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


October 3, 2017

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.


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


July 24, 2017

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 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.


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.