Interview with Rick Redding of the Index Industry Association

From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.

Recently, ETF BILD sat down to speak with Rick Redding, CEO of the Index Industry Association (IIA). We talked about the state of indexing and various regulatory and business issues. Below is a summary of the highlights from that discussion.

Regulation

ETF BILD: Will the index industry become regulated?

Redding: Index regulation has already occurred in Europe. The European Parliament approved the Benchmarks Regulation, which is a set of rules governing the use of indexes as benchmarks. This regulation has global implications for index providers, not just ones in Europe. It is possible that a new ETF regulation in the United States may be next. The SEC recently has been sending information requests to ETF sponsors of indexes. Often such requests are a precursor to rules.

ETF BILD: Are the costs of compliance and other factors driving consolidation in the index industry or causing index providers to partner with exchanges, data providers and other types of companies with deep pockets?

Redding: I do not necessarily see a wave of consolidation coming in the index industry. Rather, the alternative is for index providers to partner with companies in related industries. For example, there are many synergies with index providers and financial data providers, so those types of consolidations may make business sense.

Intellectual Property

ETF BILD: Why have intellectual property rights become important in the index industry?

Redding: Index providers naturally want to protect their intellectual property rights to the index methodology. Without the protection of their intellectual property, no provider would ever create new indexes and that would deprive investors of innovative products and competition. Some asset managers are creating their own indexes instead of licensing indexes from the large index sponsors. If a manager’s self-indexed ETF becomes successful, the methodology behind that index becomes valuable to the manager.

ETF BILD: Will new regulations such as the proposed ETF rule potentially make it more difficult to protect index methodology?

Redding: The more information an arbitrager has about an index that an ETF is tracking, the better it is able to trade the ETF’s shares to exploit any difference between the ETF’s net asset value per share and market price. The SEC emphasized the importance of such arbitragers when it proposed the ETF rule, which conceivably could require the publishing of more information about an ETF’s securities holdings. The SEC recognizes the need to protect the underlying intellectual property but also properly wants to have adequate disclosure of the underlying securities.

Data

Self-Indexing Conflicts

ETF BILD: You noted the trend for some asset managers to create their own indexes. Does this create conflict or other issues?

Redding: Managers naturally desire to sponsor ETFs and other products that track indexes that perform well as the performance of a financial product is always a key factor in its ability to attract investors. This creates a temptation for an asset manager to put more weight on designing an index that will perform well and less emphasis on making sure it is a useful benchmark. We have seen some providers of so-called smart beta indexes and products struggle with this issue. IIA believes separating the functions provides the best protection for investors.

ETF BILD: How can these conflicts be addressed?

Redding: Such conflicts can be avoided by separating functions: the product creation for investors, index design and administration. The asset manager licenses with a third party for its index or to design an index.

Complex Indexes

ETF BILD: More and more ETFs that track complex indexes are being introduced each year.  Are these indexes too complicated for investors to understand? 

Redding: Indexes with multi-variant methodologies and complex rules certainly are on the rise. It can be more difficult to understand their methodologies and why products that track these indexes would be beneficial to the average investor’s portfolio. Nevertheless, these products can be valuable to certain investors, such as institutional investors, who have the knowledge and experience to understand the products and how they can enhance their portfolios.

Direction of the Index Industry

ETF BILD: Where is the index industry headed, especially in terms of key issues?

Redding: Issues related to indexing fixed-income securities are going to become more important as more ETFs and other financial products seek to track fixed-income indexes. Because bonds do not trade on trading venues like equities do and, in many cases, infrequently trade, there are far greater challenges with valuing the bonds that make up a fixed-income index. Information about certain bonds are not as readily available and investors desire better transparency in how they are valued and priced. As these processes become more transparent, it will be easier to develop indexes that more accurately benchmark various types of bonds.

ETF BILD: Will you see more and more custom indexes?

Redding: I believe so, especially with respect to ESG investing. More and more institutional investors are demanding benchmarks that exclude certain types of securities. For example, they may know that an industrial company in a particular ESG index is a low carbon dioxide producer, but it also employs processes that pollute rivers and streams and has a poor record of diversity. As a solution, such institutional investors could seek out index companies that can design an ESG index with multiple screens tailored to their particular circumstances, beliefs and needs.

ETF BILD Submits Comment Letter to SEC on ETF Rule

October 1, 2018

Via E-mail [rule-comments@SEC.gov]

Mr. Brent J. Fields
Secretary
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, D.C. 20549-1090

Re:  Release Nos. 33-10515 and IC-33140 (File No. S7-15-18): Exchange-Traded Funds; Proposed Rule

Dear Mr. Fields:

Thank you for the opportunity to submit this letter in response to the request for comments contained in the above-captioned release (the “Proposing Release”) whereby the U.S. Securities and Exchange Commission (“Commission”) proposes Rule 6c-11 (“Rule 6c-11”) under the Investment Company Act of 1940, as amended (the “1940 Act”). Rule 6c-11 would permit certain exchange-traded funds (“ETFs”) to operate without an exemptive order, subject to the conditions contained therein.

ETF BILD

The ETF BILD (Business Insights & Leadership Discussion) is a forum located at www.etfbild.com with a mission to be the catalyst for discussions on the most pressing issues faced by the business leaders of the exchange traded fund (ETF) industry. The ETF BILD Project is at the intersection of academic research and actionable business leadership. The ETF BILD Project is focused on the business insights, leadership, and discussion of the ETF industry.

PROPOSED RULE 6c-11

ETF BILD commends the Commission, particularly its Division of Investment Management, for proposing a rule that is long overdue and strikes the appropriate balance between sensible regulation of ETFs without burdening one of history’s most successful financial products with unnecessary restrictions.  On a basic level, Rule 6c-11 eliminates the need for new entrants in the ETF industry from wasting both their resources to file for exemptive orders and those of the Commission to process such orders.  While Rule 6c-11 is largely based on conditions in prior exemptive orders and conditions in Rule 6c-11 as proposed in 2008, the Commission successfully pared back those conditions that are no longer necessary.

We caution the Commission, as we do in certain of our comments, to be sensitive to places in Rule 6c-11 and the Proposing Release that blur the lines between the different industry participants: the adviser/sponsor to the ETF, the Indexer, the stock exchanges that trade ETFs (the “Exchanges”) and the APs/market participants. Each such participant are impacted differently by Rule 6c-11 and each are in a unique position to advance many of the goals of the Rule. In addition, we emphasize that while the Commission should be commended for designing a rule and eliciting comments through questions that focus on the individual investor, it should realize that ETFs are used by a variety of types of investors: long-term investors, short-term investors, arbitrage traders, day traders, mutual funds and ETFs and institutional investors. Our comments reflect that out of this group, protecting the long-term ETF investor is of upmost importance.

Arbitrage Mechanism

We applaud the Commission for maintaining the arbitrage mechanism as the cornerstone of ETF regulation and exercising regulatory restraint by not adding superfluous conditions to a process that has consistently resulted in an ETF’s market price being close to its net asset value per share (“NAV”) since the first ETF launched in 1992. With respect to certain concerns the Commission raised in the Proposing Release about the ETF arbitration process during times of stress, we believe that these concerns should be seen in the context of larger market structure issues. ETFs operate under the rules of corporate equity securities where there is no disclosure during times of stress of whether or not a stock is trading at fair value. As seen in previous market stress conditions, the markets revert back to norm in a manner of seconds or minutes. Proper disclosure on websites of ETF issuers would be difficult to execute and more difficult to be used as an informational portal for investors to obtain that information in real time. We suggest to further protect investors. Exchange rules that govern the halting of stocks be reviewed to include more specific process for ETFs.

In the context of the arbitrage mechanism, the Commission in the Proposing Release asked a number of questions about premiums and discounts of an ETF’s share price to its NAV. The Commission asked when would a premium or discount develop due to a breakdown in the arbitrage mechanism. Breakdowns in the arbitrage mechanism would most often be due to price discovery issues of the underlying securities or inability to transact in the underlying securities. Some ETFs track non-equity assets like commodities and potentially cryptocurrencies. The inability to obtain proper pricing or execute transactions in those markets could cause a breakdown in the arbitrage function.

The Commission also asked whether there are instances where a premium or discount may develop or persist because of transaction costs relating to the ETF’s basket securities. We can foresee circumstance from costs in trading and clearing of international securities and non-equity assets as a potential scenario where transaction costs would be prohibitive. These situations are mostly addressed in the product design of the ETF and approved by the ETF’s Board of Directors (the “ETF Board”) prior to launching the ETF. However, market conditions in other markets occur and could cause pricing issues effecting the arbitrage function.

The Commission followed up with the question regarding how these circumstances can be distinguished from one another. These issues are a function market structure and occur in other contexts. We can look at the example of the closed-end fund structure where premium and discounts persist typically on a daily basis. They are disclosed at the end of day to investors and a prolonged situation over multiple days would be sufficient for long term ETF investors to recognize and react to an ongoing situation in an ETF. Those that occur and correct themselves rarely effect long-term investors. Transactions that occur outside the normal market price can be broken under Exchange rules and those rules need to be reviewed to see how the effects of premium and discounts in ETFs are handled.

The Commission asked whether the arbitrage mechanism contemplated by Rule 6c-11 keeps ETFs’ market prices at or close to NAV under normal market conditions. We would again refer to the rules and practices of closed-end fund issuers for the calculations and dissemination of premium and discounts. We agree that end-of-day dissemination would work for ETFs in the context of long-term investors. If short-term traders/investors need more real time information a market solution to provide that data rather than a regulatory solution should be the answer.

With respect to information regarding intraday changes in portfolio holdings, the Commission asked whether the dissemination of such information should play a larger role when assessing premiums and discounts. Such information may not be necessary for long-term investors; however, since the trading community maybe in need of such information for a more efficient arbitrage function to exist we once again suggest a market solution.

The Commission asked whether it is of value to assess the efficiency of the arbitrage mechanism by comparing the mean/median of the market prices on a given trading day against the end of day NAV or whether it is preferable to compare the mean/median of the market price on a given trading day against an intraday measure of the value of an ETF’s portfolio. This may be  too difficult to educate investors on the relevance and calculation of this data. The disclosure of the premium/discount at end of day would eliminate the need to this. We also feel these issues are already being addressed at the ETF Board level. Quarterly review of premium and discounts commonly occurs at the ETF Board level when Boards are monitoring how well the arbitrage process is functioning for a given ETF. Taking the extra step to disclosure premium/discounts on a daily basis would add to investor transparency of this issues and allow ETF Boards to react more quickly if a market dislocation becomes an ongoing problematic situation.

Creation Units

The Commission in the Proposing Release asks whether it should establish requirements for creation unit sizes and/or dollar amounts. Creation unit sizes commonly are 100,000 shares, 50,000 shares and 25,000 shares, with a recent trend towards 25,000 shares. Creation unit size is usually a function of the cost of the basket and discussed with the lead market maker and APs prior to launching the ETF. For example, some small ETF issuers and their lead market makers prefer a smaller creation unit size because it facilitates a greater number of creation transactions and asset growth.  It has been at the purview of the ETF issuer and should remain there on a case by case process. Thus, we believe this deserves a market solution rather than a regulatory solution. We therefore believe that the Commission should not regulate creation unit sizes. We further note that the recent trend towards smaller creation unit sizes has not adversely effected the ETF arbitrage mechanism.

Suspending Creations and Redemptions

The Commission asked for input regarding whether an ETF may suspend creations only in limited circumstances.  In our view, there may be a variety of reasons to suspend creations and limiting them or impose restrictions to certain activity will not allow for differentiation of the circumstances related to the underlying securities. The liquidity levels of various underlying securities or the suspension of trading in certain securities are the main reason for a majority of creation suspensions. We believe current practices developed in the ETF industry allow for the flexibility needed to address this issue.

Website Disclosure

Proposed Rule 6c-11 requires an ETF to disclose prominently on its website the portfolio holdings that will form the basis for each calculation of NAV per share. Website disclosure of portfolio holdings has proven to be an effective way to convey an ETF’s portfolio holdings. Accordingly, we agree with this condition and believe current standards and practices are sufficient in this area. However, they could be improved upon.

We urge the Commission to study and ask for industry input on generally how ETF industry information is generated and disseminated.  Currently, over 100 advisers to ETFs post on their website ETF basket information. While Form N-1A imposes certain requirements on how such disclosure is made, ETFs vary on how such information is presented, which sometimes making it difficult for website visitors to find such information.  Since ETF issuers already are required to send basket information in the form of portfolio composition files (PCFs) via the National Securities Clearing Corporation (“NSCC”) and are published daily through the facilities of the NSCC, it makes more sense for there to be a single industry source where collecting, housing and disseminating such information occurs. Furthermore, small- and medium-sized ETF complexes would achieve costs savings by not having to maintain websites posting such information.  We therefore recommend that the Rule 6c-11 website basket disclosure requirement remain in place but that the Commission collaborate with the ETF and the Fintech industries to develop and implement an industry website that contains daily basket information. This solution may take time to evolve. For example, the industry may be able to take advantage of distributed ledger (or blockchain) technology to provide basket and holdings information to APs. This technology also could be used to verify creation and redemption transactions with APs.

Brokerage Commission Costs

Proposed Rule 6c-11 requires new prospectus disclosure that includes, among other disclosure items, a narrative explanation that investors may be subject to brokerage and other fees when buying or selling ETF shares and a new Q&A section designed to provide information about bid-ask spreads and other trading costs. The Q&A also must provide links to the ETF’s website, which must feature an interactive calculator for hypothetical cost-related information.

For a variety of reasons, we believe that this requirement will proved to be onerous to ETF advisers and recommend that the Commission eliminate these disclosure requirements from Rule 6c-11.  The type and scope of the disclosure required by the Commission has not been required during the existence of the ETF industry and we are unaware of significant industry problems necessitating such disclosure.  Instead, ETF investors have made ETFs one of the most successful products in financial history and reaped billions of dollars of savings in the form of lower fees as compared to other financial products. We also believe that the Commission places too much emphasis in the Proposing Release on comparisons between ETFs and mutual funds.  While we recognize that ETF investors may be subject to different costs than mutual fund investors, investors have a variety of investment product choices in addition to these products including separately managed accounts, hedge funds, individual securities and others each with their unique cost structures.

Indexed ETFs

In the Proposing Release, the Commission asked whether Rule 6c-11 should include requirements relating to index-based ETFs with an affiliated index provider. We suggest the Commission should be concerned that these rules do not create a situation where a “regulatory advantage” for affiliated index providers or traditional index providers exists. The index provider, affiliated or non-affiliated, play a significant role in function of a public security and investors need a transparent and consistent process for all indexing operations. Our concern in any rules related to the indexer is to make allowances for the protection of their Intellectual property and the both affiliated and non-affiliated indexers are protected in the same manner.

Conclusion

For the reasons discussed above, we support the SEC’s proposed ETF Rule.  If the SEC or its staff have any questions or wish to discuss the comments discussed herein, please contact us at 914.406.6277.

Very truly yours,

_____________

ETF BILD LLC

John Jacobs

Richard Keary

Justin Meise

Bibb Strench

4819-3200-2677.2

Three ETF Industry Pioneers Discuss Innovation – Past and Future

ETF BILD was formed to stimulate discussion on the business of ETFs, and recently we had the pleasure of sitting down with three of the earliest innovators in the ETF industry, including our own ETF BILD co-founder John Jacobs, to capture their insights on what inspired them in the early days of ETFs and what is driving current and future innovation in the ETF industry.

Joining us are:

  • Bruce Bond – Founder of PowerShares, current President of Innovator ETFs
  • John Jacobs – Founder of Nasdaq-100 Index (QQQ), current Distinguished Policy Fellow and Executive Director of Georgetown University
  • Lee Kranefuss – Founder of iShares, Founding Partner at The Kranefuss Group, LLC.

ETF BILD:  You were one of the early innovators in the ETF industry. What did you see back then as the opportunity? How did you execute on that vision?

Bond

When John Southard and I founded PowerShares in 2002, the ETF vehicle was less than 10 years old and all of the ETFs in existence were market-cap weighted. So, while the industry was quite young, we felt there was an opportunity to create better ETFs that weighted their underlying stocks based on investment merit rather than by size. To carry out this vision, we worked closely with the American Stock Exchange to build an “intelligent” index that the first PowerShares Dynamic Market ETF (PWC) would track. We branded the index “the Intellidex” and marketed PowerShares as “leading the Intelligent ETF Revolution.”

Executing a vision like intelligent ETFs took a tremendous amount of education and distribution. In 2002, very few people knew what an ETF was, let alone understood why the ones that currently existed should be improved upon. Launching PowerShares on the heels of the tech bubble helped our cause. By the time we arrived, the Nasdaq-100 ETF (QQQ) was the most actively traded security in the world, but its reputation had been damaged by the rise and fall of several heavily-weighted constituents (technology companies). This clearly illustrated that perhaps market capitalization is not the best measure of a company’s value. It sounds rudimentary now but in 2002, these were fighting words to ETF traditionalists.

Jacobs

Nasdaq looked at the ETF space in 1997, although they were not called ETFs then, as an opportunity to create a Nasdaq-branded financial product to enable Nasdaq to interact directly with individuals, institutional investors and traders. Up until that point, Nasdaq always went through an intermediary, whether it was trying to reach shareholders through Nasdaq-listed companies or trying to attract investors through Nasdaq market makers and market participants. We thought that ETFs would be a unique way to influence investor perceptions about Nasdaq and drive positive awareness and attitude, therefore helping Nasdaq in our competitive positioning. We quickly realized that there was a tremendous financial opportunity as well in the area of index products that could help all Nasdaq businesses and be self-sustaining financially. The Global Information Services (GIS) business at Nasdaq today, which contains indexes, data and analytics, is the most profitable business at Nasdaq, and the same holds true at the LSE Group for their GIS unit, which contains FTSE Russell, data and analytics.

We decided not to license the first ETF (QQQ on the Nasdaq-100 index), but rather we created our own fund company similar to the model that the American Stock Exchange followed to create SPY on the S&P 500 Index. We then undertook a three-pronged approach to growing the business. We built out the legacy index platform and operations group to allow for the creation and dissemination of multiple indexes; we separated index data out from the exchange data feed to create separate entitlements and a business development function to work with product sponsors to judiciously license and create index products across multiple channels to reach investors and traders from the most conservative retail investor to the most sophisticated futures trader.

Kranefuss

At the time (1998), I was heading strategy at BGI. We were well aware that the largest institutions (with staff and resources to do the work) had come to realize that they were paying too much to and getting too little from most active managers. Worse yet, when they looked across the portfolio they discovered that having large numbers of active managers led to a net outcome that was awfully close to an index fund but with a lot of work and fees. The managers doing well got cancelled out by the ones doing poorly who held the “other” stocks in the index.

We realized the benefits of low-cost and, in the individual market, highly tax-efficient investments as markets that were severely underpenetrated and undermarketed. As the world’s largest indexer, ETFs made all the sense in the world and let us “break bulk.” We could manage a large central fund, with most investors buying and selling their shares on the secondary market, and we would be running what we always ran: large, relatively static and low-cost index funds.

ETF BILD:  How different is the industry today versus your original vision of the industry? What has surprised you the most?

Bond

We didn’t necessarily have a grand vision for the ETF industry as a whole when I founded PowerShares. We definitely had a clear vision for our firm, which at the time was to build more intelligent ETFs than what currently existed. In terms of brand strategy, you can either be the biggest and the best “something,” or you can innovate, subvert a category and create a new way of thinking. This is what we were doing through PowerShares: increasing people’s perception of what the ETF could actually deliver. iShares, Vanguard and State Street had all but tied up the passive ETF space. We had to create an entirely new category of ETFs and own that new space if we were going to compete with the big three. Looking back, I think we were successful. The PowerShares Dynamic Market ETF (PWC) can be viewed as the cornerstone of the smart beta ETF space, which has seen tremendous growth since its humble beginnings in 2002.

Along those lines, I think what has surprised me the most is the phenomenal growth and proliferation of the smart beta ETF space. In 2002, I never imagined the space would top U.S. $1 trillion, which it did at the end of 2017. I think it shows that investors are still seeking cheaper alternatives to active management in a more methodical way.

Jacobs

The industry has become dominated by a handful of mega-indexers and mega-sponsors today. Although not necessarily surprising, it happened relatively quickly. The concern here is that it may be harder to innovate and get new products to market. In addition, the changes in market structure at the exchanges (primarily in the U.S.) has been a big, behind-the-scenes change for the industry. The end of the specialist system, although very good from an overall market liquidity, quality and competitive standpoint, also ended the most stable supply of new product seed capital. The specialist system did allow for a larger seed capital commitment by market participants in exchange for a monopoly on trading.

Kranefuss

We launched 40 funds to start. We believed the market, which includes institutional uses such as traders who need to hedge, funds that needed to equitize cash, etc., needed the basic slices from the big providers. For example, for both Russell and S&P we wanted to offer every slice of U.S. large-, mid- and small-cap as well as growth and value cuts of each. We also saw the need for sectors and international exposure at the country, region and development level (e.g., emerging vs. frontier markets).

We saw ETFs as a better index fund that gave you pinpoint precision. We thought that we would learn from customers and come up with maybe 100 ETFs over time.

What we did not foresee, which I think is a case of turning wine back into grapes in many cases, was the attempt to keep trying to make ETFs more “active.” Suddenly, there were lots of products claiming to outperform the index fund based on some proprietary selection or trading strategy (and at a higher cost). I think the thousands of ETFs out there now – many trying to claim to be active in some way – undermines the key benefits: broad, diversified exposure, low-cost and highly tax-efficient building blocks.

ETF BILD:   Where do you see the opportunity in today’s industry? 

Bond

To me, the opportunity will come through two channels: innovation and regulation. We were fortunate to be part of leading several ETF innovations early on (e.g., smart beta, fixed income, active, commodity). Since those days, we have seen tremendous asset growth but also a high level of product proliferation. Most of these products fit into one of the aforementioned categories. I think some of the larger passive products will continue to see growth; however, we have seen many product launches fail to garner assets and subsequently close due to lack of demand. To me, if ETF issuers are going to succeed in today’s proliferated market, their products have to be innovative and either serve investors’ unmet needs or make things easier and/or lower cost for them.

Jacobs

We are still in early innings in the index investing space. For example, ETFs have yet to penetrate defined contribution platforms such as 401K’s and 529’s in any meaningful way. In addition, actively managed ETFs still make up a small part of the overall market. Although equity ETFs have a very robust offering, other asset classes such as fixed income lag primarily due to the liquidity challenges of the underlying assets because of market and product structure. Niche, innovative index product sponsors have tremendous opportunity to create products that don’t fit the models of the mega-firms.

Kranefuss

First, a back-to-basics approach. The gold standard should be a traditional index and then other offerings can be compared to it on all dimensions: cost, tax-efficiency and consistent performance over the long run.

Second, I think there are ideas and approaches that do make sense to augment what was known in 2000. Factors, for example, are a realistic and reasonable idea for the modern world.

ETF BILD:  What is the next innovation in the industry that you are working on or that you expect to see?

Bond

The ETF is an efficient vehicle that can be used to provide investors with a better overall investment experience and disrupt traditional markets along the way. One innovation I am open to discussing is the concept of replicating a structured note payoff within an ETF. The structured note space is massive (nearly $1 trillion in the U.S. alone), and we think it’s ripe for disruption. We have worked with several leading companies to build a series of ETFs that afford investors defined exposures to the S&P 500 Price Index where the downside protection level, upside growth potential, enhancement level and outcome period are all predetermined. The first two in this series of “defined outcome” ETFs – the Innovator S&P 500 Power Buffer ETF (PJUL) and Innovator S&P 500 Ultra Buffer ETF (UJUL), which were listed on the Cboe on August 8, 2018.

Jacobs

I think the next round of innovation will occur at the product level to try to solve the twin problems of lack of seed capital and the challenge of creating a liquid ETF on illiquid underlying constituents.

Kranefuss

Personally, I am working on a book and an internet app that tries to help people step back from staring at the bark and see the forest. Investing is really about meeting your long-term needs after costs, taxes and inflation. My goal is a simple-to-use, free tool for investors that lets them focus on a basic savings and investment plan (assuming to start, low-cost and tax-efficient ETFs) to see if their savings and spending plan have any hope of carrying them through retirement. The rest are seeking better performance, worrying about big market swing years and trying to catch the brass ring by buying hot stocks, or funds, that can be tested later to see if they work, especially after tax.

ETF BILD:  What is the biggest concern you have in the industry today that you would like to see change?

Bond

Historically, the investment landscape has suffered and has been held back from a type of “pay-to-play” where certain institutions seek to protect less efficient products. You see this quite often in the retirement space where mutual funds and insurance products have historically dominated. I think the ETF vehicle could bring a lot more efficiency to people’s retirement savings, and I would love to see that happen.

Jacobs

My biggest concern is that since Reg NMS was implemented, the markets have been primarily built on speed, speed, speed. That works great if you are QQQ or Apple, but less liquid products and companies don’t reap the same benefit from that market structure. There is no one single market structure that can optimally serve all types of financial products and issuers. I would love to see market segments that have differing market structures that are best suited for an issuer at any particular stage of their life. This would be an issuer choice and they would have the freedom to change market segments as their needs changed.

Kranefuss

Far too many ETFs. People took a great delivery vehicle for an investment thesis with huge amounts of empirical justification and institutional adoption and turned it into a marketing tool for their little-know investment idea. They are riding the coattails of ETF success but selling sizzle, not steak.

ETF BILD:  What is your vision for the industry 20 years from now?

Bond

The ETF structure is still in its infancy relative to other investment products. I do not attempt to predict the future, but I do try and shape it through innovation. I can almost guarantee over the next 20 years there will be markets to disrupt and new asset classes to provide access to through the ETF vehicle. If I made one prediction it would be that we see a continued decline in mutual funds and more asset flows going into ETFs. That seems like a safe bet but to me, by keeping our attention locked in the present and with an eye toward the future, the next 20 years will essentially write itself.

Jacobs

In 20 years, I foresee that the ETF industry will still be booming, the leading edge of financial product innovation and the key to investment and trading strategies for retail investors, institutional investors and their advisors. ETFs will have penetrated multiple asset classes, product channels and geographic adoption. The industry will be less focused on active vs. passive, since both are critical, and rather look to what product can deliver the investment results desired in the most efficient manner while balancing risk and return.

Kranefuss

Products that are tightly integrated with robust tools that shine a critical light on reality. You really don’t need that many funds to build a low-cost, extraordinarily diversified and tax-efficient portfolio. The right tools are the only way I see to cut through the clutter.

SEC Finds Potential Issues with ETFs that Track Customized Indexes Sponsored by Entities Not Registered as Investment Advisers

Dalia Blass, Director of the SEC’s Division of Investment Management, in a recent speech questioned whether the provider of an index used by a single ETF should be registered as an investment adviser under the Investment Advisers Act of 1940.[i] Such indexes are sometimes called “bespoke indexes” because they are built at the request and to the specifications of a single sponsor in contrast to broad-based indexes used by asset managers and investors as benchmarks. Any SEC action on this issue could dramatically impact the burgeoning self-indexing segment of the ETF industry, including by adding another regulatory hurdle for new entrants.

In the early years of the ETF industry, most ETF sponsors licensed indexes from the major index publishers such as Dow Jones and Standard & Poor’s, often incorporating the index name into the ETF’s name. These index providers, as noted by Director Blass in her speech, had and continue to have the option of avoiding adviser registration by availing themselves of the publisher’s exception to the definition of investment adviser in the Advisers Act.

More recently, it has become common for an ETF sponsor to develop or co-develop its own or bespoke indexes that are tracked by its own ETFs (called bespoke ETFs). Such sponsors design or co-design their own indexes and typically outsource the calculation of the indexes to third parties including the major index publishers. The SEC routinely grants exemptive orders allowing such “self-indexing.”

Several reasons exist for the proliferation of bespoke ETFs. The sponsor of a bespoke ETF pays licensing fees to itself instead of a third party. By offering bespoke ETFs, a firm can enter the ETF business without having to register as an investment adviser, earning revenue from the ETFs through licensing fees in lieu of advisory fees. The bespoke model allows the sponsor to tailor the index to its investment approach or thesis or to a strategy that an institutional investor seeks. Many such indexes are narrowly focused and use index methodologies with multiple and nuanced screens, producing an index that is a measuring stick useful to few beyond the sponsor or key investor.

If the SEC were to take the position that only registered advisers may license bespoke indexes to ETFs, many current ETF sponsors would be thrust into regulation as investment advisers, change the indexes their ETFs track to broadly followed third-party indexes or be forced to exit the business because such sponsorship is no longer profitable. Director Blass clearly zeroed in on the status of such sponsors when she pondered what the SEC should make of:

  • an index that the provider maintains for only one single fund;
  • the index provider taking significant input from the fund’s sponsor or board regarding the creation, composition or rebalancing of that index; and
  • the index provider being affiliated with the sponsor.

It remains to be seen how the SEC will act in this area. In her speech, Director Blass indicated that questions surrounding this issue will be asked by the Division’s disclosure staff when first reviewing the registration statements of new bespoke ETFs. A position that a bespoke ETF’s index provider meets the definition of an investment adviser and is not eligible for any exceptions from that definition would close the door to many new ETF industry entrants at the same time that the companies sponsoring the largest ETFs, which are already registered as advisers, are beginning to offer their own self-indexing ETFs. It seems likely that the SEC will address the adviser registration issue in its long-promised ETF rule, which its rulemaking staff is currently drafting. Questions from regulators often lead to more questions: Might the SEC posit whether an ETF that tracks a bespoke ETF is really in fact an index (and thus truly passively managed) based on the determination that the single index provider meets the definition of investment adviser because “it is providing advice” to the ETF? The ETF industry has much riding on the answers to these and other questions.

[i] Dalia Blass, Keynote Address, ICI 2018 Mutual Funds and Investment Management Conference, March 19, 2018 (https://www.sec.gov/news/speech/speech-blass-2018-03-19).

The ETF BILD Project Presents its First Leadership Discussion Session

ETF veterans discuss implications of FINRA Rule 5250

April 2018

From time to time, ETF BILD has the opportunity to discuss a variety of issues and topics with prominent individuals in the ETF industry. In connection therewith, we seek comments from our readership resulting in a full and thoughtful discussion around the issues and topics vital to the ETF Industry.

Recently, ETF BILD sat down to speak with three prominent veterans in the ETF space to capture their insights on FINRA Rule 5250, Payments for Market Making, and its implications.

Joining us for the discussion:

  • Reggie Browne – Senior Managing Director of ETF Trading, Cantor Fitzgerald
  • Laura Morrison – SVP, Global Head of Exchange Traded Funds, CBOE Markets
  • Jim Toes – President and CEO, Security Trader Association (STA)

Background: FINRA Rule 5250 prohibits market makers who provide quotes and related services to companies that list their securities on stock exchanges from accepting any payments from such companies. Rule 5250 is designed for corporate securities listed by ordinary companies and intends to assure that the market maker acts in an independent capacity when publishing a quotation or making a market in such corporate securities. ETFs are dramatically different from ordinary companies and do not present the same concerns, primarily because their economic returns are derived from the corporate securities they own. The application of the rule to ETFs may be preventing a relationship between the ETF issuer and market maker that otherwise could be highly beneficial to the ETF product and investor.

Currently, FINRA is conducting a general review of its rule book and has asked for comments relating to modernizing Rule 5250, which was adopted prior to the existence of ETFs. The debate is centered on whether or not ETFs should be exempt from this rule.

ETF BILD: What’s your view of FINRA Rule 5250 (Payments for Market Making)?

Browne: I’m an advocate for exempting ETFs from the rule because it solves a couple of problems. The ETF industry, on a global basis, should be harmonized to minimize the use of different practices in different global market centers. Refinement of rules governing the investor experience in ETFs should be an ongoing priority. Reorienting the U.S. so that it looks more like Europe, where ETF sponsors could have a direct relationship with market makers for services rendered, helps ensure there is a level playing field over the services delivered while negating regulatory burdens. The result of a commercial relationship between the market maker and ETF sponsor would most likely improve the investor experience in thinly traded ETFs with measurable, tighter spreads.

Also, I would like to note that in Europe there are no rules written on payments by ETF issuers to market makers; it’s silent. In my view, European regulators should take a stance on the practice to test for conflicts and mandate transparency.

ETF issuers want better outcomes, more control and more say in product delivery and process.

Morrison: I believe that Rule 5250 should apply to corporate equities for good reason because of how prices are discovered for corporate equities but not to ETFs. ETFs are essentially derivatively priced, a process that is very different than the pricing of corporate equities. Currently, ETF issuers can create agreements with market makers in Europe and the results of this engagement have been positive, not for all issuers but for some. We see the value in the ability to do it here in the U.S.

Unfortunately, ETFs have been swept into all equity security rules without consideration for what makes an ETF unique. ETF issuers are asking for the ability to pay market makers. We are suggesting that issuers not be required to enter agreements for each and every product and market maker relationship, but rather giving the issuer the option to “pull this lever” on a case-by-case basis as they deem necessary or appropriate. Also, such ETF issuers could be required to disclose if an arrangement exists but not be required to disclose the dollar amount, length of the arrangement or specific requirements and expectations of the market maker. This would be helpful from a competitive standpoint.

Allowing such payments may result in the market maker being more engaged in their quoting commitments to the ETF product. The issuer’s investment up front could result in improved quote quality and price discovery for the end investor, which in turn may improve the issuer’s ability to attract assets in the ETF product.

Toes: If the rule were reformed, it would address certain existing barriers to entry for market makers in ETFs by enabling those firms to recoup some of the initial costs. Investors would still be protected from the harm that Rule 5250 addresses due to the arbitrage feature of ETFs and other unique attributes of the structure. There should be disclosure about these arrangements, which may cause the industry to become hung up on the amount of transparency and how market makers would react if they are asked to provide too much information around specific payments, but this could be sorted out.

ETF BILD:  The ETF industry is relatively small with a lot of competitive issues, so it’s hard for them to sit at the table together. Since the STA is a long-established trade association for individuals who trade equity and listed options, can the ETF industry and the STA work together to achieve common goals?

Toes: Here’s some background on the STA. We are comprised of 20 affiliates in the U.S., major cities with financial hubs, and four affiliates in Canada. We serve the trading community and engage in a variety of events; education, newsletters, open calls and conferences. We are a grass roots organization and spend a lot of time in [Washington] D.C. with the regulators and some legislators. We split time between the Senate Banking Committee, FINRA, U.S. Department of Treasury and the House Financial Services Committee.

It terms of ETFs, while this is a new area for us, we have established relationships with the trading desks and market makers for equities and options at firms who also maintain a presence in ETFs. Thus, we are able to leverage existing relationships to obtain new ones. As ETFs are becoming a more integral part of  market making activities, it is incumbent on STA to have an understanding of how they trade and issues impacting them. Rule 5250 is a good place for us to start.

Browne:  Yes, I think there is a role for STA representing the viewpoints of their members on issues impacting ETFs such as Rule 5250. ETFs are roughly a third of all volume on the equity exchanges, so it makes sense for them to take up some of these causes. So yes, the STA is a viable venue.

Morrison: Cboe has a close relationship with the STA, and their work with the trading community at large is something we welcome in a vibrant, cooperative marketplace at every level. Functionally speaking, ETFs are a source of huge liquidity and trading activity, and so it makes sense that the STA would offer their opinions on behalf of their members and our customers.

ETF BILD: Two last questions: (1) What’s your overall view on the effect of ETFs in the capital markets system; and (2) Are there risks of having the business be dominated by a few firms worrisome?

Browne: There is enough academic research on the topic about indexing, period. ETFs are only a part of the influence of price discovery and corporate equities. I don’t think there is a need for me to comment further. Those who are misinformed will continue talking about it.

There will be more asset managers launching their own ETFs, just like USAA and others, and an evolution will occur. But the football field-length start that iShares, State Street and Vanguard have is because they were first movers and they have done most of the work for the industry, so it is natural that they should be thriving.

Toes: From a systemic risk perspective, we’re not aware of concerns regarding the concentration or market share of the largest issuers. As we learn more about ETFs, we do see some areas of concern with the Authorized Participant or AP process. Phone calls, emails and other examples of lack of electronic connectivity can cause systemic risks. Go back to the crash in ‘87 when all trades were given via phone calls; electronic trading quickly began developing from that event.

Morrison: As for ETF risk in the capital markets system, more academic study and review is always welcome. This only helps expand on the educational efforts needed to support growth. Like many industries, the 80/20 Rule is also prevalent in the ETF issuer space, but that might not last forever. There are many large asset management firms expanding in the space either by organic growth or acquisition. While the U.S. remains in the lead in terms of ETF AUM and trading, we see a tremendous amount of opportunity for additional growth in our industry globally. Consistent attention by exchanges to proper market structure parameters for ETFs will enable that growth.

ETF BILD: ETF BILD and the organizations represented in these interviews have all sent comment letters to FINRA setting forth reasons as to why ETFs should be exempt from Rule 5250.

There are alternative views. One commenter raised concerns that an exemption for ETFs from Rule 5250 could lead to improper behavior in the market making community. It is that commenter’s belief that lifting the rule for ETFs might distort market forces, increase spreads by the market makers not being compensated, create a pay-to-play environment favoring those with more capital available to make payments and ferment an anti-competitive environment with exclusive arrangements.

ETF BILD believes that the concern about these issues should not prevent Rule 5250 from being relaxed for ETFs. In our view, these concerns can be easily addressed in FINRA’s rulemaking process of exempting ETFs from the rule.

Here is a link to all comment letters: http://www.finra.org/industry/notices/17-41

ETF BILD highly recommends reading all comment letters (they are relatively short) to get a full perspective on the issue. We also welcome all comments and to use ETF BILD’s website, LinkedIn and Twitter accounts to create an open, fair and respectful dialogue.

First Item on Your 2018 “To Do” List: Send Comments to the SEC About the Proposed New ETF Rule

BY BIBB STRENCH

 

Ten years after it tried to adopt an ETF rule, the SEC has once again announced that it will propose a rule allowing a firm to enter the ETF business without first obtaining an exemptive order. Perhaps more importantly, the new ETF rule will level the regulatory playing field for all ETF sponsors.  While all of the ETF sponsors will be playing on the same field, it will be vitally important for the industry to provide the SEC with input through comment letters, meetings with its staff and other means so that level playing field has as few regulatory puddles and loose turf as possible. The SEC staff likely will look first to those exemptive orders when drafting the rule, which contain a number of granular restrictions and conditions that should be jettisoned to produce a more flexible rule that still protects ETF investors. The ETF industry also can urge the SEC to adopt a rule that clarifies what types of exchange-traded vehicles can call themselves “ETFs.”

“Plain Vanilla” ETF Rule

The Trump administration through the U.S. Department of Treasury’s Asset Management and Insurance Report released in October 2017 kick-started the ETF rule proposal. In the Report, Treasury recommended that the SEC implement regulations to standardize and simplify the approval process for ETFs by removing the need to obtain individualized exemptive relief from the SEC for “plain vanilla” ETFs. “Vanilla” was not defined.  It is certain that it does not include non-transparent, actively managed ETFs and 3X leveraged ETFs.  But there appears to be no compelling reasons for the SEC to exclude most of the other types of ETFs. It will be imperative for the ETF industry to voice the view that vanilla should be as broad as a flavor as possible to capture much of the current ETF spectrum, including ETFs that invest in derivatives.  In other words, spare as many ETFs as possible from the lengthy exemptive application process.

Grading the Regulatory ETF Playing Field

Besides dismantling the cumbersome gauntlet that new ETF providers must navigate through, Treasury in its report stated that a rule in lieu of exemptive orders should “help reduce uneven treatment between ETFs.” The ETF regulatory field currently is not level:  those ETFs complexes that received exemptive orders in the 1990s and 2000s are subject to less strenuous conditions and representations than ETF complexes that recently entered the business.  For example, with respect to redemptions, an ETF with an SEC order in 2009 may redeem a basket of securities that generally resembles the basket of securities posted by the ETF for that trading day; while an ETF that received an SEC order in 2017 must redeem the identical basket in terms of names and quantities unless it can avail itself to one of the narrow exceptions in current orders. With respect to creations, an ETF relying on an older order when confronted with a difficult-to-find security for a creation is permitted to use a similar security but is not required to use the same security.

Simple Rules Are Superior to Complex Rules

ETF exemptive orders over the years have become longer and unnecessarily more granular. The ETF industry should recommend that the SEC’s Division of Investment Management use its rulemaking authority to stop this regulatory creep and return to the ETF regulatory regime of the early 1990s. The SEC can adopt a rule with general conditions in lieu of a laundry list of conditions that simultaneously protects investors without impairing the flexibility of the ETF product.  Because the process to change rules once adopted is cumbersome, the SEC should adopt a rule that focuses more on exempting an ETF from the requisite provisions of the Investment Company Act of 1940 and less on regulating the day-to-day operations on an ETF.  The latter can be adequately addressed through disclosure and reporting rules, SEC inspections and the ETF stock exchange rules and applications that the SEC’s Division of Trading and Markets administer.

Name Calling

Are ETFs a subset of ETPs (exchange-traded products) or vice versa? What about ETVs (exchange-trade vehicles) and ETNs (exchange-traded notes)? Some are regulated by the Investment Company Act of 1940 and Securities Act of 1933, some just by the Securities Act of 1933, some by the Commodity Exchange Act, and some by a combination of all of these Acts. Most are entities but some are not. The SEC in the past have adopted rules governing what an investment company can call itself (e.g., a fund may only call itself a “money market fund” if it meets the conditions of Rule 2a-7 under the Investment Company Act). By taking a similar approach in the proposed ETF rule, the SEC could minimize investor confusion. The larger 1940 Act regulated ETF industry also would sleep better at night without worrying about the fallout from the crashing of a non-1940 Act regulated, highly speculative crypto-currency fund that calls itself an ETF.

To Do List

The SEC Division of Investment Management’s 2018 To Do List includes drafting an ETF rule, publishing it in a Federal Register notice that invites public comment and convincing three out of the soon to be five SEC Commissioners to adopt it.  Since there is talk that the rule is on the regulatory “fast-track,” it is time now for the ETF industry to put at the top of its 2018 To List conveying to the SEC its views on what should and should not be included in the ETF rule.  That message should be: (1) vanilla includes all but the few exotic flavors; (2) a plain English and concise ETF rule will lead to greater regulatory efficiencies and industry flexibility; and (3) a uniform definition of what is an ETF will be highly beneficial to the SEC, industry and investors alike.

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Boards Need to Start Laying the Groundwork for Overseeing the Rapidly Approaching ETF Liquidity Risk Management Programs

BY BIBB STRENCH AND RICHARD KEARY

 

Exchange-traded fund (ETF) boards soon will be knee deep in reports and presentations designed to facilitate their compliance with the SEC’s new liquidity rule. Rule 22e-4 under the Investment Company Act of 1940 will require ETFs (and mutual funds) by December 1, 2018 (June 1, 2019 for ETF complexes with less than $1 billion of assets) to have a liquidity risk management (LRM) program and imposes comprehensive new portfolio liquidity responsibilities on boards when overseeing the LRM programs. We caution that ETFs boards must not take a “check-the-box” mentality when carrying out this function. Rather boards should push beyond factors identified in Rule 22e-4 and statistical vendor-provided data to consider more nuanced factors and circumstances that ultimately are the best indicators of the risk that a given ETF will fail to satisfy a redemption order.

Rule 22e-4

Many of Rule 22e-4’s requirements are similar in terms of structure to other SEC rules applicable to investment company boards, including approving the LRM program, designating a person to administer the LRM program and reviewing reports on the LRM program. Rule 22e-4 has other important requirements that a board will oversee such as a 15% cap on illiquid securities, classifying the portfolio of an ETF that does not qualify as an “In-Kind ETF” into four categories if that ETF includes a non-de minimis amount of cash in in-kind redemptions and regular and special SEC reporting requirements.  Our focus is the Rule’s core requirement that the LRM program be reasonably designed to assess and manage each ETF’s liquidity risk while taking into account the five factors set forth in the Rule.

Rule 22e-4’s Five Factors

The five Rule 22e-4 factors with our commentary are discussed below.

1. Each ETF’s investment strategy and liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions, including the extent to which the strategy involves a relatively concentrated portfolio or large positions in particular issuers, and the use of borrowings for investment purposes and derivatives.

This factor directs the board to look through the ETF to its underlying portfolio holdings by requiring an analysis of the ETF’s portfolio securities in normal and stressed conditions.  Boards should request data such as bid-ask spreads, volatility of trading prices, average daily trading volume of the portfolio securities and maturity dates of fixed-income securities held by the ETF during normal and stressed market scenarios.  The investment strategy and nature of the ETF (and its holdings) will dictate how deep of an analysis will be warranted. For example, a small ETF in terms of assets under management with large cap strategy likely will have highly liquid portfolio securities and require less nuanced scrutiny.  At the other extreme, esoteric ETFs require a more in-depth analysis of the ETF’s underlying portfolio holdings.  This may necessitate the consideration of a host of other factors such as who makes markets in the portfolio security, what types of institutions own the portfolio security and what is the volatility of the portfolio security.  Obviously, the board will have to rely on summaries of the data and analysis prepared by the ETF’s adviser or vendors or risk being paralyzed with too much information.

Factor 1 also mentions an ETF’s use of borrowings for investment purposes and derivatives.  Leveraged ETFs typically invest a sizable amount of their assets (e.g., 80 percent or more) in the securities of the target index or treasuries with the remaining assets invested in cash or cash equivalents, against which the ETFs enter into derivatives transactions (typically futures and swaps) to obtain the remaining targeted exposure. The Boards of these types of ETFs will have to monitor the liquidity of these arrangements, which, among other things, will require the adviser to provide them with information and analysis of the counterparties in such arrangements and the liquidity and characteristics of the securities held in segregated accounts to cover or that are pledged to satisfy margin and regulatory requirements.

2. Short-term and long-term cash flow projections during both normal and reasonably foreseeable stressed conditions.

Cash flow projections are far less relevant to ETFs than mutual funds because ETFs typically receive securities and only small amounts of cash when investors purchase their shares. In fact, many ETFs, especially small- to mid-sized ETFs experience multiple days in a row when no cash is arriving or departing from the ETF as a result of no creates and redeems, respectively. On the other hand, cash flow projections for fixed-income ETFs may be highly relevant, especially with respect to high yield bonds that trade in less liquid markets and highly stressed fixed-income market scenarios.

3. Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.

This factor is more applicable to mutual funds than ETFs.  Mutual funds, unlike ETFs, typically do not have redemption in kind mechanisms in place and thus are highly dependable on cash on hand or borrowing facilities to meet daily redemption requests.  ETFs operate entirely differently, making episodic redemptions in kind to APs. Other than a de minimis amount of cash to facilitate irregular baskets and rebalancing by index ETFs, cash on hand only serves to be a drag on the ETF’s performance and, for index ETFs, causes them to deviate further from the performance of the index they are tracking

4. The relationship between the ETF’s portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade, including, the efficiency of the arbitrage function and the level of active participation by market participants (including authorized participants).

Factor 4 provides boards with possible symptoms of illiquidity of an ETF rather than its actual liquidity.  As spreads in an ETF’s offering and bid price and offering price and net asset value per share increase beyond a generally acceptable level or peer ETFs, it may suggest potential issues including liquidity issues. Wider spreads will trigger the Board’s need for different inputs and types of data and analysis of that data to better pinpoint the liquidity of an ETF.

The fact that a given ETF has relatively few APs should cause a board to pause to ask more questions about the APs that interface with the ETF.  APs do not receive compensation from an ETF or its sponsor and have no legal obligation to create or redeem the ETF’s shares, obviously making ETF issuers more dependent upon surviving APs for liquidity when other APs find it no longer profitable to transact business with them. On the other hand, an ETF may have an excellent relationship with one or two APs or the APs that specialize and hold inventories of the type of securities that the ETF invests in, making the number of the ETF’s APs less relevant.

5. The effect of the composition of baskets on the overall liquidity of the ETF’s portfolio.

While Factor 5 is worded broadly, one way in which this factor may be considered by the board is looking at the ETF’s “implied liquidity.” ETF implied liquidity gets at a key concept of Rule 22e-4: the extent that an ETF’s portfolio security can be converted to cash without significantly changing the market value of that portfolio security. Implied liquidity calculations require a comparison to the total number of shares of a given portfolio security with the average trading volume of that security. For example, some believe that a position in a given security may raise liquidity concerns if it is greater than 25% of the 30-day average volume of the security. For many ETF boards, it may be prudent for them to understand what an acceptable implied liquidity for a given ETF and the implied liquidity of that ETF at a given time.

Implied liquidity is a good measure assuming “normal” market conditions. The SEC in the releases proposing and adopting Rule 22e-4 also want consideration during “foreseeable stressed conditions.” That phasing leaves open a lot of interpretation and most problems of illiquid securities almost always arise during periods of market stress. Asking the lead market maker and other APs on how they handle various types of securities during different market conditions can go a long way in properly analyzing an ETF’s portfolio securities. Thus, ETF boards likely will have to be mindful of and consider subjective factors discussed in the next section that are not expressly stated in Rule 22e-4 and its proposing and adopting releases.

Beyond the Five Factors

Depending on the nature of the ETFs in a given ETF complex, it may be necessary for ETF boards to demand information and analysis on one or more factors discussed below.

Liquidity Providers

Setting aside much of the numeric analysis noted above (including implied liquidity), an ETF board will want to consider and receive input from the ETF’s liquidity provider.  For example, the Board may want to review information about actual large trades made by the ETF that theoretically should raise liquidity concerns, especially when such large trades were executed without adversely impacting the Fund. For example, an ETF trades a 100,000 share block that is more than three times the average daily volume of the ETF. There is no impact because the ETF adviser that initiated this trade was able to work with an ETF liquidity provider that had the ability to access its own inventory of that security or other sources of liquidity to facilitate the block trade. Also, the board may want to know how particular liquidity providers acted during market events such as the 2010 and 2015 “Flash Crashes” and Brexit.  Did they trade or temporarily disappear?

Market Structure

One issue that comes to light every time we see market disruptions is the challenge of market structure in times of stress. There are instances, like the flash crashes, where the ETF structure is unfairly blamed for fueling the crashes. ETFs trade on exchanges under the same rules as corporate securities, yet they are completely different products. ETF boards should understand the challenges of market structure on less liquid stocks, as well as each new and improved circuit breakers and other trading reforms designed to return markets back to normal. Since these factors will not appear in the metrics that the Boards will be provided by third-party vendors, the ETF board will need the adviser to set the stage for a robust discussion around market structure for illiquid securities.

Portfolio Manager/Traders Input

The input, including subjective input, from the ETF’s portfolio manager and/or trading desk is vital to the board’s understanding of a given ETF’s liquidity.  In many cases, the portfolio manager will have the best information about each portfolio security, including who else owns its, inflow and outflow patterns and the brokers that make markets in it. For example, it may be relevant that the owners of a small cap ETF largest portfolio positions are mutual funds and other ETFs, which are expected to act the same way in stressful markets.

ETF Shareholders

The shareholders of an ETF should be considered when examining the liquidity of that ETF.  In many cases, ETF providers do not know who owns their shares since shareholder information is held at unaffiliated broker-dealers that interface with the ETF’s authorized participants through a process administered by the National Securities Clearing Corporation (NSCC). However, ETF providers directly or through their APs often can identify the large shareholders of their ETFs through SEC reporting and other means.  The type of shareholder, whether the ETF’s outstanding shares are concentrated in a small number of shareholders and similar factors are all important to a liquidity analysis.  For example, it would be highly relevant to a liquidity analysis that a hedge fund with a market timing strategy is the ETF’s largest shareholder.

Conclusion

Educating the independent directors of the ETF boards on the proposed LRM Program and more generally liquidity measurements and how they relate to the specific ETFs is paramount to assisting in compliance with Rule 22e-3. One suggestion would be to ask internal experts at the adviser’s firm in conjunction with the lead market maker and/or other APs to present to the board how they measure liquidity. Some of the metrics will be different than the SEC requirements and thus an important part of education of the independent directors of the Board. Since the learning curve is steep and there are complexities around each corner of the ascent, it would be prudent for boards to begin the journey sooner rather than later.

Launching a Successful ETF

BY JOHN JACOBS AND RICHARD KEARY

 

The Importance of Post-Launch Activities

The ETF BILD Project is presenting this paper to create a dialogue and place emphasis on post-launch activities for new ETFs. The industry has done a commendable job of explaining how to launch an ETF; we want to delve into the important activities that are a must for creating a successful ETF after it has been launched.

Launching is easy, raising assets is more of a challenge and needs further inspection to help those who are seeking to create new ETF products.

We begin by looking at the current state of the ETF industry, followed by a discussion of the important elements of creating a successful ETF including product differentiation, distribution and messaging.

Understanding the Headwinds: The Current State of the ETF Marketplace

“It was the best of times, it was the worst of times…” are the often-quoted opening words of A Tale of Two Cities by Charles Dickens and it accurately describes the current exchange-traded fund (ETF)/exchange-traded product (ETP) ecosystem. The industry continues to enjoy tremendous growth with assets invested in ETFs/ETPs listed globally recently breaking through the $4 trillion milestone at the end of April 2017, according to ETFGI. But while ETF launches were previously strong with 284 in 2015 and 247 in 2016, new launches have slowed: 2017 is on pace for fewer than 200. Yet enthusiasm for industry growth belies some fundamental problems that are already stifling growth – and worse – innovation, an essential ingredient in the success of ETFs.

Taking a deeper look utilizing ETF.com data, we find that for the first four months of 2017, the top four ETF sponsors (BlackRock, Vanguard, SSGA, and Invesco PowerShares) garnered $272 billion in new assets under management (AUM) bringing their total to $2.482 trillion at the end of April. Of approximately $4 trillion in worldwide assets, the top four firms alone have 62 percent of all ETF/ETP AUM. In the U.S., the big three control 80 percent of the AUM.

And then there are other dynamics common to the maturation of a marketplace. Fee compression is reducing margins and creating a larger barrier to entry for emerging managers and the ability for new entrants and new ideas to come to market is becoming a challenge.

There has been a shift in many ETF sponsors to focus more on distribution than on new products. These numbers appear to confirm that trend.

Hindrances to Innovation

Three major interconnected challenges underlie the continued innovation within the ETF/ETP space: distribution, seed capital and liquidity.

First, as previously mentioned, is the concentration of distribution. As we can clearly see from the above statistics, a few large firms and their distribution channels drive the ETF/ETP field. It is increasingly challenging for the small to medium-sized player (or even the lower end of the large player) to compete for shelf space to showcase their products to financial advisors and their customers.

Second, insufficient seed capital hamstrings new product launches. The vast majority of new products have been launched with inadequate seed capital to sustain them through the very challenging market adoption phase. In fact, during the first quarters of 2017 and 2016, sponsors shut down 48 and 65 ETF/ETP products, respectively.

The third concern and directly related to these points is ETF/ETP liquidity, including the liquidity of the underlying constituents. Just as we see a concentration in AUM in the main equity products of the top sponsors, the liquidity or trading in the world of ETFs/ETPs is also highly concentrated.

Lack of liquidity is directly related to a lack of seed capital and a lack of follow-on creation capital. This makes it increasingly difficult for the new, small products from the small to medium-sized firm to get an established foothold in the space. Lack of seed capital combined with the inability to access distribution channels creates a scenario that, despite the headlines, puts the entire business at risk of losing a key source of innovation, the core foundation of the ETF industry.

Why ETF Launches Fail: Post-Launch

Many sponsors feel that launching a new ETF/ETP is the end of the process and all that is needed is a great new idea. They believe that a good idea will sell itself after ringing the bell and enjoying the initial splash and buzz. Nothing could be further from the truth. The hard work truly starts post-launch and requires creativity, proactive marketing and tireless effort to push and pull the product into acceptance and sustainability.

The sobering reality is that the time, money and expertise needed to launch is dwarfed by what is needed to raise assets. There have been many publications, articles and conference panels on how to launch an ETF but post-launch activities often are an afterthought, however; they are critical to raising assets. It’s an action item that needs to happen early in the process as to determine the real opportunity not just for a successful launch but for creating an ETF that attracts assets.

When we see an ETF fail they are usually lacking at least one of the three main components of success.

  1. Capital – Roughly $650,000 in operating capital needed to sustain an ETF for at least three years (average time frame for an ETF to hit breakeven). This does not include a marketing budget or seed capital. This number is an approximation for new issuers who are using a third-party platform. The costs will be higher if the manager is planning to handle all operational procedures internally.
  2. Quality Product Idea – Where in a portfolio or asset allocation model does this product fit? Is that space too crowded, too competitive?
  3. Distribution Plan – How are you going to sell this product and to whom?

The operational capital component is straight forward, either you have it or you don’t. Seed capital is becoming an increasingly larger part of the early success of an ETF. Launching with less than $10 million in seed capital can extend the time needed to reach breakeven and increase the burn rate of your operating capital. This is an important conversation that should be saved for another day.

The quality product idea is much more nuanced. It’s an educated guess as to whether or not the product idea will play out. There is no crystal ball. However, you must look at the competitive landscape and if heading into a direction where you will compete with the big three ETF providers, you may want to reconsider your offering. The use of smart beta indexes has skyrocketed because emerging managers can take their own intellectual property and wrap it into an ETF that differentiates itself from other ETFs.

One of the issues that arises with innovative new strategies is the complexity of those strategies. Simple sells and the successful ETF will have a strategy that investors can easily understand and that advisors are comfortable recommending to their clients.

Developing a Successful Post-Launch Strategy

The distribution plan is the most critical of all the components of a successful ETF. If an emerging manager has an existing relationship with a team of wholesalers or has a track record of raising assets, then the decision process to go or no go on the launch is much easier. But what we see most often is the “let’s build it and they will come” approach to distribution. Well that no longer works in today’s competitive ETF market.

ETFs are no longer bought, they need to be sold. There are many entrepreneurs out there who can build a product that outperforms on a back-tested basis SPY and offer it as a replacement to SPY, but they do not have the distribution capabilities of SSGA. Performance is not the only metric in selling an ETF. You need to be able to reach investors with your investment thesis, and there must be a need in the marketplace for it. There is no need to replace SPY, unless you can do it cheaper.

No magic bullet exists nor do standard operating procedures that will lead an ETF to raising assets, but there is a process that with consistent attention will give emerging mangers the best opportunity at success. Their distribution plan and its execution in the post-launch activities will determine success or failure.

More simply stated, it is operations versus marketing and sales. Operationally there is a check list that every ETF provider goes through to launch an ETF. The marketing/sales side often gets overlooked or sometimes omitted. The provider often feels that the product’s performance will speak for itself, and they most likely will spend their entire capital getting to launch day and no longer have a marketing budget. That’s a problem.

Messaging

When you review the successful launches of ETFs going back to the original Spyders or iShares or some of the most successful thematic ETF launches more recently, you will find a common thread: strong, concise and compelling narratives. Messaging about the product and the provider (firm) is crucial.

Creating successful messaging starts with taking the time to do the research to ensure you fully understand the needs and fears of your target audiences. That’s the key to distinguishing table stakes from differentiators. Too often, ETF providers lead with the things they are proud of that under analysis prove to be fairly common – investment acumen, a great team and strong capital partners. Those things are crucial, but do not resonate since you aren’t even credible with advisors, investors or financial firms unless you have them.

Employing an Integrated Model

Once you have vetted strong messaging the next step is finding the best ways to reach your audience. Today, that is more complex since more than any other time in history, audiences control the interaction. They have more ways to filter your message out either proactively or simply because of the preferences for communications channels. For example, a 65-year-old may still be reading a print edition of the Wall Street Journal while a 30-year-old may filter news through his or her Twitter feed, not necessarily conscious of the news source.

To break through, firms need to create strong content and promote it as efficiently as possible through as many channels as possible. It sounds daunting, but with the right approach it can be done efficiently and effectively. An integrated or holistic model is an approach that repackages content to create as many touch points with a target audience as possible.

The three stages to move a target to a customer are Awareness; Comprehension; Execution. No one will buy a new ETP (or any product for that matter) unless they know about it, understand it and then feel they need or must have it. There is an ancient saying in business that if you build a better mousetrap, the world will beat a path to your door. That simply is not true. The world has to know you built a better mousetrap, they need to understand why it is better and lastly, they must want or need it. The ETP space is tremendously crowded today and there is a large amount of noise and distraction. The most important activity post-launch is to continue to push the story through every channel possible.

The ETP market is dominated by an oligarchy of indexers; an oligarchy of sponsors; and an oligarchy of distribution channels. Without a strong brand, compelling story and dedicated effort to get that story out over and over again, the chance for adoption of a new product is very slim. Investors and traders need to be aware of your product and how it will help them. After that, the step to comprehension is far shorter and once they understand, the final step to purchase is the shortest of all.

We began with perhaps the most famous opening line in literature; the ending of A Tale of Two Cities is just as applicable to the ETF industry as the opening line. In the novel there was a chaotic ending that led to the belief that the revolution will transform not just the people, but the city of Paris as well. The same can be true with ETFs. As difficult as the landscape looks with the lion’s share of AUM belonging to the big three, there is opportunity and hope that other ETF providers large and small can still compete in this growing marketplace. But those emerging manager’s up for the challenge will need to execute a disciplined approach to their post-launch distribution activities. The right strategy, properly marketed with the right messaging and branding, can put forth a lead to shelf space and success. But it is no longer a ‘throw the fund into the market and let investors find it’ world. Rather, emerging managers must be thoughtful, proactive and put forth a lead to consistent effort. If so, ETF sponsors large and small along with the industry as a whole will find it is indeed the best of times.