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!)

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.

Stage 4: Exchange

Shares of ETFs and ETVs trade intraday, thus requiring the product to be listed with a primary exchange, such as the Amex, NYSE or Nasdaq. It is important to choose a primary exchange that best suits your needs. Key considerations include product support, reputation, liquidity, trading volume and cross-listing arrangements. It is important to note that nonprimary exchanges can apply for unlisted trading privileges (UTP) on a particular product.

Stage 5: Service Providers

The role of service providers has grown in importance in recent years; for example, portfolio valuation and NAV accuracy have undergone increased scrutiny to ensure investor protection. Settlement, back-office and clearing procedures also are looked at closely by regulators. As product innovation expands to include commodity, currency, fixed-income and other derivative-linked products, so does the need to establish modified operational workflows. For example, commodities are not securities, and therefore do not clear and settle through DTC. Furthermore, in addition to the SEC, commodities trades may be governed by the Commodities Futures Trading Exchange (CFTC). These differences require modified settlement and pricing procedures when compared to domestic equities and ETFs, and raise other regulatory and/or tax issues. When dealing with international securities, local market settlement procedures apply, and because some jurisdictions have settlement cycles longer than seven calendar days, ETFs holding foreign securities may need relief to delay the payment of redemption securities.

When seeking a service provider, important considerations include the firm's reputation and commitment, technology and complete product offering. Some ETFs, like funds, are eligible to participate in securities lending, generating income that is an effective means to lower total expense ratios. This is another thing to consider.

Backstage 5: Required Services

ETFs and ETVs require some, but not all, of the same services, and the requirements vary among the different ETF structures as well. Most ETFs, as open-end companies, require a registered investment advisor, a chief compliance officer and the other providers commonly used by a mutual fund, including a custodian, administrator, fund accountant, transfer agent and distributor. ETFs organized as unit investment trusts, as well as ETVs organized as grantor trusts, must have a trustee, whose duties and services extend to more than safekeeping assets and record keeping. All ETFs, as ICs, must adopt a variety of required policies and procedures, including a code of ethics and a chief compliance officer procedures and compliance handbook.

Stage 6: Distributor

If you are not going to act as your own distributor, it is important to work closely with one. The role of the distributor is to take the orders from the APs and, often, to act as the liaison between the ETF's transfer agent and the APs. The distributor passes the order information to the transfer agent, who either creates or redeems the shares in creation units.

Stage 7: Specialist

A specialist is a member of a stock exchange who maintains a fair and orderly market in one or more securities. A market-maker performs a similar but not identical function in a securities market. A specialist performs two main functions: executing limit orders on behalf of other exchange members (for which the specialist typically charges a commission), and providing liquidity by buying or selling (sometimes short) for the specialist's own account in the absence of limit orders at a price point. This helps to counteract temporary imbalances in supply and demand, preventing wide swings in price spreads.

Stage 8: Authorized Participants (APs)

As we have seen, ETFs and ETVs operate both in a primary and a secondary market environment. Apart from the fact that the portfolio assets of an ETF or ETV can appreciate or depreciate due to market events, creation/redemption orders for shares entered by APs have a direct impact on the assets underlying an ETF or ETV. APs are the large institutional counterparties who enter into an agreement with the ETF or ETV, which permits them to participate in the creation/redemption process. The APs' ability to continuously expand or contract the supply of shares permits them and others to profit from any slight premium or discount in the market price of individual shares on the exchange versus the NAV of the underlying assets (arbitrage opportunities).

Arbitrage opportunities occur because the intraday market price for shares usually is close, but not equal, to the daily NAV of its ETF or ETV. Over time, if demand for shares exceeds current supply, the market price for a share of an ETF or ETV may actually be higher than its underlying NAV; conversely, if there are more sellers than buyers for a particular ETV or ETF, the market price for shares in the secondary market may be lower than the NAV for such shares. The APs' ability to take advantage of the arbitrage opportunities by creating and redeeming shares contributes to the liquidity available in the secondary market and, in turn, helps keep a relatively small gap between the trading prices for shares as compared to their NAV. Since ETFs and ETVs receive relief to exempt trading in their shares from the short sell "uptick" rule, it is important to enter into agreements with APs that have a long interest in the ETF or ETV, because their ability to create/redeem shares provides liquidity, asset growth and a possible inventory of shares to lend short. Unless stated in its prospectus, there is no limit to the number of APs an ETF or an ETV can have.

Stage 9: Registration Process

Now you are ready to file a registration statement for the ETF or ETV. If you haven't already done so, you will need to retain an attorney to help you prepare and file the registration statement (including the prospectus and exhibits) with the SEC for review and comment. He or she also will negotiate with the SEC and file amendments to the statement, and will finalize the prospectus and other materials.

If you are establishing an ETF, you will also need to create an IC, such as a trust or fund company, and register the IC with the SEC under the 1940 Act. Depending upon the structure you have chosen, such as an ETV structured as a grantor trust or an ETF structured as a unit investment trust, the attorney will draft the trust document as well as other material contracts. If you are setting up an open-end company, the attorney will create and/or review policies and pro c e d u res for the IC, such as investment policies. These and other policies are re q u i red to be adopted and/or reviewed by the board of an open-end company on a periodic basis. Your attorney will attend organizational and any additional board meetings prior to the effectiveness of the open-end fund's registration statement. In most cases, the attorney will also coordinate with auditors and other service providers, draft material contracts and review advertising materials.

Stage 10: Give It A Go?

Still interested in bringing an ETF to market? Although launching an ETF or ETV fund can be a process with a lot of moving parts, it is also a thrilling time. By now, you've worked countless months putting in those long hours, often waking up at your desk and realizing it was 2:00 a.m. You're days away from gaining SEC approval. Five authorized participants have signed up, and you have set the launch date. As you ring the opening bell on the stock exchange on the first day of trading, you let out a sigh of relief, congratulate yourself and your partners, and then realize you now have a new battle: sales and marketing.

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