Esposito: Time For A New Way To Seed ETFs

April 19, 2011

Breaking the old model of providing ETF seed capital.

 

Mark Esposito, president of Dallas-based Esposito Securities, is a new breed of ETF seed capital provider. Instead of putting up money to start ETFs in exchange for working as the lead market-maker on the new fund, Esposito takes a fee and seeks to build long-term relationships with fund sponsors he works with.

When he recently spoke with IndexUniverse’s Steve Dew, Esposito made clear that as high-frequency trading squeezes market-maker profits and diminishes the role of specialists, it's possible that more ETFs will come to market using seed money from firms like his.

 

Dew: The Pax World products you helped seed are interesting. How did you get started seeding ETFs?

Esposito: I started at J.P. Morgan, then Southwest Securities and started Esposito Global five years ago. Throughout my tenure on the Street, it was clear that there was an underserved need—underserved by the big firms—for specialty institutional products and services. The big guys weren't willing to create customized services such as one-off algorithms or work with custom file formats, etc. All the big firms have white-label products, but they would never tweak it for small- to midtier players.

That's where Esposito’s value-added business model was shaped, by providing the extra layer of products and services. Last year, seed capital on the Street contracted based on market conditions, and we got a call for help in this area because the Street understands that Esposito is set up to help them grow. We thought this could be an interesting proposition for our firm to help grow the ETF industry.

Seed capital used to be free. But now, fund sponsors either have to pay for it or play for it. We've seeded six or seven funds. The consensus is that seed money is still tight, capital is expensive and there's a limited number of players. That's how seeding came to be part of our fast-growing ETF franchise.

Dew: How do you think the seeding area of the ETF world has changed, and did the “flash crash” on May 6, 2010 have anything to do with those changes?

Esposito: I think the landscape has been changing for years and always will. I don't think May 6 helped any, and I think that was coming either way. High-frequency traders have caused problems for seeding. A lot of people that seed rely on lead market-making and making a spread to cover costs and make a profit, and we don’t do that. The tighter the high-frequency guys get, the less the lead market-maker can make, theoretically. And with what happened on Wall Street financially in 2008, no one wanted to put out capital. And, it is raw capital.

What would be ideal would be for the issuer to find an end-user to seed, an actual investor who wants to hold the security indefinitely.

Seed capital lead market-making is a loss leader in a lot of cases. So, unless you're doing business with other parts of the firm, and you're looking at seeding as part of an overall relationship, it's hard to justify as a stand-alone business, because you could get hurt.

 

 

 

Dew: Can you walk me through your business model in terms of your relationship with Pax, for instance? What's in it for you and what's in it for them?

Esposito: I can't disclose everything because there's some intellectual property there, but I'll use broad terms.

Our relationship with Pax is unique. We put up our proprietary capital and they pay us to do that. That took seeding from being a loss leader to something we could possibly break even on or even make money on. Our goal is to do business with other parts of their firm long term, and this is just the first step in that.

We'd love to earn their agency order flow; execute custom baskets, and create and redeem for them and increase transactional flow for everyone.

The mid- to small-tier issuers in certain cases still are having a problem getting the seed that they need, and every issuer wants to bring a product to market with much more seed than they usually have. If it's $5 million, they'd surely rather start with $10 million. Some of the big players used to come to market with $50 million, and that was provided by Wall Street. That's unheard of now.

Dew: So your clients are essentially paying a fee in exchange for your seed capital. Are you anticipating doing market-making work for them?

Esposito: No. In the Pax case, we're seed-only. We are approved by the NYSE’s Arca to be a lead market-maker, but we haven't chosen to make a market in the security. Instead, we trade it off the box. In other words, we provide liquidity without performing the role of lead market-maker. Down the road, we're looking at possibly acting as lead market-maker.

Dew: I don't know how closely you follow the regulatory stuff, or if you leave that to the attorneys, but are you concerned that rule-making from the SEC or the CFTC could change the way you do business?

Esposito: I'm not concerned about it. The SEC and CFTC and FINRA—based on what they have to work with—have done an excellent job. Could they be faster? Yeah, but so could my guys. We believe in the system, and we believe in the market. We think there will be changes just because of asset growth in ETFs. There is no imminent rule out there that we're concerned about.

Dew: Are you looking at other people as prospective clients?

Esposito: For all intents and purposes, we've talked with almost every issuer, and if we haven't, we're on deck to do so or they should call me. We are in many advanced discussions with issuers to seed and I would guess we'll bring out another dozen funds or more this year.

Dew: What are some of the exciting products—your current clients excluded—out there right now, and where do you think growth is going to come from in ETFs down the road?

Esposito: I see growth in index ETFs, but slower growth. Our research shows that in four years, total ETF assets under management in the U.S. will be at $4 trillion. The products that get that money will have to be creative.

I also think what's exciting is the active space. I think you'll see more active strategies, more long-short and more hybrid funds, where the manager really matters more than the index. The active space is wide open for asset-class growth.

On the index side, there's still room for creative new products in frontier and emerging markets, and there's some space left in commodities and in managed futures as well. But we're excited about actively managed funds. We're excited about the whole business—we really believe in all ETFs.

 

 

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