Voting rights refer to the power bestowed on shareholders of an organization that gives those shareholders the ability to vote on matters concerning the organization. The voting power mainly depends on the number of shares the shareholder owns in the company. In the case of ETFs containing an index consisting of different shares and ETF holders, do they have this voting right?
ETFs, otherwise known as ETF providers, can have access to voting rights if they own any shares within a company. On the other hand, ETF holders do not have voting rights because they do not own shares with the company. Instead, the shares belong to the ETF provider or ETF.
There are different ways that ETFs can operate, which in turn affect their ability to vote. There are synthetic ETFs and physically replicating ETFs; the mode of operation of these ETFs determines whether or not they will be granted voting rights. We’ll be looking into these ETFs in more detail below.
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The Difference Between ETFs (ETF Providers) and ETF Holders
ETF holders simply refer to people who are invested in ETFs or ETF providers. It’s important to note that ETFs and ETF providers are the same and can be used as two interchangeable terms.
ETF holders, on the other hand, refer to those that have investments under ETFs. However, ETF holders do not have voting rights because they don’t own any physical securities; the ETF providers own them.
The ETF provider purchases the shares or security from the company or companies, and the ETF holder buys into the ETF to further simplify it. Hence, the voting power falls to the ETF.
However, the ETF can make decisions based on the inclinations of the ETF holders.
Understanding ETFs and Voting Rights
For an individual or body to possess voting rights in an organization, it’s required that they own part of the shares in that company. In other, simpler terms, they must be shareholders. Furthermore, the amount of voting power they can exercise is dependent on the number of shares that they own.
The reason mentioned above is the main reason why ETF holders don’t have access to the voting rights while ETFs or ETF providers do.
Also, not all ETFs have voting rights and this depends on the way the ETF operates, which leads us to discuss more about ETFs and the way they operate in the subtopics below.
Types of ETFs
There are two types of ETFs: synthetic ETFs and physically replicating ETFs. Each of these types has a unique mode of operation that affects their ability to vote.
Synthetic ETFs don’t have voting power; this is for the simple reason that they don’t own any shares in the company. They don’t buy the shares made available to ETF holders. Instead, they use alternative methods and replicate the returns on indices with the aid of financial engineering.
In synthetic ETF, instead of tracking the index by buying the physical stock or shares, they use replicative methods, such as derivatives and swaps.
This means that they don’t own any physical security with the companies. Thus, ETFs do not have access to voting rights, since you need to be a shareholder. To be a shareholder, you need to own a portion of the physical securities in that organization.
When compared to the other forms or traditional type of ETF, this synthetic ETF offers more risk than reward. It leaves the investors open to larger chances of a loss and can be very hard to control in terms of risk management and control.
Physically Replicating ETFs
Physically replicating ETFs are not all that different from synthetic ETFs in terms of functionality. However, they do differ in their mode of operation or structure. While synthetic ETFs track indexes using derivatives and swaps, physically replicating ETFs track their different indexes by purchasing shares from their companies of interest.
Physically replicating ETFs buy physical securities from the companies; hence, they possess shares with the company and also have the right to vote on matters that affect the interest of their shares.
Can ETFs Lose Their Voting Rights?
ETFs, more specifically – physically replicating ETFs, comprise different types of shares from different companies by sampling the index of the company and trying to replicate it to optimize profit. Two things can cause a physically replicating ETF to lose its voting right: an optimized methodology or lending out securities to a third party.
Application of an Optimized Methodology
The introduction of an optimized methodology can cause the ETF provider to lose voting rights in some companies. How? As the name suggests, an optimized method is a sampling method that tries to bring out the best form of securities available in an index or indexes and targets investments towards those.
By doing this, the optimized methodology removes investments from companies that are not deemed fit, and hence the ETF also loses the voting rights that belong to the company.
The optimized methodology is usually adopted to increase the potential returns on investment and also to reduce risk. Companies with a higher rate of returns are given more priority, and investments are directed towards them.
Lending out Securities to Third Parties
This is another way ETFs can lose their voting rights. It‘s possible for shares and other forms of physical securities to be loaned out to a third party. The process is not too different from borrowing money from the bank; it involves two parties, collateral, and interest.
In a situation where an ETF loans out their shares, they immediately lose their voting rights and ownership of that security pending the time that it is loaned out.
The logic behind this is straightforward, the ETF has given out their portion of shares for an amount of money, so for the duration of the loan, the ETF no longer owns the shares, and instead, it now temporarily belongs to the borrower. Therefore, the borrower assumes the voting rights for that time and can exercise those rights, while the ETF no longer has the right to vote during that period.
It’s essential to mention that loaning out securities is on an open system, meaning there is no particular time frame that the loan lasts. The loaned security can be retrieved whenever the lender sees fit.
If the lender requests for the loaned security, it is not a must for the party that loaned the security to return the security in its exact form. They can return the loaned security in monetary terms or give something of equivalent worth that the lender can use to purchase the security back.
Furthermore, if the party that borrows the security is not returning the security exactly, whatever mode of payment they use must be worth the current market value of the amount of security that was borrowed. Therefore, the loaner can use the method of payment to buy back the exact amount of security that was borrowed.
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From research, we’ve differentiated between an ETF and an ETF Holder and how their voting rights are affected. We’ve also established that for a party to enjoy voting rights, they must own physical securities in that company.
ETF holders don’t have any voting rights with the companies, but they can indirectly affect voting through their invested ETFs.
Also, not all ETFs have voting rights, and there are two distinct types:
- Synthetic ETFs don’t have voting rights because they don’t own shares with the companies.
- Physically replicated ETFs have voting rights because they own physical securities with the company.
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