Stage 1: Landscape
Let's call this the glint-in-the-eye stage. Before you even get to the drawing board in terms of your product's design, it is necessary to gauge the investment interest landscape. Are there interested investors? What is the level of product demand? Who are the current competitors? What are the barriers to entry?
Some things to consider include first-to-market advantage, the availability of similar products and pent-up demand. If similar products exist, you must identify ways to differentiate your product, such as by expense ratio, structure or index structure. This leads to stages two and three, choosing the best product structure and index.
Stage 2: Product Structure
ETFs and ETVs are not uniformly structured; they have used a variety of forms. For example, there are ETFs in the form of unit investment trusts, such as SPDRs, as well as open-end funds, such as iShares. Currently, there are ETVs structured as grantor trusts, such as streetTracks Gold Trust, and those that use a limited partnership structure, such as United States Oil Fund (ticker: USO). There is not one preferred choice. The structure of the fund depends on its portfolio and the needs of investors.
When choosing a structure, it is important to consult legal counsel, and possibly a service provider, exchange representative or other ETF industry experts. Decide on a structure that will be most suitable for your investor base. As is the case when creating any new product, you must review the legal, regulatory, tax and accounting considerations that apply to the structure, establishment and ongoing operation of the new ETF or ETV. Issues relating to the underlying assets (such as liquidity, transparency of trading and pricing, clearance and settlement arrangements, financial accounting, and taxation), complex structures (such as "multiclass," "master-feeder" and "fund of funds"), intellectual property issues (such as trademarks and patents, marketing and distribution channels), as well as investor preferences, must all be taken into account to create a successful product.
Backstage 2: Relief And The Regulatory Process
When designing a new product, it is vital that you analyze whether or not it will be considered an IC under the Investment Company Act of 1940 (1940 Act). If so, it must be registered as such with the SEC and must receive relief under the 1940 Act and its rules so that it can properly operate as an ETF. If you choose not to operate an open-end or unit investment trust IC, one alternative may be to restructure your product as an ETV since, as we have seen, ETVs are not ICs and thus do not need to obtain such exemptive relief. Structuring a new product as an ETV may expedite bringing it to market, because the regulatory process with respect to the 1940 Act will be avoided. Beware, however, that the legal definition of an IC is very broad.
ETF Relief Under The 1940 Act And Its Rules
Typical ETF requests include relief to permit: (a) The ETF to redeem its shares at NAV only in creation units; (b) trading of individual shares on a stock exchange to take place at prices other than NAV; and, (c) an exemption from prospectus delivery requirements in connection with secondary market trading activity. Prospectus delivery relief is conditioned upon the requirement that a "product description " summarizing the key features of the ETF is delivered to investors purchasing such ETFs as part of the primary listing exchange's rules. Other exemptions are sought, among other things, to permit: (a) redemptions of creation units to be made in excess of the statutory seven-calendar-day requirement; (b) a "fund of funds" structure; and, (c) certain affiliated parties to deal with each other if the structure of the ETF and relationship with its participants and service providers necessitate such relief. As indicated above, the regulatory process for obtaining relief from the SEC under the 1940 Act is slow, and therefore costly.
Relief From Provisions Of The Securities And Exchange Act of 1934 (The "1934 Act") And Its Rules
Currently, both ETFs and ETVs listed and traded in the U.S. secondary market require relief from various 1934 Act trading restrictions. The relief requested varies depending upon the kind of portfolio assets that the ETF or ETV buys, holds and sells (e.g., securities or commodities), but usually, ETFs and ETVs receive relief: (a) from the "uptick rule" with respect to short sales of ETFs and ETVs; (b) to permit broker-dealers and others to bid for, purchase, redeem or engage in other secondary market transactions for ETF and ETV shares and their underlying portfolio securities during a distribution or tender offer for portfolio securities; and, (c) to permit ETFs and ETVs to redeem their shares in creation units during their continuous offering of such shares.
Also, each primary listing exchange must adopt listing rules and standards under the 1934 Act before the shares of an ETF or ETV may be sold, bought or traded in the secondary market. The SEC is charged with reviewing and approving the listing rules, which is also accomplished by means of a regulatory process. At first, the SEC required that the primary listing exchange adopt a separate listing rule for each new ETF or family of ETFs. Over time, however, the SEC has approved the listing rules of primary listing exchanges for certain ETFs that comply with stated "generic listing standards." (See, for example, AMEX Rule 1000A.) The adoption of these generic listing standards has helped to speed up the launching of new ETFs, providing that those ETFs comply with the rules. Note, however, that certain new ETFs cannot meet the "generic listing standards." In such cases, the primary listing exchange must engage the SEC in the regulatory process to adopt specific and appropriate listing rules designed for the new ETF. This can be a relatively simple and quick process, or it may be complex and time consuming, depending in large part on the nature of the new product's portfolio assets. Note also that ETVs do not have the benefit of "generic listing standards," so the primary listing exchange for each new ETV product must still submit listing rule proposals to the SEC for review and adoption. It is hard to predict if, and when, the SEC may permit exchanges to adopt "generic listing standards" for ETVs, but at a minimum they will likely insist on more trading history for each ETV now trading, as well as more ETVs in general, so that they have a better statistical sample to evaluate.
Interpretive Relief From NASD Rules
Certain NASD conduct rules, designed to cover practices with respect to the issuance and sale of UIT and open-end fund securities, were adopted before the issuance of ETFs. Therefore, some ETF issuers have submitted request letters to the NASD seeking confirmation that these practices do not violate the conduct rules or NASD interpretive materials. The NASD has granted favorable interpretive relief, which is expressly conditioned on the continuing applicability of the ETF's 1940 Act order, and is limited to the factual descriptions and legal representations contained in the ETF's request letter.
Stage 3: Index Selection
Since an ETF aims to follow or outperform an asset class or investment area while at the same time offering increased trading flexibilities and, ideally, a brand or idea that has resonance with investors, index selection can be crucial to a product's success. Sounds easy, right? In reality, most well-known indexes (such as the S&P 500, Russell 2000 and MSCI EAFE) have already entered into a restrictive or exclusive licensing agreement with fund managers, and therefore are not available. If a well-known index is not available, try working with an existing index provider to create an index that is unique-utilizing a specific alpha or quantitative model with proven market performance. Market niche indexes have been steadily growing in popularity.
Once you have completed the core development and selection process, the next wave of stages deals with selecting a listing venue, service provider, distributor and specialist firm, and with attracting APs to the new ETF or ETV. There is not a specific point in time when these parties need to be identified, but establishing these providers early can aid the registration process.