It's All About ETF Seed Money

June 29, 2017

It’s not shocking to note that the ETF market is growing. It’s slightly shocking to see that we’re in the middle of the best year ever in terms of ETF flows—over $200 billion in just the first five months of the year.

But perhaps what I find most interesting is how radically the growth of the industry has altered. It’s not the question of where the money is going—the money’s overwhelmingly going to low-cost beta, to the benefit of a whole generation of investors. No, I’m talking about what new funds are finding traction—and how.

Seed Money
Once upon a time, a firm looking to launch a new ETF would go around to various market makers, who serve as authorized participants for ETFs, and ask for seed money. Unlike a UIT or even a corporate IPO, there’s no subscription period to launch a new ETF. At the very moment it begins trading, somebody has to put money in. Typically, ETFs are seeded with around $2.5 million of somebody’s money. Time was, ETF issuers could simply ask, and the market makers would happily pony up that initial capital.

Why? Because they were going to be market-making for the ETF anyway, which meant they needed some shares to trade. They’d also already have to run a hedge book, buying and selling the underlying ETF securities, or at least proxies. They were the logical choice. And after a few days or weeks, as investors clambered for whatever the hot new ETF was, they’d be able to sell out their inventory and have their seed money back.

But under the hood of the ETF ecosystem, that seed money has become increasingly hard to find. This has led to an interesting paradox: Money’s flowing into ETFs like crazy, but fewer new ETFs are actually launching and finding traction.

But there’s an interesting exception to that trend: funds that come preseeded not by the street, but by actual investors. If you look at the top launches of the last few years, almost all of them came to market with big assets within days. Assets that came from clients who were one way or another “presold” on the ETF even before it launched. Some of these we get details on, like the SPDR SSGA Gender Diversity ETF (SHE) launching with over $250 million in money from CalPERS, or when the Arizona State Retirement System seeded four iShares/MSCI smart-beta products with $100 million each.

Increasingly, however, we see funds come very strong out of the gate with no really clear strategy. As we point out in our new launches story in the July 2017 issue of ETF Report, many of this year’s winners simply had big anonymous clients in the wings.

Migrating The Role
This is an incredibly good thing. Nobody—not me, not issuers and not investors—thinks it’s a good idea to have hundreds of ETFs with no assets and no trading volume just lying around. It’s far better for everyone if the new products that launch are quickly—and definitively—healthy. By migrating the role of seeder from traders to investors, we’ll get better products that actually meet real investor demands.

What’s not to love?

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