Step 4: Ensure you are ETF ready
While ETFs enjoy many of the same operational requirements as a mutual fund, there are unique, day-to-day requirements that a firm must be aware of and monitor to support a new ETF business. The calculation and delivery of the portfolio composition file, the receipt of creation and redemption orders from APs, and the use of in-kind trading may present nuances and additional operational requirements for managers considering this type of fund reorganization as their entry into the ETF market. Firms should look to educate not only their internal constituents but confirm their existing service providers have the capabilities needed to support ETFs.
Authorized Participants (APs) & Market Makers
As managers approach the conversion, they should engage APs and market makers. It’s critical that ETFs have APs under agreement to facilitate creation and redemption orders on day one and market makers to match buyers and sellers over the exchange. Additionally, these firms can help managers assess any potential changes to their portfolio as they convert from a mutual fund to an ETF.
The mutual fund holdings need to enable a liquid, deliverable ETF basket for the APs and market makers to trade. Additionally, the basket should be tradeable in a way that is compatible with the large aggregations of ETF shares called Creation Units, the blocks of ETF shares utilized in the creation and redemption process. Fund managers may want to work with an AP to confirm the portfolio is using the best tradeable lots sizes for specific securities and markets, remove illiquid positions, or even limit the size of the basket to enable it to be traded in a cost-effective and liquid manner. The APs and market makers may also assist in creating customized baskets post conversion to help facilitate these changes in a tax efficient manner.
Firms may consider adding staff or assigning some of their team to the ETF business. For example, most ETF firms employ a Capital Markets group (or individual) who is responsible for building relationships with APs and market makers, monitoring trading and spreads, approving creation and redemption orders and presenting ETF activity to the board. This is often a new role for traditional mutual fund firms and one that will often lead to discussions with APs, exchanges, market makers, and other ETF ecosystem partners. Ideally, this role would be part of a reorganization road map given its widespread integration in the ETF market.
Additionally, a firm’s 38a-1 compliance program may need to be amended to account for exchange-based trading, monitoring of spreads and APs, design of basket policies and procedures and the presentation of fund performance based on share trading prices as well as NAV per share. Chief compliance officers as well as chief operating officers will likely need to affirm to their board in advance of the fund reorganization new controls and oversight that will be implemented to support the new ETF business.
Firms will also need to examine their underlying strategy and positions to confirm that such strategies and positions will meet the ETF Rule’s requirements and listing standards, as applicable. For firms looking at a non-transparent actively managed ETF model, the exemptive relief currently only allows for exchange-traded securities trading synchronous to the U.S. market.7 Beyond these considerations, managers should be aware that APs will want to discuss the portfolio and confirm it’s tradable, the costs associated with trading and hedging, and better understand the portfolio strategy.
Lastly, and perhaps most importantly, are the impacts an ETF business can have on a firm’s distribution team. As ETFs trade over the exchange, it can be difficult to track underlying buyers of the products. Sales teams may need to consider how they can access this information from third-party data firms or from their intermediary partners, likely with additional costs. As mentioned, converting a mutual fund to an ETF may present changes to the access the mutual fund has with intermediary partners. While ETFs typically do not charge 12b-1 fees to shareholders, revenue sharing arrangements with intermediary partners do exist between the ETF sponsor and the respective platforms. As firms enter the ETF market, they should engage their distribution partners to better understand any potential changes to current business incentives that an ETF wrapper may present.
Incentivizing the sales team to market the ETFs may be part of potential changes to distribution strategy and sales compensation firms should consider. Training sales professionals on the nuances of the ETF wrapper will also be critical as their wholesaling efforts will likely require commentary on how best to trade the new product, and spread analysis and connections to liquidity providers (e.g. market makers). Installing a Capital Markets person or hiring an ETF specialist within the sales team may aid in these training discussions during the reorganization process as well as on-going product support.