How ISE Builds ETF Partnerships

March 08, 2016

Kris Monaco, head of the International Securities Exchanges ETF Ventures, spoke with ETF.com recently about the options exchange’s expansion into the ETF space, how it’s become a behind-the-scenes participant in some key products and the business plan driving those deals.

ETF.com: ISE seems to have a lot of business partners that it works with on ETFs. Can you explain the business plan?

Monaco: When I joined in 2002, the exchange had recently launched and focused on equity options or options on individual stocks and it was going very well. It quickly became the largest equity options exchange in the world, mostly because of its technological edge. It was purely electronic, and the first one to do electronic trading of options.

But when I joined, the goal was to expand the number and types of the listings on the exchange. So I had focused on what I thought was highly adjacent to that space—ETF options and index options.

We started to come up with proprietary indexes. At that point, ISE was the first exchange to be created in almost 30 years, so all of the major headline indexes were exclusively licensed to other exchanges prior to our existence. There was no easy way to break in.

We created our own proprietary indexes, and we came up with first-to-market thematic ideas, like water, homebuilders, homeland security and the SINdex, which covers alcohol, tobacco and gambling.

People were very interested, but they didn't want to trade options, they wanted to trade ETFs. We thought about how to break in to the ETF market, and the way we thought about doing that was to talk to ETF issuers, and to license our indexes to them.

We did that by focusing on very-well-known investment management firms that didn't have an ETF presence yet, like First Trust, for example. They’re fantastic partners of ours, but they weren't getting any love from the S&Ps of the world at that time, and we were there saying, “We will build this for you, we want to work with you.”

We started working with First Trust, Direxion, UBS and other issuers of the day. But we noticed that as soon as they grew, then the index providers would come in and we'd have to now compete with some massive companies.

We thought about, how do we take our high-conviction ideas and bring them to the market? How do we commercialize them, knowing that there's a lot of competition out there for index providers to provide their ideas to issuers?

We thought about providing the startup capital and the backstopping support—basically putting up the money to launch ETFs, but using our proprietary product concepts. The first one was a series of products we did with PureFunds that focused on the mining space—junior miners, junior silver mine suppliers and diamond miners.

ETF.com: Was the point—once those ETFs launched—to then launch options on those?
Monaco:
Not at all. That was part of the ecosystem, but the focus was to diversify ISE's revenue to areas that were more than just transaction fees. The way exchanges generate their revenue is from transaction fees. So when two parties trade, there's a transaction, and each party gets assessed a fee.

This was totally different. This was independent of trading activity. It was really about assets under management in the fund. It doesn't have to be a volatile product, it doesn't have to be actively traded by trading firms to be successful. That was very attractive for us.

When we started to talk to issuers about taking our ideas and launching ETFs based on our indexes, it quickly morphed into, “Well, how do we help them launch their ideas that they came up with?”

It evolved to the point where we now have this program that was born out of necessity, where we provide the underlying R&D for the index. We provide the startup capital for launching a fund. We provide the backstopping capital while the assets are low and someone's got to pay the bills to keep the lights on for the fund. We provide the marketing support, a dedicated marketing budget, an internal marketing team that comes with the plan and executes that plan.

We also have active distribution by way of a partnership with one of the private-label issuers called ETF Managers Group, or ETFMG. They hire wholesalers on our behalf, and the wholesalers actively distribute the products. This is about a strategic relationship where we are providing all these other things. Think of it almost like an accelerator, if you will.

ETF.com: I was actually thinking “incubator.”

Monaco: Yes; incubator, because sometimes we'll come up with the idea and plant it, or sometimes people come to us with an idea and we like it and we'll help nurture it. It's really a way to enable the creation of ETFs with emerging managers, who may be entrepreneurs who have had different roles in the investment management space.

They could be executives that have left a longtime position at an ETF issuance shop. It could also be firms that are looking to break into the ETF space. They could be an ETF model portfolio manager that wants to bring out a one-ticker solution product, foreign firms that want to establish a beachhead in the U.S. or mutual fund companies that just aren’t wired for ETFs but need to establish a presence.

We're talking to quite a few firms now that could use our support—maybe not as much on the financial side, but in all the other areas—to help get the product going.

Our biggest one, of course, has been the PureFunds ISE Cyber Security ETF (HACK | C-32). The timing has been awesome and very fortunate. But we never count on that. Our goal is to participate in as many smart products as we can, even if it’s a smaller amount. Because when we're investing, we're investing in our partner. Good ideas come from good people. And once we find a good partner, we want to expand the relationship.

With PureFunds, after the video game tech and drone tech funds launch, it'll be six products, and there are more coming.

Same with YieldShares. We’re working with Christian Magoon on the Amplify-branded online retail ETF.

We’re working with Brad Loncar for Loncar Investments and the Loncar Cancer Immunotherapy (CNCR). We worked with Tierra XP to launch the Tierra XP Latin America Real Estate ETF (LARE).

All of these firms are either young firms, or established players that don't have a presence in the ETF space, and we get to help them grow their product. We're not diluting their interest in their firm. We're not pushing for an exit strategy. We're not asking them to sell something. We're not asking for a board seat.

We're looking for a long-term relationship. If things are going well, there's no exit strategy. The only exit strategy is when things aren't going well and the fund has to be closed or changed.

ETF.com: So they're not hiring you, they're partnering with you.

Monaco: Absolutely.

ETF.com: Does that mean you’re selective about who you partner with?

Monaco: We are. We hear a lot of ideas, and sometimes they're good ideas, but we have to ask “How will you participate in the growth of this? It still has to be built out. There's a lot of work and resources that have to be spent in order to do this. What's your plan?” If they say, “Well, I don't really know,” we politely decline.

They have to have some experience in investment management, because otherwise managing expectations becomes super difficult. A lot of people come to us and they think they have the next billion-dollar idea. Well, they may, but when do you think it's going to be a billion dollars? Because if you're going to tell me by year one, two, three, forget it. It may happen, but never, ever count on something like that happening.

ETF.com: How do you build indexes around such specific spaces like cybersecurity or video game technology?

Monaco: The team becomes equity analysts in the space. They dive right in. They're calling the investor relations teams of these firms. They're reading through financial statements. They're reading through marketing material, any research report coming from the sales side from equity analysts actually covering the space already.

The goal is to immerse ourselves in it as if we're covering this space. Because that's what people want from us: They want us to understand the space.

ETF.com: What do you see for the future?

Monaco: Certainly expanding existing relationships is a priority. There's a wealth of intellectual property just waiting to be commercialized, but not all of it will work.

We have our own pipeline of ideas that we also want to commercialize and maybe find new partners to help do that, because they'll be the face of the product, or they're a subject matter expert as well.

The activity that we've done so far is just the tip of the iceberg in terms of how a venture role will help influence the future of the industry, in a very positive way. There are great ideas out there that aren't being heard and aren't being commercialized. There shouldn't be all this concentration among the top three issuers.

That's a huge opportunity, and I'm not going to claim that we'll have tens of billions of assets in our products, but it doesn't take that to be successful and to provide benefits to investors.


Contact Heather Bell at [email protected].

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