The Curious Case of Variable Fees vs. Passbacks

The Case for Variable Fees

When an AP creates or redeems ETF shares, the fund may incur transaction costs associated with buying or selling underlying securities.

A variable transaction fee establishes a predetermined charge, typically expressed in basis points, designed to compensate the fund for those costs.

For example, suppose an ETF charges a 10-basis-point variable fee on a $10 million cash creation. The AP knows in advance that the transaction will cost $10,000.

That certainty has value.

Market makers can incorporate the fee into their calculations when determining where to quote the ETF. They know the cost of accessing the primary market and can account for it when managing inventory and hedging positions.

But what happens if the actual cost of purchasing the securities is only four basis points?

The AP still pays 10 basis points.

That additional cost becomes part of the economics of creating ETF shares and may ultimately be reflected in wider secondary-market bid-ask spreads.

The opposite problem can also occur. If the variable fee is 10 basis points but actual execution costs reach 30 basis points, the fund may absorb the difference.

A predetermined fee offers certainty, but certainty does not necessarily mean accuracy.

The Case for Passbacks

An actual-cost passback approaches the problem differently.

Rather than relying on a predetermined percentage, the fund or its trading agent executes the underlying securities, and the resulting execution difference is charged back to the AP.

Suppose an ETF processes a $10 million cash redemption. The securities being sold are valued at $10 million for NAV purposes, but the actual sale proceeds are $9,975,000.

The $25,000 shortfall, or 25 basis points, is passed back to the AP.

The fund is compensated for the difference between its valuation and the amount realized through execution, helping protect shareholders who remain invested.

From a shareholder-protection standpoint, that alignment is appealing.

However, the market maker faces a different challenge.

Unlike a predetermined variable fee, the final passback amount is not known when the redemption is submitted. The market maker must estimate the likely execution difference, account for market volatility, and incorporate that uncertainty into its pricing.

In other words, a passback can provide greater precision for the fund while introducing additional uncertainty for the market maker.

That uncertainty also has a cost.

When the 2% Cap Becomes Important

Many ETF prospectuses and Statements of Additional Information establish a maximum redemption transaction fee of 2% of the value of the redeemed shares. Depending on the fund's specific arrangements, that limit can restrict how much of an execution shortfall may be recovered from the redeeming AP.

Consider what happened in China during the early days of COVID-19.

Mainland Chinese equity markets remained closed for an extended Lunar New Year holiday. When trading resumed in February 2020, markets opened sharply lower, with many individual stocks falling approximately 10%.

Now consider a hypothetical ETF that accepted a $10 million cash redemption based on a NAV that had not adequately reflected the decline in the underlying market.

If the securities were subsequently sold for only $9 million, the execution shortfall would be $1 million, or 10%.

Assuming the fund's applicable redemption transaction charges were capped at 2%, and no other mechanism allowed recovery of the excess, the fund could recover $200,000 from the redeeming AP.

The remaining $800,000, representing 8% of the redemption value, could ultimately be borne by the fund and its remaining shareholders.

This is a hypothetical example, not a description of an actual ETF redemption during that period. It illustrates why even an actual-cost passback may not guarantee complete shareholder protection during an extreme market dislocation.

Proper fair-value pricing can substantially reduce this risk by adjusting NAV to reflect market developments while underlying markets are closed. However, it cannot guarantee the prices at which securities will trade when those markets reopen.

Fair-value NAV is an important subject in its own right, and one I plan to explore in a future article.

The Secondary-Market Connection

Creation and redemption mechanics do not operate independently of secondary-market liquidity.

Market makers evaluate the costs of creating or redeeming ETF shares when deciding how aggressively they can quote the fund.

A variable fee that is unnecessarily high can increase the cost of accessing the primary market, potentially contributing to wider bid-ask spreads.

An actual-cost passback may avoid charging more than the realized execution difference, but uncertainty around the final amount can also influence market-maker pricing.

These considerations become particularly relevant for international ETFs, where underlying markets may be closed during U.S. trading hours and cash-in-lieu transactions may be necessary.

For U.S. equity ETFs, where underlying markets are generally open and execution costs are relatively predictable, a reasonable predetermined variable fee may be the more practical choice.

For international equity ETFs, where different trading hours, currencies, and local-market conditions introduce greater uncertainty, actual-cost passbacks may offer better protection for existing shareholders.

However, the international ETF market has evolved. As market makers have expanded their direct trading capabilities into a growing number of countries, they have gained greater flexibility in how they execute and settle underlying securities. In some markets, this has reduced the need for cash-in-lieu arrangements, although local-market restrictions and operational considerations can still make passbacks useful.

The lowest published transaction fee is not automatically the best arrangement, and a predictable fee is not necessarily the most protective for shareholders.

The objective is to establish a process that appropriately allocates transaction costs while allowing market makers to provide competitive liquidity.

The Issuer's Responsibility

ETF issuers should understand how their funds handle cash creations and redemptions, how transaction charges are calculated, and what happens when actual costs differ from expectations.

These decisions should not be viewed solely as operational details delegated to service providers.

They are part of the broader ETF capital markets framework and can influence shareholder protection, market-maker participation, and secondary-market trading costs.

Variable fees offer certainty. Actual-cost passbacks offer greater alignment with realized execution costs. Neither eliminates risk.

The real question for ETF issuers is not simply which approach costs less. It is which approach best protects existing shareholders without unnecessarily increasing the cost of trading their ETF.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.