Brett Eichenberger
Auditing ETFs: What Investors Don't See
Brett Eichenberger is an audit partner at Cohen & Co., a top 50 accounting firm in the United States that has built deep specialization in the investment management industry. The firm audits a substantial number of ETFs, including products from some of the largest issuers in the market. Brett has spent his career focused on alternative investments and registered products, and he brings a unique perspective on the operational backbone that makes ETFs actually work. On this episode of Behind the Ticker, Brett joins Brad to talk about what goes on behind the scenes in the ETF industry, from fund auditing to the operational details that most investors never think about.
The Plumbing Behind Every ETF
Brett explains that Cohen & Co. sits at the intersection of audit and advisory for investment products. The firm audits hundreds of funds, which gives them a bird's-eye view of industry trends and operational challenges across the entire ETF ecosystem. He describes the audit of an ETF as fundamentally different from auditing a traditional company. The key areas of focus include NAV calculation accuracy, compliance with investment restrictions, proper valuation of holdings (especially for active ETFs with less liquid positions), and making sure the creation/redemption process is functioning correctly.
For ETF issuers, particularly newer and smaller ones, Brett emphasizes that choosing the right service providers from the start is critical. Fund accountants, administrators, custodians, and auditors all need to work together seamlessly. A breakdown in any one of these relationships can create problems that ripple through the entire operation. He's seen cases where fund accounting errors caused NAV discrepancies that took significant time and resources to unwind. Getting the infrastructure right from day one isn't glamorous, but it's what separates firms that scale successfully from those that struggle with operational issues that compound over time.
Active ETFs and the Valuation Challenge
The explosion of active ETFs has created new complexity in the audit world. Passive index funds have straightforward valuation processes because they hold securities priced on public exchanges. Active ETFs, particularly those holding less liquid instruments like small-cap stocks, fixed income securities, bank loans, or derivatives, require significantly more judgment in valuation. Brett notes that the auditor's job is to make sure those valuations are reasonable and that the fund's pricing policies are being followed consistently across all market conditions.
He describes a hierarchy of valuation complexity: Level 1 assets are priced from active markets (public equities), Level 2 assets use observable inputs but aren't directly quoted (many bonds and derivatives), and Level 3 assets require significant judgment (illiquid structured products or thinly traded securities). As ETFs push into more exotic strategies, the proportion of Level 2 and Level 3 assets increases, which means more audit work and more risk of pricing errors that could affect all shareholders. Cohen & Co. helps ETF issuers think through their valuation policies before launch, not just after problems arise. The goal is to build a framework that works across normal and stressed market conditions.
Industry Growth from the Auditor's Seat
From Cohen & Co.'s vantage point, the ETF industry's growth has been remarkable and is accelerating. Brett points out that the firm has seen a steady increase in new ETF launches year over year, with active products making up a growing share of total launches. He highlights several trends reshaping the audit space. The mutual fund to ETF conversion wave has brought established strategies into the ETF wrapper, creating audit work that involves transitioning entire fund complexes with their associated track records and tax histories. Defined outcome and structured products have added complexity that requires specialized audit expertise in options and derivatives valuation. And the entry of crypto-related products, including spot Bitcoin ETFs, has forced the audit profession to develop entirely new frameworks for digital asset custody verification and valuation.
Brad and Brett discussed the importance of choosing service providers that specialize in investment products rather than going with a generalist firm. Brett makes the case that a firm auditing ETFs needs deep familiarity with 40-Act regulation, custody requirements, and the unique mechanics of creation and redemption. A generalist auditor might technically be qualified but would miss the nuances that can create regulatory or operational risk down the road. Cohen & Co.'s concentration in the investment management space means their auditors see patterns across hundreds of funds, which helps them identify emerging issues early and share best practices across their client base.
Key Takeaways
- Cohen & Co. is a top 50 U.S. accounting firm that audits hundreds of ETFs and investment funds, with deep specialization in registered investment products and alternatives.
- Active ETFs holding less liquid instruments create valuation complexity across Level 1, 2, and 3 asset classifications that requires significantly more audit judgment than passive index funds.
- Getting the right service providers (fund accountant, administrator, custodian, auditor) aligned from day one is critical. Infrastructure breakdowns cascade through the entire operation.
- The mutual fund to ETF conversion wave, defined outcome products, and crypto ETFs are all creating new audit requirements that demand specialized expertise.
- An auditor with deep 40-Act and ETF-specific experience will catch nuances in creation/redemption mechanics, custody, and regulatory compliance that generalist firms miss.
Listen to the full conversation on Spotify, Apple Podcasts, or YouTube.
Full Transcript
4,758 wordsMachine transcribed from Brad Roth's conversation with Brett Eichenberger, with speakers identified automatically. Timestamps link to that moment on YouTube. Lightly cleaned, otherwise unedited.
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Welcome to Behind the Ticker. Today we have on Brett Eichenberger. He is from Conan Company and we are talking about auditing and accounting and the important function that it has in the ETF ecosystem. It's often sometimes overlooked as a important function, but it is something that gives shareholders a lot of trust in the products that they are buying. So without further ado, please enjoy this episode with Mr. Brett Eichenberger.
Hey Brett, welcome to the show. Thanks for having me. Appreciate being here today.
So before we get started, why don't you give everybody a bit about your background and your current role at Conan Company?
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Great. Again, thanks for having me here, Brett Eichenberger. Based out of our Cleveland office, Conan Company is about an 800-person firm, have offices in 13 different states, been working in the mutual fund, ETF, closed-end interval fund space now for over 19 years. Started my career as an intern at Conan Company and kind of worked my way up building the business to where we're at today. Conan Company today audits over 1,800 registered funds. So that's mutual funds, ETFs, closed-end funds, interval funds, and collective investment trusts. That puts us as the fourth largest auditor of registered funds in the country and actually number two in the ETF space.
So if you look at that kind of as a whole, we look at not only the number of funds that we audit, but the number of advisors we work with. And if you look at the number of unique advisors we work with, we actually work with more advisors than any other firm in the country. So see a lot of different products in this space.
I'm sure you guys do. You're our auditor, so thank you for all the work that you do for us. But I always like to ask somebody before we get into the nitty-gritty of the world of auditing, any hobbies? What do you like to do when you're not working?
Good question. I have three girls, so they keep me pretty busy, 14, 12, and 6. If I'm not on the sports field during the weekend, I'm usually working out, running, spending time outdoors, working in the yard, doing anything to keep my mind busy. The other thing I like to do is ski. Me and my wife and the kids enjoy getting out on the slopes in the winter. So that's one of our favorite hobbies.
Yeah, that's great. We try to do the same thing. I about broke my back trying to do a ski with a two-year-old last year, but he's getting there. But my daughter's pretty good at it. So at least I don't have to – I still have to watch her, but I'm hoping he's a little bit – his ankles are a little stronger, so I'm not bent over in an L shape for two hours trying to get him down the slope. Yeah, but it'll pay off in the end.
You start them young, and next thing they're six years old going down the hill by themselves. So there's a payoff.
Yeah, my whole thing in my head is if he can ski, he can skate. So I want to get him on hockey skates as soon as possible. So all right, let's talk about auditing. It is a very important subject. People kind of look at it as something that might be a nuisance to them or something that's bad. But really, it's a really, really important aspect of the ETF space. I think it helps with making sure everything in the space runs very, very smoothly. So first, how does the auditing process for ETFs differ from, let's say, traditional mutual funds or other financial products?
It is really important for the public trust when you think about our capital markets. Obviously, I'm biased, but you're right. The audit process is important. When you look at the audit of an investment company, it's very specific. And we could talk about ETFs, mutual funds, but there's very nuanced rules in auditing these types of products. The number one most important piece is really the valuation of the securities that underline the portfolio. That's 95% of the assets in the fund are made up of securities. So it's really important that we understand the valuation policies and procedures of the investment company and making sure that they're following those for different types of securities. That's where we spend a lot of our time.
When you think about some of the differences between ETFs and mutual funds, there are some nuances. ETFs report out both total return on a NAV basis, net asset value basis, but also because they're traded on the secondary markets, we also report out market value total return. So that's a nuance similar to like a closed-end fund that you'd see in an ETF versus a mutual fund. Some of the other differences that you'll see is the capital activity process. In a mutual fund, you have individuals buying and selling shares directly with the fund at NAV. Well, you still have NAV as the basis for buying and selling of the ETF, but they're done via creation units.
And these are with authorized participants, not individual shareholders. So that's a big difference. And that changes the audit aspects of the capital activity of the ETF and how we look at that. Because generally, these are in-kind as well in an ETF versus a mutual fund. So you've got securities coming in-kind, securities going out in-kind associated with the capital activity. So you really look at the capital activity along with the portfolio basket as well, because that's how shares are created and redeemed within an ETF structure. Another kind of nuance that you'll have with an ETF, different from a mutual fund, is mutual funds generally have multiple classes. ETFs don't.
They usually have just one class. They also, ETFs don't have like a dividend reinvestment into the actual fund. The dividends just get paid out to the shareholders. There's no mechanism for reinvesting directly into the ETFs. That's a little bit of a nuance as well.
So when we look at some of the accounting challenges with ETFs, what are some of the most common accounting challenges? And really, how do you address them?
So the accounting challenges, number one, as I mentioned earlier, is around valuation. So making sure that whether you're holding equities or bonds or derivatives, whether it's options or swaps or FX contracts or even total return swaps, that there's a solid valuation policies and procedures in place and a good methodology for valuing each of those securities. A lot of times we're using independent pricing services, but you want to make sure that you have good due diligence over those pricing services, that it's the right pricing service for that type of security. And that's a really important piece of the portfolio on a day-to-day basis.
When you talk about accounting challenges as well, when I think of a fixed income portfolio, amortization and accretion and the way that that gets accounted for when you're buying bonds at a discount, which we've seen over the last couple of years, which you haven't seen in a while, versus buying bonds at a premium. And just the different book and tax rules associated with how the fund accounting systems report that amortization and accretion. So that's an area we spend a lot of time on. Complex corporate actions. If you hold an international portfolio, you're going to see a number of different corporate actions throughout the year and then how those get reported both from a gap perspective and a tax perspective as well is really important because that could impact how you distribute out distributions to your shareholders.
So that's an area we spend a lot of time on too.
No, that's great. And so I think, I touched on this earlier, but the audit process really kind of ensures the transparency and the regulatory compliance, which gives people the trust in these products. So can you walk us through your role as an ETF auditor, ensuring that transparency and strict regulatory compliance?
We're not only independently valuing all the positions held in the portfolio. We're also confirming all of those positions that they're held in custody, that they're the assets of the fund. We're also looking at, as you mentioned, some of the regulatory compliance. So you're looking at, for Rick, you're looking at subchapter M testing. So making sure that the fund has qualified income. You have to have 90% of your income from qualified income. That's investments in securities. You can't have direct real estate or other non-qualified income coming into the fund. So that's important for transparency. We're also looking at to make sure that the fund's properly diversified from a subchapter M.
Some funds are diversified for SEC purposes, which means more than 75% of their assets are in less than 5% securities versus a non-diversified fund, which would be more at 50%. And so we're looking at that also testing on a quarterly basis. That's a quarterly test that's done by not only the administrators that oversee on a daily basis the ETFs, but also independently by the auditors as well.
Well, I think, too, there's another element of that as well, that not only is it just coming down to the numbers, but it also comes down to when I sit down with your auditing team, just speaking from experience, they also want to know different facets of the operational side of the business as well. That's just as important, is it not?
It is. So we get an understanding both of the control environment, not only at your third-party administrator from a fund accounting perspective, TA perspective, but also the advisor. What are your controls in place to oversee the portfolio on a daily basis? Are you reconciling all the positions on a daily basis? How are you valuing those securities? How are you looking at corporate actions? How are you looking at securities that may be impaired from a valuation perspective or unusual income that you might receive from a particular investment? How are your controls in place to oversee that on a daily basis? Because every day we're striking an app for an investment company. So that's an important process as well.
Yeah. And, too, I think it really, when you start to look at some of these things, really takes a firm that might not be super institutionalized in nature and almost forces that institutionalization to make sure that, like, you're doing the right things on a daily basis. Because the worst thing that can happen to you, in my opinion, outside of blowing up a portfolio, would be a bad audit report.
Yeah, you don't want that. There's things that we'd have to disclose associated with that. You could go into a scenario where you'd have a material weakness internal controls if there was a problem within the audit of the financial statement. So it's an important piece. And with the ETF structure as well, when you think about it, different shops are set up for trading as well. Some do the trading themselves. Some outsource the trading. So you may be the investment advisor, but you may have a sub-advisor that's doing the trading of the portfolio. So then the question becomes, what are you doing as the advisor to oversee that sub-advisor to make sure they're doing all their proper reconciliations as well?
So there's a – the thing about the ETF industry, though, is a really good ecosystem and a lot of checks and balances in place to make sure things are done properly, not only from your administrator, your sub-advisor, the advisor, but also the custodian as well and your distributor.
So let's talk about the recent rise of thematic niche and active. So these have to pose like some unique challenges from an accounting and auditing perspective outside of the traditional passive products. So kind of what goes into that audit process that might be a little bit more unique?
We've seen a lot of products that are investing maybe in Bitcoin futures. We see products that are investing in maybe complex derivatives. With those types of products, there's more work that goes in on the front end from the advisor standpoint with their legal counsel. If you're going to have non-qualified income in your portfolio, do you need a blocker, a controlled foreign corporation blocker? That's put in place to invest in certain securities, whether that be Bitcoin because it's not considered a security or a commodity. So we see if you're in a commodity ETF and you want exposure to different futures contracts, you'd have to do those within your controlled foreign corporation.
And what that does, you can only do 25% of the fund in that, but it allows that income to be qualified income when it gets paid from the CFC up into the parent fund. So we'll see that structure put in place with some of the other things that we see. I mentioned earlier about Subchapter M, some of these more niche products, making sure you have proper diversification, whether you're investing in certain options or swaps, total return swaps or credit default swaps. The collateral requirements associated with investing in swaps. it's different between each broker, proper tri-party agreements in place between your broker and your custodian are really important from a reconciliation standpoint, moving collateral back and forth.
So there's some operational challenges with those types of products. And the other thing we see is if you're in a niche product, something maybe that has some foreign investments in it, some of those names that you might be investing in could be less liquid or less traded. So just monitoring that to make sure that, you have a proper valuation for those securities and that you're monitoring the liquidity underneath those individual positions as well can be a challenge too.
Well, let's move to the other side of the table with, you mentioned, non-traded securities and low liquidity. So let's talk about times of market volatility, right? So how do you ensure that ETFs are, adequately priced during those high volatile periods?
Well, a lot of ETFs, the one nice thing about ETFs is that most of them are in fairly liquid investments. And open-end funds are also, restricted to so many percent of their assets being in non-liquid investments, 15%. So that's a good start for ETFs. Generally, when you're putting together an ETF, you're going to talk to your market makers. You're going to want to make sure the names in your portfolio are liquid. So when it comes to ETFs, overall valuation's generally better. When you're talking about periods of market volatility, though, you want to make sure your primary pricing service that you oversee that to make sure that the prices you're getting on those securities are proper. You may even want to have a secondary pricing source in times of market volatility as a second check to see if there's a difference between those two pricing services.
And if you come to the conclusion that you might have to do a price challenge or price override, you want to make sure you have really good documentation for those reasons. But that's what we see. And what we also see in periods of high market volatility is that when you're talking about this ETF trading all day long, priced all day long on an exchange versus a mutual fund that prices once a day, you're actually getting potentially more price discovery in an ETF product than some other products. So that's an interesting nuance to ETFs.
So we're seeing firms of all types adopt technology, and we're seeing it happen quite rapidly. So what role does technology play right now in the auditing and accounting process? And how do you see that maybe evolving in the future? And yes, this is kind of an AI question.
Well, it's moving quickly. I don't know if the standards will keep up with the change in technology, but we're already implementing it in our audit process as we sit today and have been for the last couple of years. So just to give you some examples, when you think about auditing, it used to be more done on a sample basis, right? You select samples of transactions that you're going to test. And sampling has its faults because you could be missing an important piece. So what we're trying to go towards is more of a 100% testing. So you think about all the dividends that the fund receives during the year. We use our data team to go and independently pull those rates from an independent source and test 100% of that activity.
That's what we're working towards. When you think about fixed income securities and interest income that is earned by those underlying bonds, being able to test near 100% of the income that's coming from those underlying bonds is a better audit outcome than sampling as well. And we're working on that towards realized gain losses as well. Being able to look at the activity that comes from the underlying fund accounting records and not only look at maybe the trade ticket for the trade that took place, but also pulling underlying pricing services to see what that security was trading at on the day that you sold it. Did it meet the high and low of that day? And then also what you paid for it and looking at the high and low of that day to see if there are any exceptions in that testing.
And we're also using a new technology that looks at the financial statements in a PDF format. And what we used to do is, you'd have your 10 key and your, we call it footing. auditors love to foot your foot, your entire SOI and you tie it to the balance sheet. And then you foot the balance sheet and tie it to the statement of changes in net assets. We have some new technology that looks at that PDF and automatically sums all of those columns and shows you the formulas that are in, in there and comes up with what they should be. Not only does it do that, but you could get a new draft and it's still looking at that same data to see if it changed from the previous draft and do all those numbers that need to tick and tie it and use another audit term between the statements match.
So we're using some technology like that. We're also using that technology. When you think about, we select a number of transactions throughout the year for purchases and sales of securities. We're able to have that Excel document look at the underlying, whether it's a trade ticket or electronic trade ticket and see that it matches and then embed that underlying documentation within the audit file. So some of those things that were taking us a long time before, we can do instantly. And that's where we're working towards. We have to embrace the technology and we have to continue to get a higher quality audit. There's also a new PCOB auditing standard out there, QC1000, that looks at your firm's quality control policies and procedures in place.
So we're going to be implementing that as well. And that's kind of the oversight of the entire audit process and the accounting firm and how they go about auditing investment companies or really any type of company. QC1000 won't be specific for investment companies, but that's some of the stuff we're working on.
You brought me back to my childhood there for a minute. My dad is still a CPA and accountant or auditor and the 10 key, but he had the adding machine and I can still hear the sound of that thing in my dining room during tax season. But I got pretty good at it. And I still, I don't, the downside of the Mac is you don't have your number pad. So I still hook a number pad into my Mac because I like to have it as well. But gosh, him and that adding machine, I can still hear it today.
We used to put together a firm Olympics event and one of the, one of the contests was the 10 key race. So it was a whole page of mathematical numbers that you had to foot and who was able to do it the fastest and then pull the tape off of the machine to show that you had the backup for it. You got to tie it. And then you got to tape it and tie it. When I first started, it's kind of crazy. It doesn't seem like that long ago, but it's over 19 years ago. When I first joined the firm, we had certain individuals at the firm that were printing out the financial statements, footing them and attaching that, that tape to the actual financial statements.
Well, that's a very accounting office thing to do is to have a 10 key race. So I love it. Let's get back into the ETF space. Just a couple more things. really, what are some of these red flags and key risks that you guys are looking for when you're kind of looking at the ETF structure or, our financials?
Yeah, we're looking at a number of things. there's some risks and some of the nuances of in-kind transactions. So making sure those are reported properly, both for tax and book purposes. So, breaking out the in-kind gain loss within the financial statements. Portfolio turnover for ETFs is a little bit unique because in-kind transactions doesn't affect the portfolio turnover ratio. So making sure the in-kind transactions are pulled out from that. When you have transaction fees associated with certain creations and redemptions, sometimes those are, if it's a cash in lieu or if it's certain securities that you can't do in-kind, then there's a fee generally associated with that that goes into the fund, that transaction fee to cover the costs of buying and selling those positions.
And that shows up in a couple of different places, one on the statement of changes and one on the financial highlights. So we see that. And when you think about the valuation of derivatives, really important. And also, there are certain securities that you can't do in-kind. So maybe international securities are one of those that you can't do in-kind because of the way those trade. And certain derivative transactions, certain options you can do in-kind, certain ones you can't. And so just being cognizant of all those kind of nuances, when you think about the ETF structure. The other one we see is for international funds, your valuation policy. Some funds might use what they call a fair value factor, which takes into account kind of the market movement between the close of the U.S. and other markets.
And some may not. So neither one is incorrect. But just some nuances of kind of the policies and procedures of an ETF, some things to look out for.
So what's on the horizon here? What kind of trends or regulatory changes? I'm sure you guys really follow those quite closely. Could you foresee that would have like a significant impact on ETF accounting maybe in the next couple of years?
So there's nothing – I mentioned the QC1000, making sure that standards keep up with technology. There's nothing too specific, to be honest with you, on the standards front that will affect ETFs. Things that could change is if we see more niche products in Bitcoin. So those are generally in 33-act fund products, though, the grant or trust structure for funds that hold Bitcoin directly. But we'll also see derivative products based on those. So when you think about ETF, it could start investing in another ETF that has exposure to Bitcoin.
Or it could invest directly into the 33-act product that holds Bitcoin. So I think I start watching for some of those, how those affect your underlying fund is what kind of exposure you could potentially have from Bitcoin being, say, a fund-to-fund structure that you don't hold it directly in your fund, but you have exposure to it. So those are some of the things to think about as we think about Ethereum coming to market and other currencies coming to market as well. So that's on the horizon too. But I think we're going to continue to see more transparency in the ETF product structure. The other thing we could potentially see on the horizon is an ETF share class of mutual funds.
So it's when, obviously, the Vanguard's had that for many, many years now, over 20 years, where we've seen a lot of exemptive reliefs filed for this. And they're filing it for their mutual fund that could have an ETF share class. And we're also seeing it on the other side where you have an ETF like yours that could then potentially offer a mutual fund share class. Got it.
So I guess the last thing here is how it's very difficult as a new issuer or as somebody coming to market to pick who their service providers are going to be. So there are definitely people listening to this right now that are thinking about launching an ETF, their money manager. How should they be thinking about evaluating and choosing the right auditing firm?
It's something you should spend some time on understanding. What are the qualifications of that firm? How long have they been in that marketplace? Do they have similar clients to me? I'm launching a strategy that's going to be an option overlay base. What other clients do you have in that marketplace? I'm going to do international fixed income securities. Okay. Can you tell us about some of the clients that you have in this space and your experience? Because I think that's really important from their expertise level to make sure that they're qualified to make sure that they can help catch some issues that come up. Whether it's on the gap side that we talked about earlier on some of those items or on the tax side as well.
And making sure that you have a provider that understands the niche nuances of the industry, both from an investment company itself, but also the ETF wrapper are really important. And tax is really important, obviously, for ETFs as well. So making sure that you understand what tax partner would be on the job with you. What type of interaction would you have with them? What are their experience with working with your other service providers? Do they have experience working with your sub-advisor? Do they have experience working with your administrator, your custodian, all of that entire ETF ecosystem, the market makers, the exchanges? What's their experience and familiarity level with those industry individuals as well?
Well, Brett, I really appreciate you spending some time with me here. We're live at the Ultimate Client Summit. So again, thank you very much. Before I let you go, where can people learn more about you and Cohen & Company?
So you can learn more about Cohen & Company at CohenCPA.com. You can also sign up for our quarterly newsletter that we have related specifically to the investment company industry. You can find me on LinkedIn and you can also find me on our website as the market leader of our registered funds practice.
Again, Brett, thank you so much. Thank you.
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