In recent years, Exchange-Traded Funds (ETFs) have emerged as the passive vehicle of choice for a wide range of institutional and retail investors. Global ETF assets grew from just $417 billion in 2005 to over $5 trillion in August 2018,1 representing annualized growth of 21%.2 The popularity of ETFs is not surprising: ETFs come with low expense ratios, trade like a stock, and offer intra-day liquidity. With more than 5,600 ETFs available today, there is no shortage of options for investors to choose from.3
While ETFs have been around for more than 25 years, originally they were built to track broad indexes — like the S&P 500 — and were deployed by investors as passive strategies. But ETFs have evolved in recent years to include actively managed strategies, more sophisticated smart beta methodologies, thematic vehicles, and factor-based approaches. As ETF demand continues to rise for retail and institutional investors, many asset managers are adding ETFs as a core part of their product strategy to either retain assets or drive flows across existing or new distribution channels.
For asset managers new to the ETF market, the products’ operating model may look familiar. By our assessment, roughly 80% of the ETF workflows resemble that of a mutual fund. Hence, the real question: How do you handle the 20% that is new and different to your business?
After you conduct a thorough evaluation and decide to take the leap, there are a multitude of factors you should consider prior to the launch. Here are five that stand out.
In recent years, ETFs have emerged as core products for large scale asset managers. In fact, out of the top 20 largest asset managers globally (based on AUM), 18 offer proprietary ETFs.4 This leaves new entrants with the challenge of differentiating their ETF products in a crowded marketplace. Managers can do this through investment strategy, cost, and brand awareness.
Given the widespread availability of established core-index ETFs – which are dominated by a handful of incumbent ETF providers – there isn’t much shelf space for new products that mirror these strategies. In recent years, some new entrants have turned to smart beta and active strategies to launch new, differentiated ETFs. ETFGI reports that the 5-year CAGR for smart beta ETFs globally is 33% and for active is in excess of 20%. Esoteric sectors and nuanced strategies have also become increasingly popular targets for new issuance, including thematic, currency hedging, and environmental, social, and governance (ESG) ETFs. No matter the strategy, delivering an ETF that solves the needs of an investor segment is imperative for competing successfully.
Cost can also be an effective way to differentiate. A common misconception is that all ETFs are low-cost and therefore will cannibalize existing higher-fee products (e.g. active mutual funds) rather than complement them, but a look beyond the total expense ratios (TER) of certain core index products shows this is often untrue. On an asset-weighted basis, the global average TER for an ETF is 23 basis points (bps) – 21bps in the US and 27bps in Europe.1 The TER increases, however, depending on the level of product innovation and complexity. For active ETFs, the sponsor generally needs to commit more technical and human resources when compared to passive index strategies.
Globally, average TERs for active ETF strategies is 56bps but can extend well north of 70bps. Investors, for now, are willing to pay a premium for active strategies that look to outperform the index. For managers, cost is a delicate balancing act: ETF success is largely defined by the ability to scale quickly (i.e. AUM). And to gain AUM, an ETF needs to not only have a differentiated strategy but must also have a competitive TER against peer products.
Managers who can capitalize on an existing brand will be at a significant advantage in building assets in the initial post-launch phase, particularly when combined with a unique strategy. Research indicates that building a brand in ETFs may hinge more on educating investors through thought leadership than targeting them through traditional advertising.6 Findings from our 2017 US and European investor surveys underpin the need for education as 1/3 of respondents said they want more education in smart beta products.
Most of the functional elements managers must address to support stand-alone ETFs will likely overlap with mutual funds, but nuances and outright differences arise in operational areas such as portfolio management, distribution, fund accounting, and transfer agency. While attracting ETF talent can be challenging, especially in Europe and Asia, operations staff must be well-trained to understand these distinctions. There are additional support functions required to run an ETF – such as a Capital Markets team who manage the relationship between the Portfolio Management team and the Authorized Participants (APs).
Shareholder servicing costs for ETFs are substantially less than for mutual funds due to the lower volume of order activity (but higher order values) from fewer primary market investors (APs) as most of the buying and selling is on the secondary market. In addition, the sub custody transaction charges as a result of order activity is generally paid by the AP. Both of these items contribute to lower costs for the sponsor.
Another key difference is that ETFs must publish a portfolio composition file (PCF) on a T-1 basis (minimum). This is used for both creation and redemption purposes, as well as indicative NAV (iNAV) calculation. Generally, the administrator, custodian, or a third-party servicer will provide these files. However, an asset manager will need to build the capability from both a technology and personnel perspective to accommodate this process into their work flow.
Choosing Your Fund Structure
Asset managers should also consider the fund structure, as the operational workflows can vary significantly. Typical structures for ETFs include:
The most common structure used to launch ETFs is a stand-alone legal entity. Stand-alone examples include 40 Acts in the US, UCITS in Europe, Investment Trusts in Japan, and Unit Trusts in Hong Kong. The entity can have multiple sub-funds each with segregated liability. Each sub-fund can track different indexes and can have different investment objectives.
The master-feeder structure also leverages common portfolio management and reporting expenditures, but the ETF is a separate legal entity. Master-feeder funds are formed when the assets of a mutual fund are transferred to a newly established master fund, making the existing mutual fund a “feeder fund” to the master. This structure, however, has been slow to take off given that converting to such a structure may present tax, legal, and operational hurdles, incurring costs for the manager and investor.
Asset managers in Europe have shown interest in the share-class model, but it has not yet become a prevalent approach. However, that could change as the Central Bank of Ireland (CBI) recently indicated in a “Feedback Statement” that it intends to revise its policy to allow co-mingling of listed (ETFs) and unlisted (mutual funds) share classes in a single fund structure. The full CBI guidance will be released in the coming weeks, but sponsors can expect that the CBI will accept submissions that permit the establishment of listed and unlisted share classes within the same UCITS sub-fund.
In the US, Vanguard patented a model where the ETF is a share-class of an existing mutual fund. By leveraging existing funds, administrative and portfolio management costs are reduced compared to stand-alone ETFs. The share-class structure reduces many complexities but also introduces new challenges. Challenges lie in treating all shareholders equally in areas such as taxation and trading of shares.
2016 marked the launch of a new fund structure in the US market that seeks to replicate the cost savings of ETFs while limiting the disclosure of daily portfolio changes so that active managers can protect their proprietary investment strategy. This semi-transparent product is called NextShares and the filings owned by Eaton Vance. The NextShares line-up includes funds from Eaton Vance, Ivy, and Gabelli and additional launches are expected in 2018. Currently, this is the only structure that has approval by the Securities and Exchange Commission (SEC), though patents from Precidian, Fidelity, T. Rowe, and Natixis/NYSE are under review by regulators.
The semi-transparent structure, or similar vehicle, has yet to gain widespread adoption globally.
The ETF marketplace is a crowded space with more than 5,600 ETFs globally.7 In order to survive, ETFs must quickly grow assets at the outset and carry that momentum through the early stages of the ETF launch lifecycle. Identifying the right distribution strategy is perhaps the most important aspect in building AUM. This starts by firmly establishing a comprehensive distribution plan pre-launch and training sales and distribution personnel on the features and nuances of the ETFs so they can make an impact immediately. Those who wait to initiate this process post-launch stand to delay asset growth in perhaps the most critical time.
In an industry increasingly defined by scale, some managers may look to distribute in channels where they already have a significant client base. If they can successfully onboard existing clients by transferring assets from pre-existing funds to the newly-launched ETFs, the sooner they can attain critical scale (i.e. AUM). Once a fund achieves scale, the easier it is to get on distribution platforms where registered investment advisors (RIAs), online retail brokers, and institutional investors can purchase.
From a marketing perspective, emerging technologies such as digital platforms, social media, and robo advisors are transforming the ways in which many investors learn about ETFs. Understanding and harnessing these technologies will become increasingly important for asset managers as they look to promote their products.
As asset managers look to distribute in new regions, it’s important to recognize that not all markets are created equal. For this reason, asset managers should consider leveraging local expertise or potentially setting up a regional shop.
Channels and Platforms in the US
Institutional channels in the US are evolving in their ETF usage. Non-401(k) channels, like pension plans, endowments, insurers, and hedge funds have purchased ETFs from a handful of issuers in the past, but these were typically in fixed-income asset classes for cash equalization strategies. However, given the low cost of most ETFs, many of these channels are now using ETFs in core asset classes, including domestic and global equity strategies – often at the expense of active managers. Smart-beta demand has been a key driver of some of this product growth, as institutional investors gain access to multi-factor, low volatility, and equal weight strategies at a low cost. Insurance companies have also entered the ETF fray. Blackrock believes that $300 billion of bond ETFs will be purchased by insurers by 2021.8 ETF managers should note that brand can be a distinguishing feature for these markets. Vanguard and iShares consistently rank at the top in terms of support for and usage by institutional buyers.
As for the retail channels, RIAs were the earliest adopters of ETFs and allocate the highest percentage to ETFs (23%) when compared to other channels.9 Not surprisingly, in 2018, 87% of financial advisors said they used or recommended ETFs with their client portfolios — the most popular investment vehicle among 19 listed options. This is a pronounced leap compared to 2006 when ETFs were only recommended 40% of the time.10
Fragmentation in Europe
With over €694 billion in ETF assets,11 Europe is the second largest market globally. Encompassing 28 countries, 25 exchanges, and 14 currencies, the fragmented nature of the market adds additional layers of operational complexity and presents unique distribution challenges for both mutual funds and ETFs. This is especially pertinent for managers outside of Europe who may not have experience distributing product within the EU.
Distribution in Europe tends to be bank driven, however each market has its own financial advisory channels, which is expected to drive the next phase of growth for retail ETF investors in Europe. While approximately 80% of ETF assets are currently held by institutional investors, many believe retail adoption will continue to accelerate as issuers increase their focus on financial advisors.
Some managers may find it helpful to partner with a local firm, leveraging in-house experience to glean insight on specific markets. A key factor for success involves locating regional sales staff thus enabling sales personnel to meet directly with shareholders and intermediaries.
The majority of European ETFs are domiciled in Ireland (55%) or Luxembourg (22%)12 and follow the UCITS frame- work, enabling managers to distribute ETFs cross-border through a fund passport. The UK is a major ETF consumer and the UCITS passporting rules may be disrupted when the UK leaves the EU. It is difficult to predict what type of access the UK and EU will have to each market post-Brexit, but asset managers should keep a watchful eye on the ongoing negotiations.
Opportunities in Asia
Fragmentation is an even greater issue in Asia than in Europe. ETFs face headwinds in retail channels where they compete with mutual funds that pay high commissions to distributors. Japan has the largest ETF market in Asia with $311 billion in assets13 and the industry has been a significant beneficiary of the Bank of Japan’s Quantitative Easing program. Hong Kong and Korea are starting to position themselves as regional trading hubs for ETFs as well, with 7.4% and 7.0% of market share respectively.
Hong Kong may have an advantage as an access channel to Mainland China if ETFs are included in the Stock Connect program. Including "eligible ETFs" in the program would allow Mainland investors to access Hong Kong listed ETFs and international investors to access ETFs listed in Shanghai and Shenzhen. While there are a number of open questions as to how the program will operate (which ETFs will be allowed, will there be quota restrictions, will there be domicile requirements on the ETF or manager), it could be a great way for asset managers to access investors in Mainland China. It should expand the range of investment opportunities for Mainland investors beyond the ETFs currently available in Mainland China. The industry believes that the SFC (Hong Kong regulator) will provide some clarification regarding the restrictions by the end of 2018.
Despite their rapid growth, there is currently no specific regulatory framework for ETFs – a fact that has not gone unnoticed by policymakers. The CBI is playing a leading role in driving the ETF debate in areas that will shape policy on a global stage due to Ireland’s status as the largest ETF domicile in Europe and second largest globally.14 The CBI brought this to the forefront in 2017 with the release of a discussion paper on ETFs and the latest update was released to the market in September 2018 in the form of the “Feedback Statement.” The CBI review follows similar ETF studies by other regulators, the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB).
In June 2018, the SEC proposed a new ETF rule that would allow asset managers to bring certain types of ETFs to market without first obtaining explicit individual exemptive relief – a sea change long sought by the industry. It would also would rescind all exemptive relief that had been granted to certain existing ETFs, making them liable to the new rules as well. Additionally, in a move long sought by many in the ETF market, the regulator included provisions that would permit qualified ETFs to accept custom baskets from APs. Most ETF issuers who received exemptive relief after 2012 are not permitted to use custom baskets, creating inconsistencies in how managers can interact with APs, and manage funds’ tax efficiency and liquidity. Overall, the proposed rules have been well received by the market.
Asset managers ready to make the leap to launch their own ETF essentially have three options: Buy, build, or rent.
Buy: The first option is to acquire an existing ETF business through the purchase of an established company. This approach comes with pre-baked regulatory approval, an existing distribution network, and immediate ETF expertise and sales experience, not to mention live products with track records and AUM. These advantages, however, may be tempered by potentially higher upfront costs—monetary, time, and labor—as well as potential complexities integrating a new workforce.
Build: The second approach is to develop ETFs from the ground up. While creating a bespoke ETF allows firms to align new products with core investment expertise, scale staff over time, and tailor their marketing and distribution plan, drawbacks do exist. New funds lack track records, may require staff additions, and a product with a nuanced, carefully-crafted strategy can take many months to gain regulatory approval. Since the ETFs are being created from scratch, asset managers may also have to build out additional operational functions, which may inhibit speed to market.
Asset managers who have an existing unlisted fund also have the additional build option of launching an ETF share-class within this structure. In the US, Vanguard owns the patent for this model but any sponsor with an Irish or Luxembourg domiciled UCITS can apply to the regulator to launch an ETF share-class within their UCITS. In choosing this route, asset managers may find benefits from enhanced speed to market, reduced launch costs, and the ability to leverage existing performance history.
Rent: Lastly, managers can create an ETF through a third-party platform. These providers offer a turnkey service, handling some or all aspects of the development, launch, and ongoing management of the ETFs. Additionally, in the US, these platforms offer the benefit of tapping into existing trust and exemptive relief (for now), freeing the manager to focus on product and distribution strategy. While this route offers one of the quickest ways to enter the market, managers must consider that revenue may be split with the platform and they may have to contend with sharing shelf space with other issuers using the same platform. The rent option has seen limited uptake in Europe, but there are still a number of providers offering solutions to asset managers looking to take this route
Are You Ready?
The ETF market appears perched to accelerate its development pace and provide asset managers with a new array of fund types to satisfy increased investor demand. Since 2013, the global ETF market more than doubled in size from $2.2 trillion to over $5 trillion, as of August 2018.15 The 10-year CAGR is 18.9%. Some analysts predict the ETF market can grow to $7.6 trillion by 2020, equivalent to a conservative CAGR of approximately 18%.16
Asset managers are embracing ETFs as an opportunity to distribute their investment strategy in a new wrapper, rather than writing them off as a threat to their existing business. Like with any new product, adding ETFs to an investment menu can be disruptive, especially in light of their unique structure and distribution nuances. Managers must assess several factors when evaluating how ETFs can complement their business. Top-down commitment by management is essential. Growing an ETF business is a long-term venture and as such, needs the framework of ample resources and capital to be successful. However, given the growth to date and future growth projections, it is clear why so many managers have decided to enter the ETF marketplace.
Over the past 14 years BBH has partnered with 39 asset managers and sponsors to bring ETFs to market in the US, Europe, and Hong Kong. We would be happy to consult with you as you assess, develop, launch, and manage an ETF lineup.
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2 EY: Reshaping Around the Investor, Global ETF survey 2017.
6 PwC: ETF 2020 Preparing for a New Horizon
8 Bloomberg: Blackrock Sees 300 billion From Insurers Pouring Into Debt ETFs, 2017
9 The Cerulli Report – US Exchange-Traded Fund Markets 2017: Differentiating Strategies for Sustained Growth
10 Financial Planning Association: 2018 Trends in Investing Survey
16 EY: Reshaping Around the Investor, Global ETF survey 2017