So you want to launch an ETF? A lot of people are surprised that there's no one way to do it. There are as many different operating models as there are ETF sponsors—you can outsource or take in-house just about any function.
ETFs at the core are open-ended mutual funds, and there are more similarities than differences between them. But the differences are significant enough that you often see the ETF management business broken out as a separate and dedicated division within the larger financial organization, or you at least find ETF-specific personnel located within the various functional units. Providers of fund services including custody, fund administration, distributor, listing exchange, index provider and other services also tend to have personnel, if not whole business units, dedicated to ETFs.
"Who will buy my ETF and why?" is probably the most important question you can ask yourself. This is certainly the issue that I see most of my clients get hung up on. One observation I can share is that if you think people will buy it simply because it's listed for trading on a national exchange and available to trade through any broker, you'll probably be disappointed. Typically, the key issues here are identifying who your target market is; the most effective way to reach that market; and where your pricing needs to be.
But having the idea isn't enough. Following are some key issues to address on the road to your own ETF launch.
Step 1: Build The Sales Pipeline
Oftentimes, asset management organizations that have existing sales channels struggle with the best way to integrate ETF sales. Do you use the same salespeople or hire new ones? If you're a small startup without any existing sales resources, what do you do?
One of the unique aspects of ETFs is that they trade like stocks in the secondary market. Closed-end funds also trade this way, but the revolutionary thing about the ETF is that it gets special exemptive relief from the SEC to allow for large institutional investors called authorized participants (APs) to create and redeem new shares directly with the fund in exchange for baskets of the underlying portfolio securities. This primary market activity allows for an arbitrage mechanism to force secondary market pricing to be in line with the fund's NAV. A standard knock on closed-end funds is that there's no arbitrage, so you can experience large premiums and discounts in market pricing relative to the fund's NAV. ETFs address this concern with the creation/redemption mechanism.
Why is this important for you, the nascent ETF sponsor? Because the sponsors who succeed incorporate this part of the business into their distribution strategy and have resources dedicated to APs, market makers and listing exchanges. Think of selling to the end-investor as creating demand for liquidity, and selling to the capital markets crowd as creating supply for that liquidity.
Step 2: Cutting Through The Red Tape
So you have a product idea and a distribution strategy. What else do you need?
Much of the corporate governance structure looks the same for ETFs as it does for mutual funds. You'll need a trust, an advisor and a board of directors. The board will likely hire a number of service providers, such as custody, fund administration, transfer agency, distributor, audit and more. Just a few years ago, this meant you either used a trust and board you already had for mutual funds or you created new ones. If you consider this the "build" option, you now have to consider the "buy" or "rent" options as well. With a large number of small sponsors as well as a number of sponsors who have started the regulatory process, there are frequently shops that are explicitly for sale or would entertain a discussion. There are also some shops that are offering an ETF platform model where you use their trust, advisor and board for a fee, and they will help put together the other pieces.
If you decide to do it on your own, you'll need to file for exemptive relief with the SEC's division of Investment Management. You'll ask the SEC for exemption from certain provisions of the securities laws that will allow your mutual fund to operate as an ETF. Unfortunately, this process has never been streamlined and is looked at on a case-by-case basis. If you want to operate index-based ETFs, that's one application with the SEC. Active ETFs require a separate application as well as a product-specific filing with the SEC's division of Trading and Markets, which can take just as long as the exemptive application.
All in, you're probably looking at anywhere from nine months on the short end to several years on the long end to complete the regulatory hurdles.
Step 3: Keeping The Trains Running
The key thing for ETFs is the daily construction and maintenance of the creation/redemption baskets. The best sponsors have integrated their investment process with the basket process and provide support to the capital markets. This work can be outsourced to a fund administrator, or the majority of the work can be done in-house, though typically the fund administrator liaises with the NSCC to disseminate the daily basket files to APs, market makers and other capital markets participants. There are a number of operations—tax, risk, compliance and other issues that are unique to ETFs—that will need to be addressed.
If you're going to launch an index-based ETF, you'll need to select an index or work with an index vendor to create one. Even if you have your own index methodology, you'll still need to work with an index vendor to disseminate the index and its data. You'll need to select an exchange to list your ETF for trading, as well as line up APs and market makers to help provide liquidity. You'll also need to select an indicative intraday NAV (iNAV) agent, a requirement of the exemptive orders to provide updated pricing estimates for the fund's NAV at least every 15 seconds throughout the trading day.
Another requirement of the exemptive orders is a publicly available website with certain key information about the ETF. You'll also need to source seed money to get the fund launched, something that has become increasingly difficult as ETF trading has gone electronic, economic incentives have changed and newer ETFs have been slower to attract ample trading volume.
The number of people you'll need, the amount of money it will cost and amount of time it will take to launch your ETF can vary widely based on the type of ETF you're looking to launch, the nature of your organization and what your metrics for success are. Generally speaking, you'll need someone to oversee the day-to-day operations of the funds. You'll also need some form of sales support, either dedicated sales professionals or ETF specialists who can support your sales professionals and your marketing effort. A startup organization may have just one of each type, while a large asset manager new to the ETF space may have specialists who focus on different areas of operations, capital markets, sales, marketing, legal, compliance, etc. A number of costs are fixed regardless of the number of funds, while others are specific to each fund.
Step 4: The Finished Product
So what's the butcher's bill? If you're launching a small number of ETFs with your own advisor under your own exemptive relief, you should probably expect to pay around $500,000 to $1 million in startup costs, plus $150,000 to $300,000 per ETF in fund-specific expenses. You'll still need to spend money on a sales and marketing effort, which is typically the largest expense, as well as the one with the most variability. As for timing, the biggest factor is typically the SEC review process. Outside of that, four to six months is generally enough time to hire service providers, establish daily process flows and finalize a distribution strategy.
Is it a lot of work? You bet. But the end result is your very own publicly traded exchange-traded fund. Good luck!
DUSTIN LEWELLYN, CFA, IS THE FOUNDER AND PRESIDENT OF GOLDEN GATE INVESTMENT CONSULTING LLC, AND MANAGING DIRECTOR, HEAD OF ETF SERVICES FOR PENSERRA CAPITAL MANAGEMENT LLC.