So You Want To Launch An ETF

July 01, 2006

It seems as if there is now a constant stream of articles, commentary and news headlines discussing ETFs. While many people still have no idea what an ETF is, there are an increasing number of experienced participants in the ETF investment industry, and there is a sense among many of them that says, "Hey, maybe I could launch my own ETF." We're here to tell you that, well, it's not easy. But if you want to give it a try, here's what you need to know.

Let's begin with a definition of an "exchange-traded fund," or ETF. An ETF is an investment vehicle that typically tracks a stock market index and trades on an exchange, just like a regular stock. The key term in that sentence is "typically." ETFs were first developed in the U.S. to make stock program trading available to retail investors, so that, like institutional investors, they could trade a basket of securities in a single transaction.

The method of creating an ETF starts when an institutional investor provides a basket of specified securities for deposit into the ETF's portfolio. This basket of securities generally includes most or all of the securities underlying the ETF's index. In exchange, the institutional investor receives the equivalent value of the ETF's shares in large lot sizes called "creation units." Thereafter, the institutional investor (known as the "authorized participant," or AP) may hold the shares in creation units, or sell some or all of the individual shares into the secondary market, where they are bought, sold and priced throughout the day on a stock exchange.

When an AP wants to create shares of an ETF, it will buy the requisite number of stocks in the ETF's underlying portfolio on the secondary market (a creation unit is often comprised of the equivalent of 50,000 shares of the ETF). The AP can also redeem its shares directly to the ETF: If it has enough ETF shares on hand, it can tender a creation unit in exchange for the equivalent value of the ETF's portfolio securities (at net asset value, or NAV). Just as it tenders actual shares of individual companies to the ETF "in kind" when creating ETF shares, it receives the actual shares of the underlying ETF portfolio back-again in kind-when redeeming ETF shares.

This method of creating and redeeming shares is commonly called the "creation/redemption process," and it is the key to what makes an ETF an ETF. Retail investors do not participate in the creation/redemption process; rather they buy, hold and sell ETF shares just they way they invest in and trade any other listed stock. Many institutions also trade in shares on the secondary market and do not participate in the creation/redemption process. But the creation/redemption process is the key to the efficiency that keeps the pricing of ETF shares close to the actual value of their underlying portfolios.

Technically, an ETF is an investment company (IC) registered with the U.S. Securities and Exchange Commission (SEC), because it holds a portfolio of securities and continuously issues and redeems its shares at daily NAV, just like an open-end fund (commonly known as a "mutual fund"). As we have just seen, however, many institutional and all retail investors do not acquire or redeem their shares directly at the NAV from the ETF provider, but instead buy and sell them at their market prices on the secondary market, similar to the way in which shares of closed-end funds are bought and sold. This hybrid structure, consisting of mutual fund and closed-end fund elements, does not fit into the existing regulatory regime governing investment companies. Therefore, each ETF must request and receive from the SEC formal exemptive, interpretive, no-action and other relief from certain provisions of applicable federal securities laws before it can be brought to market. For regulatory purposes, without this relief, each ETF's structure and operations would be illegal (more on this topic later).

The ETF structure has been copied and expanded since the first ETF, the S&P 500 Depositary Receipt or SPDR (ticker: SPY), was launched on the American Stock Exchange (Amex) in January of 1993. A variety of stock and fixed-income ETFs have been brought to market over the years. Recently, the ETF concept has expanded outside of the securities arena into nontraditional asset classes. Increasingly frequent requests for retail-available "exchange-traded vehicles" holding or tracking gold, silver, crude oil and other commodities culminated with the launch of the streetTRACKS Gold Trust (GLD) on the New York Stock Exchange (NYSE) in November of 2004, followed by the iShares Comex Gold Trust (IAU) in January, 2005. In this article, we will use the term "exchange-trade vehicles," or "ETVs," to identify those exchange-traded products that: (1) are not investment companies, (2) usually hold nontraditional portfolio assets, but (3) nevertheless use many essential features of the original ETFs, such as the creation/redemption process.

ETFs and ETVs can take many forms. With the exponential increase in the number of funds and their total net assets over the years, we have seen a corresponding emergence of innovation and diversification both in terms of the investment areas targeted by these funds and the structures of products on the market. There are now exchange-traded products that track virtually every recognizable stock market index, many bond market indexes, and as mentioned, even commodities and currencies. Since the launch of the original SPDRs, the global ETF industry has grown to more than $450 billion in assets and around 500 products. The industry is global, too: The aforementioned 500 ETFs are run by 52 managers trading on 33 exchanges in 24 countries, and that count is rising across the board.

It Isn't Easy

The astonishing evolution and growth of the ETF/ETV industry has spanned just 13 years, but it has consisted of countless hours of product development. All of this effort over the past 13 years, however, has served a remarkable purpose: It has brought products to market that not only fill the needs of institutional investors, but bring retail investors into an institutional space in terms of ETFs' competitive pricing and efficiencies as investment vehicles. Product innovation has yet to slow, and some experts predict a trillion-dollar industry within the next few years.

With more and more asset managers issuing new ETFs, the question remains, "Do I jump on the gravy train and issue an ETF of my own?" Before you have dreams of conquering the financial industry, make sure that you understand that while the task of bringing an idea to market through an initial public offering (IPO) certainly can be thrilling, it also can be both long and costly.

For example, let us take a quick look at the first five ETFs: the SPDR, MidCap SPDR, DIAMONDS, Country Baskets and iShares MSCI Series. Four out of these five funds took 18 months or more to come to market, even after they were initially filed with the SEC. For example, the original SPDR filed its first application for relief with the SEC on June 25, 1990, and received its order on October 26, 1992; the iShares MSCI Series first filed its application for relief on September 19, 1994, and received its order from the SEC on March 5, 1996. Although the SEC has adopted certain rules and positions that reduce some of the time involved in obtaining relief, it is still the case that in a new launch of ETFs or ETVs, the SEC is the biggest barrier of entry. Also, don't forget that ETFs and ETVs issue securities sold to the general public and therefore must file registration statements containing prospectuses, which must be reviewed by the SEC through its registration process. Neither ETFs nor ETVs can sell shares legally on the secondary market through a U.S. exchange without a final prospectus.

Now that we have defined an ETF, witnessed the asset growth and discussed SEC registration, let's take a pulse check: Do you still want to launch an ETF? If so, brace yourself for many sleepless nights, shore up your bank account and be prepared for a difficult but sometimes thrilling time. The process from product conception to IPO takes dedication across multiple stages. Let's identify several of these stages. (Note: We're assuming here that you have already identified the sort of ETF you would like to launch!)

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