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Launching an ETF? Thinking Out Loud on ETF Distribution Challenges

With the passage of the Securities Exchange Commission’s (SEC) Rule 6c-11 and the approval of various models for semi and non-transparent exchange-traded funds (ETFs), everyone wants a piece of the ETF action. As an ETF distributor, we get asked many questions about how our policies and procedures work, what our fees are, how long it takes, etc. As a medallion distributor of ETFs, our role is more of a regulatory oversight role, which perhaps causes confusion. The distributor works primarily with the trust, the transfer agent/custodian and the authorized participant. They are not actively distributing the ETF. So, as a firm, when talking to potential and new clients, our two most common questions we ask are whether the client has a capital markets person or team, and what their distribution plan is. Not only is this important to the distributor, but also the board of trustees. These parties need to know you have a plan, and if not, what some of those options might be.

Although there are many considerations and challenges with ETF distribution, which we dived into during the Thinking Out Loud on ETF Distribution Challenges webinar, these two elements are key. Let’s break it down and discuss the importance of both.

Capital Markets

What is the significance of capital markets? It is a unique role within asset management. This person or team, depending on the size of the firm, will wear several hats.  Not only do they need to act as a relationship manager to the authorized participants (AP) and market makers (MM), and exchanges to nurture a healthy trading environment—arbitrage, liquidity, and tight spreads—they also help facilitate the creation redemption process to ensure that trades in and out of the ETF are cost-effective and efficient. In addition, they take on a sales support role to educate clients, as well as the marketing and wholesale teams, about the mechanics of the ETF and best practices for trading.

Why is this important? A trust would have an extremely tough time getting an ETF listed on an exchange without the assistance of capital markets. When a fund is seeking to launch a new product, the capital markets team speaks with market makers to ensure the product will work with their strategies; evaluates what the trading volume might look like based on the strategy; selects and engages the lead market maker; educating other MMs and APs on what the ETFs strategy and wrapper are—active, passive, transparent, semi or non—and which of those new models it is utilizing  (ActiveShares, BlueTractor, NYSE, Fidelity, T. Rowe or Invesco) and seeking the seed capital to launch the ETF on the exchange. All this is in the name of tighter spreads and active depth of book of liquidity to facilitate the smallest to largest trades that may come on any given day.

Could a fund self-seed to launch? Yes, a fund could seed its own ETF, but pursuant to the registration statement, the distributor can only accept orders from an authorized participant who has entered into an agreement with the distributor on behalf of the trust and accepted by the transfer agent. All creation/redemption orders whether from the parent fund or a market maker have to go through an authorized AP.

The primary market creates a healthy and efficient secondary market where Joe Smith the retail investor has the ability to buy or sell an ETF via the exchange, usually at very attractive prices relative to the underlying portfolio. This is different from the way a mutual fund works, in which the investor goes directly to the fund.  Capital markets also assist investors with entering and exiting an ETF at a fair price. This is important because when you execute a trade it could greatly affect your total return. To do this, you need to be able to source liquidity for investors. This liquidity includes the ETF itself as well as the underlying holdings, depending on the size of the order. For instance, a smaller order for liquidity will matter more at a fund level whereas a large order will affect the liquidity of the underlying securities. Capital markets groups not only assist in the transfer of assets through the exchanges at fair prices but also advise all manner of clients on when and where to get the best prices.

Active Distribution

Like any fund, having a distribution strategy is equally important as the Capital markets team. In fact, it is Capital markets that are educating the salespeople initially on the product as mentioned above.  It’s those salespeople who are tasked with educating and selling the ETF to Registered Investment Advisors (RIAs) and financial advisors so that their clients can benefit from its inclusion in their overall investment strategy. If the firm doesn’t have distribution resources—salespeople, marketing, media, technology, all of it plays a role—well, just like “there’s an ETF for that,” there are partners out there, like FLX Distribution, to assist new issuers in navigating these waters.

With the market seeing more and more ETFs being launched, this is an increasingly bigger challenge. For instance, wealth management home offices are incorporating even more in-depth due diligence processes to approve an ETF for use by its advisors. 

They are also requiring more information in the due diligence review. Things they are looking for outside the basic information (passive or active, transparent or non/semi-transparent) are:

  • Is the index an established index or self-indexed?
  • What is the AUM of the firm?
  • What does the back-tested data look like? And was it accepted by the SEC at the time of filing?
  • What does the six-month or one-year track record look like, depending on the product?
  • What are the assets under management for the fund?  In some cases, you may need up to $100 million in AUM.
  • If this is an active ETF, does the firm have an established track record with active management?
  • Is there an advisor demand?

And these are just a few of the challenges firms face when launching an ETF. It is no longer the days of “if you build it, they will come.” Firms need to actively engage their teams, starting with capital markets to grease the wheels for efficient markets and educate the sales teams. If you do not have or do not want to commit the internal resources to develop and execute a distribution strategy, then look to a partner like FLX Distribution. These strategic steps will make a difference in how successful your ETF will be as well as impress your board with the plan you have in place.  

To learn more about all the challenges, view our recording of Thinking Out Loud on ETF Distribution Challenges webinar.

 Jillian DelSignore, Managing Director, Head of ETFs & Indexing FLX Distribution and Anita Rausch, Head of Capital Markets at WisdomTree and GLSW Board Member also contributed to this article.

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