Emerge Canada’s debt to suspended ETFs described as ‘unusual’
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Fund industry analysts have expressed surprise at the “unusual” financial arrangements of a family of Canadian exchange traded funds that are subject to a trading ban.
The Ontario Securities Commission suspended trading in 11 ETFs after their sponsor, Emerge Canada, failed to file audited financial statements by a March 31 deadline after parting company with its auditor, BDO Canada, in November last year.
The balance sheets of six of the suspended ETFs, designed to replicate the performance of technology-focused funds managed by Cathie Wood’s Ark Invest, reveal they were owed a total of C$2.54mn ($1.89mn) by Emerge Canada as of 30 June 2022.
This sum had risen sharply from C$1.12mn at the end of 2021 and represented 2.4 per cent of the funds’ combined assets of $107.5bn.
The sums are listed as “receivables from the manager”. Since the launch of the first funds in 2019, Emerge Canada has absorbed some of the operating expenses of the ETFs, over and above those covered by the management expense ratio. Such costs would normally be paid out of the issuer’s own resources.
Although the MER was relatively high in percentage terms — Emerge Canada’s website estimates it at 1.15 per cent of assets under management in 2022 — this was insufficient to cover all the ETFs’ costs, given the relatively small size of the funds.
“Over the past four years, Emerge has gone to great lengths to reduce the MER of its ETFs and protect performance during some of the most volatile markets we have ever experienced,” The Toronto-based company said in a statement.
“To this end, Emerge absorbed certain operating expenses of the Emerge ETFs, which is a common practice in the fund industry. Absorption is not borrowing from the ETFs.
“The operating expenses absorbed by the manager benefited unit holders, as it reduced the MER and contributed positively to performance,” it added.
Analysts said that while prepayment of fees to a fund manager was not unheard of, the fact that the debt was rolled over from one financial year to the next, with accrued interest of 2.5 per cent a year, was unusual.
“This is not something I have seen before,” said Bryan Armour, director of passive strategies research, North America, at Morningstar.
“I think it’s problematic. Other issuers typically make their funds whole every year. Accruing interest is nice but I don’t think ETF investors would expect an IOU being part of what they hold. This isn’t something I would ever expect as an investor,” he said.
“You would expect that the management fee would be only what is stated in the prospectus and manager filings. If [Emerge Canada] need to charge more they should charge more. That’s on them.”
Elisabeth Kashner, director of global fund analytics at FactSet, said: “It’s unusual, I can’t recall a similar case.”
Kashner argued there was “nothing really odd about prepaying expenses, businesses do it all the time, [such as] paying insurance premiums up front. I’m not convinced that prepayment is unethical in and of itself.”
Nevertheless, she said any payments needed to be “proportionate”.
Kashner asked: “What was the expected source of the repayment? What conditions would have to pertain in order for these repayments to happen? At what point does the advance become an investment or a loan, rather than an expense?”
An alternative school of thought is that the prepayments have not harmed investors at all, and should ultimately benefit them, assuming the money is repaid.
“The lending is on absorption costs above the expense ratio, so it’s not like they took the money out of the funds as a loan,” said one individual with some knowledge of the situation.
“The small nature of the funds was such that the expenses would have resulted in a larger expense ratio [without the cost absorption]. These were fees that would have been legitimately owed by the fund,” he said, adding that his understanding was that there was sufficient capital available to repay the accumulated debt.
Emerge Canada said in its statement that the receivables were disclosed in the funds’ financial statements and that it had three clean annual audits from BDO.
Ark Invest declined to comment, but said in a written statement that it only became aware of Emerge Canada’s failure to file audited annual financial statements after regulators suspended trading in the ETFs, “a situation in which we are deeply disappointed”.
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Ark said it was monitoring the situation “closely” and was “prepared to take additional action if warranted or necessitated”.
Separately, Lisa Langley, chief executive of Emerge Canada, said it was “in active conversations with two auditors” to replace BDO and “expects to have that resolved very quickly”.
Langley said the relationship with BDO ended “for reasons that we can’t discuss” but that it had not been declined by any other auditor.
She attributed EC’s failure to find an alternative auditor in time to file its 2022 financial statements by March 31 to post-Covid capacity constraints within the auditing sector, “so, as an emerging manager we went to the back of the line”.
“We went through the due diligence process but we waited too long. That was our strategic mistake,” she added. “We deeply regret it and we apologise for it.
“I’m 60 years old. I have been in the industry for a long time and I have never had a problem like this. It definitely goes into the textbook for emerging managers. It has been a big learning curve.”