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  • Appendix A: Understanding ETFs
  • Appendix B: Fund Operations

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Entrance Strategies

Companies looking to enter the ETF market can follow one of two models: independent development, or partnerships.

Independent Development

At the dawn of the ETF industry, every ETF sponsor had to build its products from the ground up. Large banks such as Barclays, State Street and the Bank of New York came to the market with experience managing index funds for institutional investors and the infrastructure systems to support and manage many of an ETF’s operations in-house. Their biggest challenges were navigating the regulatory maze to create the products, and to then convince the investing public to purchase these new investment vehicles.

While much groundwork has been laid, these challenges remain for new entrants.

For established companies that are not currently ETF sponsors, the challenge is one of focus. The complexity of managing the ETF infrastructure is often not a core competency even in a large firm.
The advantages of building an independent ETF platform aren’t insignificant for a company with an existing brand. Investment management companies with long track records in traditional mutual funds can have instant credibility both with investors as well as financial advisors (the dominant distribution point for ETFs). They can convey a feeling of “establishment” and help persuade investors that both the fund and the strategy are sound, strong and designed for the long haul.
The smaller end of the market has seen some do-it-yourself start-ups succeed as well. Before it was acquired by the mutual fund giant Invesco, for instance, PowerShares was the largest independent ETF provider, and is widely credited with driving much of the recent innovation in the ETF market. WisdomTree Investments, a company that offers primarily dividend-screened ETFs, is now the largest independent ETF company.

Even the most die-hard independent will need to establish effective partnerships, however. Many of the roles in running an ETF (some of which are outlined in Appendix B) are necessarily outsourced even in the largest investment management companies. And even independent WisdomTree has begun partnering with traditional mutual fund companies such as Dreyfus for new products.
But the bigger challenge lies with handling distribution. The distribution mechanism for ETFs differs sharply from that for traditional mutual funds. Whereas mutual funds keep detailed records of each investor that owns their funds, ETF companies only have partial snapshots, so the challenges of building, monitoring and incentivizing a sales force become large. In addition, ETFs do not come with sales loads, commissions or 12(b)-1 fees, all of which play a major role in the mutual fund distribution apparatus. Navigating these differences while still building mind share is a major challenge.

Partnerships

In today’s market, companies entering the ETF market face many uphill battles. A de novo fund sponsor must create new infrastructure to maintain its funds, develop distribution channels in both the retail and institutional markets and then market heavily to gain mind share. Larger companies may have expertise in one or more of these areas, but will inevitably need additional resources.
The solution is often to develop partnerships or joint ventures that take advantage of each party’s strengths. The most innovative approach is to partner with a full-fledged ETF provider.

One leading example of this is the TDX Independence ETFs, a family of target date ETFs launched through a partnership between discount broker TD Ameritrade and ETF sponsor XShares. In this agreement, TD Ameritrade provides the marketing, index construction and portfolio management of the funds, while XShares provides a standing exemptive relief order from the SEC and back-office experience managing the details of ETF operations. By partnering with XShares and leveraging its existing relief order with the SEC, TD Ameritrade was able to leapfrog other competitors and launch the first family of target date ETFs ever, relatively quickly.

In Europe, a slightly different arrangement partnered Caixa, the largest bank in Portugal, with international ETF company SPA ETF. Together, the pair created the first ETF to list on the Portuguese market, tracking the benchmark PSI-20 Index. SPA ETF is responsible for developing, launching and managing the fund, while Caixa is responsible for marketing and distribution of the product.
But other models do exist. A company with an established distribution model could establish a pure sales and profit-sharing arrangement for an existing line of ETFs. Those same ETFs could be re-branded or co-branded for new distribution. Or separate ETFs could be established where the fund sponsor provides minimal support beyond distribution.

The advantages of these partnerships are that each firm brings its skills and necessary infrastructure, speeding the process of launching new funds and preventing fund sponsors from “reinventing the wheel.” This creates a critical time-to-market advantage: Typically, the first ETF to enter a given market captures the majority of market interest, assets and liquidity. While profits must inevitably be shared among partners, start-up and operational costs are reduced.