Mutual Fund and ETF Audits: Key Differences

Posted by Jim Kaiser on Apr 15, 2021 10:26:00 AM

Given that mutual funds and ETFs are both types of regulated investment companies with audits subject to the requirements of the Public Company Accounting Oversight Board, there are certainly many similarities in the audit process for both. However, there are some key differences to note, particularly in the areas of:

  • Realized Gain(Loss) Testing
  • Shareholder Transactions
  • Creation/Redemption Transaction Fees
  • Custom Basket Transactions
  • Total Return

Realized Gain(Loss) Testing

For mutual funds, investment trades are transacted primarily in cash. The cost relief methodology typically utilized is “Specific Identification,” with a default to “High Cost.” Auditors test a sample of gains/(losses) for proper cost relief.

ETFs utilize a two-pronged cost relief approach.

Many investment trades in an ETF are transacted in-kind. The gains realized on securities sold in-kind are not taxable, and there is not a requirement to distribute these gains to shareholders. Cost relief on in-kind transactions should be set at “Low Cost” to maximize tax-free gains.Untitled design (39)

ETFs can also transact in cash, just like a mutual fund. In these cases, the cost relief methodology for these cash transactions should be the same as for mutual funds.

In an ETF audit, in-kind gains(losses) are segregated from gains(losses) on cash transactions. A sample of each is tested to ensure proper cost relief.

Shareholder Transactions

With a mutual fund, auditors test a sample of shareholder transactions during the year to ensure the shares were purchased/redeemed at the proper NAV. Auditors will also confirm shares outstanding with the Transfer Agent.

In an ETF audit, the procedures noted above for mutual funds are also performed.

Additionally, as ETF shareholders primarily contribute and receive securities in-kind in exchange for fund shares, additional testing of these transactions is performed.

For a sample of creation and redemption transactions, the values of the securities contributed/received in-kind are tested to ensure proper consideration was paid/received in exchange for fund shares.

Receipt of all securities transacted in-kind for the selected creation/redemption transactions are traced to their receipt/disbursement by the custodian.

Creation/Redemption Transaction Fees- ETFs Only

ETFs may charge two types of transaction fees on creation/redemption activities.

One is a fixed charge to offset custodian fees charged to transfer securities in-kind. Accounting for this fee can vary depending on the form of the payment ( e.g. directly to the custodian vs. to the fund).

ETFs also may charge a variable fee for creations in cash. This variable charge is meant to compensate the fund for transactional costs and fluctuating market values for securities the fund must purchase due to the cash creation.

Industry practice is to treat these charges as an addition to paid in capital, which can result in interesting scenarios when comparing a fund’s Financial Highlights to the fund’s Statement of Operations.

Audit procedures in this scenario involve reviewing transactional fees to ensure appropriate accounting based on the type of fee and the form of the payment.

Custom Basket Transactions- ETFs Only

ETFs are designed to be tax efficient vehicles due to the in-kind mechanism. To enhance tax efficiency, most ETFs engage in “custom basket” transactions around rebalance dates.

In a custom basket transaction, rather than buy and sell securities to rebalance the portfolio, the fund will work with an Authorized Participant (“AP”) to place both a creation order and a redemption order.

To satisfy the redemption order, the fund will transfer in-kind to the AP the securities it needs to dispose of as part of the rebalance.

To satisfy the creation order, the AP will transfer in-kind the securities the fund needs to purchase as part of the rebalance, or more likely, cash which the fund then uses to purchase the securities needed for the rebalance.

This custom basket transaction creates tax risk as the Internal Revenue Service could review the transaction and apply the Step Doctrine for the Substance Over Form Doctrine to collapse the two transactions into one, thereby negating the tax benefits.

To mitigate this risk, industry practice is to have a 24-hour period pass between the two legs of the transaction.

Related audit procedures involve reviewing all activity to identify potential custom basket transactions and ensuring each leg was not executed on the same day.

Total Return

In a mutual fund audit, Total Return is recomputed using the following assumptions:

  • The investment is made at the NAV at the beginning of the period
  • Distributions are reinvested at the NAV on the ex-dividend date
  • The investment is redeemed at the NAV at the end of the reporting period

In an ETF audit, two total returns may be presented:

  • NAV Total Return
  • Market Value Total Return

In an ETF audit, NAV Total Return is recomputed using the same assumptions used in a mutual fund Total Return.

Market Value Total Return is recomputed using the following assumptions:

  • The investment is made at the market price at the beginning of the period
  • Distributions are reinvested at the NAV on the ex-dividend date
  • The investment is redeemed at the market price at the end of the reporting period

It is interesting to note that no investor could ever earn either of these Total Return figures unless the NAV is equal to the market price on all relevant dates.

Please reach out to us with any questions about mutual fund and ETF audits.

Contact Us