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So You Want to Launch Your Own ETF?

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The 19th century British prime minister Benjamin Disraeli famously quipped: “When I want to read a good book, I write one.”

Today, an enterprising financial advisor with a strong investment thesis, loyal client base or unique niche could similarly say: “When I want to invest in a good ETF, I launch one.”

As Bill Smalley, president of ETF Issuer Solutions (ETFis) puts it:

“ETFs are the most easily ownable vehicle out there today,” he told ThinkAdvisor in a phone interview.

ETFis is one of several firms — others include Exchange Traded Concepts and ETF Managers Group — that provide ETF-in-a-box solutions for financial advisors and others who want to quickly commercialize an investment idea.

In the same way that Amazon and many other vendors help authors with literary aspirations publish and distribute their own books, the private-label ETF firms handle the product registration, recordkeeping and other administrative aspects of operating an ETF.

It is not uncommon for retail advisors to harbor visions of investment stardom by coming first to an idea whose time has come; for example, cybersecurity is du jour, and indeed the International Securities Exchange (ISE), another ETF player, just launched PureFunds’ HACK cybersecurity ETF in November.

But Smalley of ETFis advances a unique insight of relevance to ambitious advisors, framing the move in quasi-succession planning terms as a means “to keep assets in house in way that is not dependent on the person running the firm,” he says. “An ETF is clever way of running the firm in perpetuity.”

Smalley says about half of his firm’s client base — who serve as subadvisors under his firm’s registration and distribution umbrella — are RIAs who have branched out into separately managed accounts (SMAs).

But advisors should know that ETF white-labelers are not the only way to create your own funds. S&P Dow Jones Indices is but one prominent index vendor hawking its wares at ETF.com’s annual InsideETFs conference convening Sunday in Hollywood, Florida.

Roger Scheffel, also attending InsideETFs, runs Wilbanks Smith & Thomas (WST), an RIA with a significant SMA business. The Norfolk, Va.-based firm manages some $2.5 billion in assets under management, about two-thirds of that through its wealth management business and one-third of that through its asset management side.

Scheffel has taken a custom-index, rather than ETF, approach in creating his funds, working with S&P Dow Jones Indices to create rules-based “tactical specialization” portfolios that would aid advisors seeking to create an investment “overlay.”

Say an advisor has $1 million to invest for a client in an example Scheffel says is overly simplified to aid in understanding. The advisor may want half of that in U.S. large-cap equities, but rather than put all of that in the appropriate Vanguard or iShares ETF, he could keep half of that in the standard ETF and the other $250,000 in Scheffel’s tactical fund.

S&P helped him build an entirely different kind of U.S. large-cap equity fund. They started by rejiggering their S&P 500, which is market-cap weighted into an equal-weight fund. So Apple, the index’s largest component, now has the same weight as its other 499 stocks — that is, 0.2%.

“That pushes the S&P to small-cap and value,” Scheffel tells ThinkAdvisor. “We like those tilts based on [Eugene] Fama studies.”

But on that equal-weight chassis, Scheffel’s rules call for eliminating four of the S&P 500’s nine sectors based on quantitative criteria indicating poor future expected returns. That, in essence, is his approach to alpha generation.

“The reason we like to run quantitative strategies is that we give you a rule set and we always follow those rules,” Scheffel says. “If I’m an active [mutual fund] manager managing a fund while going through a divorce or with a kid sick at home, I may make weird decisions; but [advisor using WST funds] can rely on the fact that whatever I’ve done in the past, I’ll do in the future [no matter what].”

S&P custom indices product manager Michael Mell helped Scheffel create his rule-based indices. Mell, also at InsideETFs, says his firm has recently seen 200% growth in the scope of work being performed for the RIA and financial advisor community.

“We serve a powerful function for them as a branding tool,” he tells ThinkAdvisor. “If you’re a new entrant to the ETF marketplace, you need a way to distinguish yourself and you need credibility,” something that using “an agent of repute” provides.

Another benefit, says Mell, is the intensive, free consultation his firm provides advisors and others seeking to launch an index-based fund.

“I’ve spent [as much as] nine months working with a prospect before ever talking costs and price,” saying those discussions tend to focus on shaping a methodology for obtaining an optimal index, a step he feels is a prerequisite to accurately determining fees.

Besides the private-label firms (each, by the way, with different emphases — Smalley says his firm for example focuses on ETFs with “alpha-generating value propositions”), and besides custom index firms like S&P and Solactive, a third approach for advisors cum ETF entrepreneurs would be to partner with ISE ETF Ventures (ISE-EV).

That division of the International Securities Exchange takes something of a venture capital approach to new ETF launches, even providing financing in return for a share of revenue.

But the head of ISE ETF Ventures, Kris Monaco, makes a crucial distinction between his firm’s investments and those of a VC, who Monaco says always has his eye on an exit strategy.

“We’re doing what you can think of as permanent capital,” Monaco, also attending InsideETFs, tells ThinkAdvisor. “We’re investing in [the ETF]; they [the advisory firm launching the product] can sell company whenever they want; if the fund is working well, everybody’s happy.”

Monaco says his firm doesn’t compete directly with white-label firms like ETF Issuer Solutions or index calculation agents like S&P.

“We like them all, and work with them all,” he says, adding that “we wouldn’t be the advisor of record [like, say, ETFis]. It’s complementary; we would make introductions” to other such firms. The private labelers, he says, launch the ETFs, while ISE focuses on post-launch distribution, promoting and selling the fund. Smalley, it should be noted, says his firm, ETFis, is very active in distribution. (“We have our own fund distributor in-house,” he said.)

And Monaco stresses that his firm goes to great lengths to flush out the index design through in-depth research (“we become equity analysts,” he says) unlike index calculation agents (though, again, Mell emphasized the extent to which S&P involves itself in R&D).

Regardless, despite this potential overlap, ISE, according to Monaco’s description, appears to have a broader scope because it is involved in index R&D; start-up capital; marketing; and distribution.

The key difference seems to be the financing, though Monaco says ISE is not eager to take financial risk.

For that reason, the firm looks to partner with subadvisors who have a track record of success, though they will consider working with a recently formed company consisting of principals coming from different backgrounds if the proposed ETF has unique commercial potential.

“We look at the idea,” says Monaco. “Is it solving an actual problem? If so…this is clearly something that has an easier education path because it is filling a gap in the competitive landscape. Are they bringing IP [intellectual capital]? Is it patentable, protectable? Of course, they can talk about the idea, but can you sell the idea?”

If the proposed ETF meets those tests, then Monaco and the ETF entrepreneur can discuss the financing:

“Do they want to offload all the costs, or maybe it’s half or two-thirds? Our proposal is purely contractual, we’re not seeking equity in the firm,” he says, saying that the revenue-share result is “custom-tailored to the specific scenario we’re being presented with.”

While Monaco was reluctant to pin down a dollar amount he associates with a fund’s success, noting that it is a constantly moving target depending on market conditions and the market gap that the fund fills, he acknowledges that it usually takes “a $25 million minimum before [market participants] take a fund seriously.”

Advisors particularly are loath to put client assets in a fund that hasn’t been around for at least three years, for which reason “the more early adopters you’re bringing to the table with you, the better,” he says.

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