Appendix B: Fund Operations
While many of the roles and responsibilities of an ETF would be familiar to any asset manager, the differences are worth noting. Establishing the right relationships is often the difference between success and failure with an ETF launch.
Fund Sponsor
Mutual funds as well as ETFs are created by a fund sponsor. Sponsors typically create families of funds and provide the main distribution network for the funds. Sponsors are responsible for creating the fund, registering it with the SEC and filing corporate documents. Mutual fund sponsors provide the seed money necessary to purchase the initial portfolio. ETF sponsors typically pass that responsibility on to market specialists.
In most cases, mutual fund sponsors have large distribution networks ready to market the funds through a variety of channels. ETF sponsors do not sell directly to investors, but instead rely on a distribution system that often emphasizes educating investment advisors about a particular ETF’s benefits and working with institutions and hedge funds on trading issues.
Having an effective sales strategy from launch on is the key to an ETF’s success: The more rapidly an ETF can gain market share, the quicker it will attract trading volume in the market. The more trading volume it attracts, the lower the bid/ask spread that investors pay when buying or selling the ETF, and the deeper the market is for shares. Throughout 2008, several smaller ETF providers were forced to close innovative ETFs because of their inability to market the funds.
Board of Directors
Funds, whether mutual funds or ETFs, are legally companies owned by their shareholders. The board of directors governs the operation of the fund, providing fiduciary oversight for shareholders and negotiating all fund contracts. Typically, 50 percent of a fund’s board will come from the fund sponsor, with the remainder independent.
Investment Advisor
The investment advisor, or fund manager, runs the portfolio in accordance with the fund’s objective. ETF fund managers also manage the fund’s day-to-day operations. Fund sponsors may outsource that function to a separate administrator, although quite commonly, this is a function of the fund sponsor.
Custodian
Mutual funds as well as ETFs typically use a custodian bank to hold the fund’s underlying securities. This is a form of protection for shareholders. Funds pay a fee to the custodian. Mutual funds also use a transfer agent—a third party is responsible for maintaining records of shareholder transactions. Transfer agents also send account statements and other important documents to shareholders. ETF companies also rely on back-office support to manage complicated topics like tax lot management, securities lending, etc.
Index Provider
Like a mutual index fund, the index provider calculates the daily value of the index, and provides the benchmark that the fund manager tries to match. For traditional, cap-weighted indexes, the role of the index manager is limited to overseeing the application of a core methodology.
The further away from plain-vanilla equity indexes you get, however, the more complicated the index provider’s role becomes. For tactical and strategic indexes, index providers are deeply involved in designing the strategy and methodology behind the indexes. In the fixed-income market, and for international equities, the index provider must create a methodology for assigning fair market valuations to illiquid securities. The quality of these measures can have a huge impact on the functioning of the ETF.
Authorized Participants
As covered in “Appendix A: Understanding ETFs,” all ETFs establish relationships with market-makers who manage the creation and redemption process.