There has been a meteoric rise in the popularity of ETFs in recent years. From an investor’s viewpoint, an exchange-traded fund offers several advantages over traditional open-end mutual funds, with the primary benefit being the ability to buy and sell during the trading day and not being limited to end of day pricing. ETFs also have a reputation for low fees.
According to a recent Bloomberg report, the last three years have seen $1.4 trillion flowing into US mutual funds and index ETFs that charge less than 0.5% as fees. There has also been an outflow of $0.9 trillion out of funds that charge more than 0.5%. Actively managed ETFs are still in their infancy and fees are higher than index ETFs, but fee pressure is expected to keep actively managed ETF fees below 1%, 20-40% lower than comparable open end funds.
Many successful financial advisors have made the shift to ETFs. Smart Beta ETFs provide the opportunity to make targeted investments and individual investors can deploy their funds in an index that is constructed based on specific objective factors.
Along with the emergence of ETFs, there is another shift that is taking place. Financial advisors are moving away from an approach that places its primary focus on the investment opportunity. Instead, they are promoting a client-centric model. This requires the financial advisor to give the greatest importance to the investor’s needs.
The business model has evolved from one that implies “if you build it, they will come” to a more investor-friendly structure. The emphasis is on client relationships and meeting the specific requirements of different types of investors.
But this move places large demands on the time of advisors. They can no longer afford to handle each aspect of the investment management activity themselves. It is absolutely essential to outsource certain functions.
Complexities of establishing an ETF
Launching an ETF is a more complicated process than launching a traditional open-end mutual fund because of the exemptive application process. An ETF requires that the investment advisor and fund structure file an application with the SEC to outline their operational intentions and framework for compliance with statutes and regulations.
The exemptive application process typically takes over a year from start to finish, with the corresponding magnitude of legal expenses to shepherd that process along the way. Partnering with an advisor that has already undertaken this process, therefore, can have both timing and financial advantages.
Although very few small firms attempt to handle the day-to-day operations of any registered mutual fund, handling the day-to-day operations of an ETF is virtually impossible. Due to the way ETF shareholder trades are settled (with securities in many cases rather than in cash), a broker dealer must be involved. Whereas an open-end fund transfer agent operates on a cash basis, the transfer agent for an ETF can accept both securities and cash in exchange for ETF shares, so the transfer agent must also be a custodian capable of accepting and delivering securities.
Any firm starting an ETF will, therefore, need to engage a team of experts in the various functions. A handful of fund administration firms have built these teams of experts. The team will include:
1) Administrator for compliance and legal filings
2) Custodian/transfer agent/fund accountant to accept, deliver, and hold portfolio securities and process ETF share transactions
3) Securities exchange on which the ETF is traded
4) Lead market maker willing to accept a lead role in maintaining an active and accurate bid and ask and
5) APs who make bid and ask offers in the ETF and build creation units to settle shareholder purchases in exchange for ETF shares delivered by the custodian/transfer agent.
You will need operational help
After you launch your ETF, it is essential that you market it effectively. You will need to ensure that prospective clients understand the unique nature of the product that you are offering. Your challenges will include gaining access to the appropriate types of audiences and convincing them that your ETF can deliver a sufficiently high level of returns.
Nottingham, builds and operates pooled investment vehicles for investment advisory firms has special expertise in ETFs. As I previously explained, “I started Nottingham to allow independent investment management firms to focus on doing what they do best. They focus on their clients and managing portfolios.”
An ETF service provider should be able to handle all your back office procedures. This includes:
- Fund organization – you will get help and guidance in preparing the draft documents that will then be submitted to outside legal counsel. Once these are finalized and submitted to the appropriate regulatory authorities, you can concentrate on your marketing efforts and on completing the registration process with platforms.
- Fund accounting – it is crucial that this aspect of ETF operations is handled perfectly. The service provider should have online capabilities that allow investment management firms and their clients to gain access to investment data, balances, and real-time reports.
- Fund administration – ignoring or misinterpreting regulatory issues can have serious consequences. The agency handling your back office procedures should have the bandwidth to tackle all your compliance requirements.
Since many service providers have minimum fees for a relationship, establishing relationships with each of these firms for a one-off, standalone registration may be quite difficult or economically non-viable unless the start-up assets in your ETF are well over $100mm. Leveraging the existing relationships of a fund administration firm like Nottingham or other similar firms can pay big dividends and save significant costs. Nottingham currently has structured relationships with BNY Mellon for custody, transfer agency and fund accounting; the NYSE as the exchange on which its ETFs are traded; and Cantor Fitzgerald as the lead market maker for the issued ETFs. Several top level APs are also making markets.
Leveraged Investors prefer ETFs
A recent survey by the Financial Planning Association has found that an overwhelming number of financial advisors recommend exchange-traded funds to their clients. In 2006, only 40% of survey participants used or recommended ETFs. But by 2017, this percentage had risen to 88%, making exchange-traded funds the most popular investment vehicle among 18 options.
The lower costs that index ETFs carry are their greatest advantage. Actively managed ETFs have a higher expense ratio typically but are still showing up as lower cost than the average open-end mutual fund. The tax efficiency and trading flexibility that exchange-traded funds offer have also contributed in a big way to their growing popularity. A majority of financial advisors think that the best approach for their clients is to invest in a mix of financial instruments that include both actively and passively managed funds.
How can financial advisors ensure that the ETF that they are promoting gains traction and becomes self-supporting?
The first step, of course, is to have a product that is better than the competition’s. You will need to estimate your fixed costs and calculate the AUM level that you should achieve to break even. After this, it is a matter of marketing your ETF to the appropriate client segments.
Engaging an efficient service provider for your back office work will allow you to run your fund effectively and provide high-quality service to your clients. It will also allow you to allocate a greater portion of your time and energy to marketing your ETF.