Piecing together the Product Strategy Puzzle Part II: Transforming Your ETF Idea into Reality

1. Financial Analysis and Projections

We begin with the dollars and cents of it all. One primary motivation to launch an ETF is to expand and deepen engagement with your clients, which if done well, leads to increased revenue potential for your firm over time. To understand the financial investment needed for success:

Conduct a break-even analysis: Understand the expense and revenue forecasts for each ETF in your product suite. 

The projected profitability across time horizons will reflect the strategic decisions made on your go-to-market approach. Ask yourself how the type of product launch (for example, a new strategy or a fund conversion), infrastructure, distribution, capital markets, and marketing support you’ve put in place could impact the break-even timeline. The market environment in which you launch an ETF also provides fundraising headwinds or tailwinds.

Expense Forecasting: Account for both startup and ongoing costs.

Examples of startup costs include internal infrastructure development to integrate ETF operational processes, technology enhancements to meet regulatory requirements, trust and board formation, legal filings and registration, initial exchange listing fees, and seed capital. 

Examples of ongoing costs include fund operating and administrative expenses across service providers, ETF trading data and sales tracking data, trust and fund board continuation, and for indexed ETFs, index licensing fees.  Consider the need for dedicated ETF personnel, whether they be internal or external resources, and the size of the marketing budget.

Revenue Drivers: Based on ETF management fees from assets under management.

These cost examples are not comprehensive and will vary by organization.

2. ETF Product Structure

Upon finalizing your investment strategy, align its asset class exposure, investment process (active or indexed), and the securities or investment instruments held in the strategy with the product structure that best supports its effective portfolio management.

Legal Structure:

Most ETFs are formed under the Investment Company Act of 1940 (‘1940 Act) as open-ended funds. However, commodity, currency, digital asset, or derivatives-based strategies that invest in “non-securities” can require a different structure and formation process under the Securities Act of 1933 (think commodity pools or grantor trusts), and are considered Exchange Traded Products (ETPs), not ETFs. The legal structure used to go to market impacts the filing requirements, tax implications, and diversification requirements for the strategy.

Fund Name:

Use a naming convention that aligns with firm branding, for example incorporating the firm name or ETF brand name, while clearly reflecting the investment strategy in compliance with the “Names Rule” (35d-1) of the ‘1940 Act.

Transparency Level:

Full daily transparency into portfolio holdings is the norm across the ETF industry and a key benefit of the ETF structure.    

In the earliest days of active ETF launches, the industry saw a mix of semi- and non-transparent ETFs come to market, driven by managers’ desire to protect their alpha-generating intellectual capital and/or the complexity of the investment strategy. 

However, like their indexed counterparts, the norm for active ETFs has become full transparency, driven by both investor expectations and the daily transparency requirement to launch an ETF under The ETF Rule (6c-11).  The alternative is the more timely and costly process of filing for exemptive relief under the ‘1940 Act.

New semi-and non-transparent active ETFs continue to come to market, although managers have raised the bar when determining which strategies warrant the longer approval process required. In parallel, investors also seek to clearly understand how they benefit from the semi-transparent structure. 

Distribution Frequency:

Determine the expected distribution frequency (monthly, quarterly, or ad hoc) based on the investment strategy.

Fee Structure and Pricing:

Most ETFs adopt a unitary fee structure, which bundles all management, operational, and service fees, and is deducted from the fund’s daily net asset value on a pro-rated basis.  

Unlike mutual funds, ETFs do not have a front load fee or back-end contingent deferred sales charge (CDSC), and do not typically charge a distribution fee (12b-1). The growth of active ETFs, however, fuels an ongoing discussion on the role of 12b-1s in the ETF ecosystem. Like mutual funds, ETFs approved by client due diligence teams are also subject to platform placement fees at certain firms.

When setting the management fee for an ETF, analyze the fee range for competing strategies based on their performance, assets under management, and time in market to gauge your competitive positioning.

Given downward fee pressure across the industry, you may want to leave room for a potential fee reduction in the future. To assist in fundraising efforts, a number of ETFs also implement a fee waiver at launch. To date, those fee waivers have not typically been removed, save for recent examples with crypto ETF launches where a swath of new similar ETFs come to market in a short time frame.

Seed Capital Approach:

Most ETFs launch with the minimum required seed capital to manage the portfolio effectively, balancing operational efficiency and initial trading activity. However, some firms opt for higher levels of seed investment.

3. Board Governance and Service Providers

The next step to bring an ETF to market is to establish a trust with a board of directors that houses and governs your ETF. You’ll need to answer two questions in the trust creation process.  

1. For your firm, should the ETF be added to an existing trust that holds mutual fund strategies, or should a new trust be established for the ETF?
2. Should a series trust to accommodate multiple ETFs or a single stand-alone trust be created?

The answer to these questions depends on your product structure, launch strategy, and goals for building out your ETF product platform. For example, a firm that has an existing mutual fund business, and is looking to expand into the ETF industry with multiple products, may prioritize the establishment of a series trust independently from their mutual fund offering.

When creating the Board of Directors for the trust, consider the composition of its members, who overlaps with an existing mutual fund board, who has prior experience with ETFs, and who will focus on ETF efforts going forward. Then focus on the Board’s education of the ETF ecosystem, competitive landscape, product structure and the business case for launching an ETF, particularly for first-time issuers.

Select your ETF service providers, including custodian, fund administrator, transfer agent, and auditor, focusing on those that best meet your operational needs and timeline. Leveraging your relationship with existing service providers who also support ETFs can streamline the launch process, better accommodate new data feeds, and create broader cost efficiency.

With your product structure, governance, and service providers set, prepare 15(c) reporting materials to present to the board for formal approval.

4. Regulatory Filings and Compliance Considerations

When exploring the launch of an ETF, involve your legal counsel early in the product development process to account for compliance considerations and confirm the regulatory filing requirements for your circumstances.

ETFs that file with the SEC in compliance with The ETF Rule (6c-11) can theoretically receive approval to launch 75 days post initial filing. These requirements include, but are not limited to, daily transparency into portfolio holdings and the website display of liquidity and holdings data. Those filing for exemptive relief have a longer approval process.

New ETFs:

New ETFs file with the N-1A registration form for ‘1940 Act funds, which includes the initial registration statement, preliminary prospectus, statement of additional information (SAI). 

ETF Conversions:

For a mutual fund to ETF conversion, determine the structural approach used, for example a direct conversion or a merger. In a direct conversion, the ETF replaces the existing mutual fund within the same trust. In a merger, a new ETF shell structure is created, and the existing mutual fund merges into the newly created ETF.

Each method has distinct regulatory and operational requirements, considering if it is an asset transfer (for accounting, custody, and record keeping purposes), if it requires a shareholder vote to proceed, and its filing documentation. Timely shareholder communication is also required throughout the process.

5. Operational Planning and Technology Infrastructure

As you establish an ETF's operational processes and technology requirements, note which require further development relative to other open-ended, commingled investment products on your platform. 

ETF operations require technology infrastructure that supports efficient data management, compliance monitoring, and investor services. Common ETF enhancements include:

• Automating daily holdings file creation with 6c-11 required data points to streamline reporting.
• Building a dedicated ETF webpage featuring daily data on NAV, trading volume, bid/ask spreads, fund holdings, and performance based on NAV and price.
• Integrating create/redeem data into risk and portfolio management systems to improve efficiency and transparency.
• Ensuring seamless data flow between custodians, transfer agents, and internal systems to maintain operational accuracy and regulatory compliance.

For asset managers converting a mutual fund into ETF, consider how these operational steps could streamline the conversation process based on your circumstances:

• “Clean-up” Fund Distribution – Reset the capital gains basis prior to conversion to optimize the post-conversion tax efficiency.
• Share Class Consolidation – Roll A and C share classes into an institutional share class prior to the conversion date to simplify accounting and operational procedures.
• Listing NAV Adjustment – Set the ETF’s listing NAV and consider a share split or consolidation to maintain a 1:1 NAV conversion ratio between the mutual fund and ETF.

6. Risk Management and Contingency Planning

Throughout the ETF product development and implementation process, be aware of potential risks and plan for how they will be managed. Think about risk across these pillars:

• Investment: Assess the risk profile of new products to account for potential capacity and liquidity constraints, given the inability to close or gate an ETF to fund flows.
• Operational: Establish contingency plans to manage unforeseen breaks in ETF processes.
• Regulatory: Ensure the ETF does not fall out of compliance with 6c-11 regulation, and if it does, outline the steps needed to remediate.
• Reputational: Identify potential risks and uncertainties that could impact the success of your ETF product platform.

Tying It Together

Bringing your ETF vision to life through the product development and implementation process to be operationally ready requires meticulous planning and collaboration across product, legal and compliance, technology, and operations, investment, capital markets, distribution, and marketing teams.

Please reach out through LinkedIn or my personal website if you are interested in learning more.

Disclosure:

This material is provided for informational and general investment education purposes only and nothing herein constitutes investment, legal, accounting, or tax advice, or a recommendation to buy, sell, or hold a security. It is essential that you seek advice from a registered financial professional prior to making any investment decision.