust is different. Some Trusts retain more operations at the Trust level, while others delegate responsibility to the Advisor.  For example, a Trust has to have its own compliance program; however, it can share a CCO with the Advisor and rely on Advisor personnel to execute most of the Trust’s tasks, like submitting filings to the SEC.

Remember, Boards are responsible for what the Fund does, and fails to do, from a fiduciary perspective. Like most people, Board members don’t like being sued (and generally, they want to take care of shareholders). So, how does a Board mitigate that liability? By being a good board member and effectively overseeing Trust and Advisor operations successfully.

Board members have a “duty of care” to manage ETFs properly. Specifically, this means that a Board must assess compliance programs, vendor policies, and other operational matters. This oversight can include onsite due diligence, document review, and a litany of other approaches to ensure programs are in place and functioning correctly.

An essential aspect of the “duty of care” involves relying on attestations from key players retained by the Trust. This is a crucial dimension of the Trust / Advisor relationship. For example, a written attestation from the CCO of the Advisor about its compliance program provides coverage to a Board in terms of their due diligence. Granted, a Board cannot rely on attestations alone and cannot rely on attestations from unqualified individuals; however, these attestations are essential for demonstrating good oversight and transitioning liability from Trust to Advisor. If the Advisor puts their hand over their heart and affirms their operations are robust, the Board can rely on this attestation and shift more liability risk onto the Advisor.

To summarize, an Advisor makes representations to a board with significant implications for liability. While the Board isn’t entirely off the hook and must still demonstrate good due diligence, the Advisor will assume responsibility and liability for certain aspects of ETF operations, compliance requirements, and vender oversight. New white-label entrants are well-served in understanding the legal liabilities of being the designated advisor to an ETF.

Advisors don’t “control” Trusts. It’s against the law and runs contrary to a fiduciary standard. But they do control operations that the Trust wants them to be responsible for.

One of the biggest misconceptions we hear in the industry is that if you are the Advisor, you can “control” the Trust. This is not true, or rather, it should NOT be true. Remember, the Board is held to a fiduciary standard and is ultimately liable to the shareholders for harm if they fail to conduct proper oversight. As such, allowing an Advisor to “control” a Board directly violates that principle. The only “controlling” principle in effect should be that of the fiduciary requirement to the Fund. I pity the shareholders who may find themselves represented by a Board controlled by another entity.

Where does the perception that advisors “control” things come from in our industry? Granted, the Board may delegate responsibility for certain functions to an Advisor, which they, by default, control and therefore, are liable for. For example, the Advisor typically provides key officers to the trust like a Principal Executive Officer and a Principal Financial Officer, who sign registration statements and shareholder reports and therefore take on a significant degree of liability for the proper execution of the Trust’s activities.

While Advisors do not control a Trust, they do control operational matters that the Trust has charged them with overseeing. This point is critical: if you are a named Advisor on a Trust, you will likely have more fiduciary responsibility and liability (both to shareholders and the SEC) than you would otherwise have as a Sub-Advisor with very specific responsibilities (and therefore limited risks). As an Advisor, you will be making representations and warranties on programs and compliance matters you oversee. Some firms may want these additional liabilities and risks because they feel they can manage them better or more efficiently; however, most ETF business owners should prefer less risk to more risk when given the option.

Let’s talk about incentives. Private Equity and Big Firms love it when you are an Advisor. You take on all the big risks, so they don’t have to!

Being an Advisor versus a Sub-Advisor sounds great. Still, in principle, it’s only “great” for the vendors telling you to be the Advisor because it allows them to minimize their own risk while collecting service fees. Most ETF white-label clients are in no position to oversee and underwrite these risks, OR they are seasoned veterans who understand these risks, and they want to offload those compliance requirements to a more scalable, efficient counterparty. Simply put, being an Advisor increases liabilities and risk, with no real reward. Sadly, most entrants do not understand this dynamic and sign up for the “Advisor” role without understanding what they are on the hook for. The industry loves this relationship because it offloads all the risks to the Advisor while collecting all the fees for the services provided. But what happens when there is a large NAV error, trade error, SEC enforcement action, tax lot issue, or other black swan event that hits the Fund? The counterparty that stuffed you with the wonderful “Advisor” title can simply say: “Hey, we are just a vendor…you are the Advisor, it’s your problem, not ours.”). Don’t believe us? Ask the provider pitching you the “Advisor” title and inquire if you CAN serve as a Sub-Advisor. The answer is always, “No, our legal team advises against that and we suggest it is best if you are the Advisor.” When they tell you that having them be the Advisor (and you the Sub-Advisor) doesn’t fit within the risk tolerance for their business, that should tell you everything you need to know about how serious the risks of being the Advisor really are.

Like any business relationship, it is critical for a white-label client to understand a platform’s incentives and rationale behind pushing an “Advisor” relationship. Some white-label platforms are “gateway drugs” for larger product offerings. For example, a large bank may offer a white-label platform to garner more custody assets while promising to do the heavy lifting, but then turn around and have you review and sign-off on everything (i.e., transferring 100% of the risk to you even for things they draft). Similarly, a private equity-controlled platform may offer white-label platforms as an entry point to sell Fund Administration to ETF clients, consulting, or distribution. Be sure to understand where a white label makes money and the end incentives for the platform owners.

In contrast, pure-play vertically integrated white-label operators, who facilitate trust, regulatory, and trading operations, serve as the advisor and take on all the core legal liabilities mentioned above. These “genuine” ETF white-label platforms allow sub-advisors to limit their risk footprint and “free ride” on the coattails of the Advisor. In this relationship, the sub-advisor (i.e., ETF entrepreneur) is merely a service provider to the Advisor, and they are therefore liable for the niche services they provide (e.g., portfolio management signals), but not all the activities the advisor performs.

Can’t the Advisor just “steal” my ETF if I’m the sub-advisor?

If an ETF entrepreneur joins forces with an ETF white-label structure that facilitates sub-advisory, the “white-label clients” are 1) named portfolio managers and sub-advisors of their fund and 2) economic sponsors of the ETF. The economics, branding, and discretion are theirs. The AUM on their Form ADV is discretionary. In short, the nuance between Advisor and Sub-Advisor regarding retail investors is meaningless. It’s the white-label client’s fund, their strategy, their story, and it’s their show. Full. Stop.

Let’s dig in a bit on the nuance. Role #1 of the white-label client is that of discretionary portfolio manager and sub-advisor. At the end of the day, the ETF portfolio is managed by the portfolio manager (“PM”). Even if the PM isn’t trading directly, the intellectual property is owned by the PM. This responsibility is delegated to the PM from the Trust to the Advisor and on to the Sub-Advisor. This delegation is memorialized in SEC rules and statutes with decades of precedent. The Trust (and, generally, the Advisor) effectively “hires” the Sub-Advisor as a supporting party to run the Fund.

The other role played by a white-label client is that of the Sponsor. The role of being a Fund’s Sponsor is a non-SEC regulated role. The Sponsor is the firm or person that puts their hand in the air and says, “Yes, I am fronting the cash, promising to pay the bills, and therefore reaping the economic benefits of the Fund if it is successful.” This role is an economic and contractual role that represents the real “strength” of the white-label client’s position: While the ETF white-label client is legally “hired” by the platform to manage the portfolio, the Sponsor is hiring the white-label firm to provide the resources (people, process, and tech) to launch the ETF, and thus, the economics of the ETF are theirs from a contractual perspective.

Given that backdrop, we can now discuss the difficulty of “stealing” a fund on a white-label platform, which is a common concern for white-label clients. The first thing to remember is that the Board is held to a fiduciary standard. It would be a gross violation of shareholder interests to unilaterally fire the sub-advisor and portfolio manager hired to run the fund (let alone invite a litany of lawsuits aimed at the Trust). In addition, changes to the advisor or sub-advisor for a fund trigger a proxy effort (which is a costly and public endeavor). Third, the ETF white-label firm is in the business of helping ETF entrepreneurs enter the marketplace. If the marketplace thought that the ETF white-label firm “stole” property, they wouldn’t be in a business that long. Most importantly, the Sponsor Agreement dictates who receives the financial benefits of the ETF, which is separate and distinct from the Sub-Advisor or PM role. So even if the ETF white label platform nefariously fired its client in an attempt to “steal” the fund, they are contractually obligated via the sponsorship contract to send the ETF’s profits to the Sponsor. None of this makes sense for any party involved. Of course, this logic relies on the fact there are strong agreements in place to ensure incentives and commercial interests are aligned. We recommend reviewing the ETF sponsor agreement to ensure your economic rights. One can even add language to the sponsorship agreement that mandates uneconomic penalties on the Advisor if funds are unilaterally “stolen”, etc. Ask the white-label firm what provisions are in all of their agreements by default to protect your interests. If such “anti-theft” provisions are only added if you negotiate for them, be very suspicious of whether that firm is serious about your success or just their own.

Conclusion

Choosing a white-label platform is a big decision on many fronts. One decision is whether to serve as an advisor or a sub-advisor. There are two common options: 1) vertically integrated ETF white-label firms that take on advisor functions and liabilities and allow white-label clients to serve as sub-advisors. And 2) the other white-label firms that offer a specific service but force the white-label client to be an advisor and the commensurate liabilities and risk that this entails.  Be sure to fully understand what you are buying, who does what, and, most importantly, where liability resides. Culture and incentives matter; thus, ensure you have a clear view of who is behind the white label and where their money comes from. Are you their core business, or are you a vehicle for follow-on services being sold? Most importantly, do the homework and ask the tough questions.

[1] https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf