Barron’s: The ETF Industry’s Biggest Problem, and How to Fix It

Exchange-traded funds have been hailed for their accessibility, transparency, and, above all, low costs. But the way in which investors are actually able to buy and sell ETFs—and at what cost—runs counter to their promises.

Even the word the industry uses—distribution—obscures the process: ETF providers have to get their products in front of investors, whether that means via a discount brokerage aimed at individuals and registered investment advisors, or on the platforms offered at big wealth managers, or through any other means of institutional trading. How do ETF providers get on these platforms? They pay.

This model, employed by mutual funds for decades, has long been criticized. Mutual funds have share classes—versions of the same portfolio that come with different fees—that facilitate these kinds of payments from the firm offering the fund to the firm making it accessible to the end investor. Known as revenue-sharing agreements, these costs get passed on to the investor. ETFs don’t have share classes, but they are not immune from this sort of pay-to-play way of selling. And it has limited the industry’s growth.

The gatekeepers at the big wirehouses, brokers, and home offices decide which ETFs see the light of day. “The gatekeeper’s job is to identify and confirm the quality of the product being considered for inclusion,” says Paul Ricciardelli, who oversees research and evaluation of investment products and strategies at Morgan Stanley . ETFs usually need the assets and a track record to become firm-approved and placed on a wealth management or brokerage platform.

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This may not sound like a high hurdle, but the distributors want to be paid for that distribution. Mutual funds, in this sense, can have an upper hand, because their 12b-1 fees—a marketing fee that investors pay annually—can go to compensating the platform on which they’re sold.



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