[This article originally appeared in our May 2016 issue of ETF Report.]
So you want to launch an ETF? Many people are surprised that there’s no one way to do it. There are as many different operating models as there are ETF sponsors—you can outsource or take in-house just about any function.
ETFs at the core are open-ended mutual funds, and there are more similarities than differences between them. But the differences are significant enough that you often see the ETF management business broken out as a separate and dedicated division within a larger financial organization, or you at least find ETF-specific personnel located within the various functional units. Providers of fund services including custody, fund administration, distributor, listing exchange, index provider and other services also tend to have personnel—if not whole business units—dedicated to ETFs.
“Who will buy my ETF and why?” is probably the most important question you can ask yourself. This is certainly the issue that we see most of our clients get hung up on. One observation we can share is that if you think people will buy it simply because it’s listed for trading on a national exchange and available to trade through any broker, you’ll probably be disappointed. Typically, the key issues here are identifying who your target market is, the most effective way to reach that market and where your pricing needs to be.
But having the idea isn’t enough. Following are some key issues to address on the road to your own ETF launch.
Build The Sales Pipeline
Oftentimes, asset management organizations that have existing sales channels struggle with the best way to integrate ETF sales. Do you use the same salespeople or hire new ones? If you’re a small startup without any existing sales resources, what do you do?
One of the unique aspects of ETFs is that they trade like stocks in the secondary market. Closed-end funds also trade this way, but the revolutionary thing about the ETF is that it gets special exemptive relief from the SEC to allow for large institutional investors called authorized participants (APs) to create and redeem new shares directly with the fund in exchange for baskets of the underlying portfolio securities.
This primary market activity allows for an arbitrage mechanism to force secondary market pricing to be in line with the fund’s NAV. A standard knock on closed-end funds is that there is no arbitrage, so you can experience large premiums and discounts in market pricing relative to the fund’s NAV. ETFs address this concern with the creation/redemption mechanism.
Why is this important for you, the nascent ETF sponsor? Because the sponsors who succeed incorporate this part of the business into their distribution strategy and have resources dedicated to APs, market makers and listing exchanges. Think of selling to the end investor as creating demand for liquidity and selling to the capital-markets crowd as creating supply for that liquidity.
Cutting Through The Red Tape
So you have a product idea and a distribution strategy. What else do you need?
Much of the corporate governance structure looks the same for ETFs as it does for mutual funds. You will need a trust, an advisor and a board of directors. The board will likely hire a number of service providers, such as custody, fund administration, transfer agency, distributor, audit and more. Just a few years ago, this meant you either used a trust and board you already had for mutual funds, or you created a new one. If you consider this the “build” option, you now have to consider the “buy” or “rent” options as well.
With a large number of small sponsors, as well as a number of sponsors who have started the regulatory process, there are frequently shops that are explicitly for sale or would entertain a discussion. There are also some shops that are offering an ETF platform model where you use their trust, advisor and board for a fee, and they’ll help put together the other pieces.
If you decide to do it on your own, you’ll need to file for exemptive relief with the SEC’s division of Investment Management. You will ask the SEC for exemption from certain provisions of the securities laws that will allow your mutual fund to operate as an ETF. Unfortunately, this process has never been streamlined, and is looked at on a case-by-case basis. If you want to operate index-based ETFs, that is one application with the SEC. Active ETFs require a separate application, as well as a product- specific filing with the SEC division of trading and markets that can take just as long as the exemptive application.
All in, you’re probably looking at anywhere from three months on the short end to several years on the long end to complete the regulatory hurdles, with a three- to six-month window common for most new products.
