Choosing Your Path to the Semi-Transparent ETF Age

How to Get There Regardless of which approach is chosen, there are some key things that firms should consider when adding semi- transparent ETFs to their product line up. For managers launching ETFs for the first time, much of the operating model will be familiar but there are ETF-specific nuances that must be taken into account. “The biggest organizational change when entering the ETF market is the need to establish a capital markets team,” according to Joe Rappa, Director, ETF Product Development at Citi. “The capital markets team interacts with the broker-dealer and AP community to assist in the creation/ redemption process, which is a critical function for ETFs.” Consideration should also be given to specialized ETF product and sales teams. Operationally, firms will have to determine how to integrate the creation/redemption basket process into their existing workflows. All firms embarking on the journey to semi-transparent ETFs have some product-related issues to consider. Firms need to decide if they should launch new strategies that are tailored to best utilize the semi-transparent structure or simply replicate existing strategies. If the decision is the latter, then pricing needs to be considered. Semi-transparent ETFs are designed to lower the operating costs of active funds to better compete with passive funds. It could raise some eyebrows if a firm is offering the same strategy at two different price points, since the SEC has made this sort of pricing disparity a focus. With Regulation Best Interest due to come into effect in June 2020, financial advisors will be under pressure to ensure they are giving their clients the best option. Having a lower-cost option of an existing strategy could push financial advisors to move investors into semi-transparent ETFs, at the expense of the existing fund product. Though, managers may not necessarily need to lower management fees. “There is a general misconception that if you are offering a strategy in an ETF wrapper, the management fee needs to be lower,” notes Thomas. “Managers should focus on ensuring that the management fee is the same between wrappers and that operational cost savings result in better returns for investors.” A Potential Shortcut A potential solution to this dilemma is to convert an existing fund structure into a semi-transparent ETF. “Historically, the SEC has opposed mutual funds converting to an ETF structure,” notes Kelli O’Brien, Director of Fund Administration at Citi. “However, having recently completed its ETF rules, which streamline the launch process creating faster speed to market, the SEC is now focusing on other issues in the ETF marketplace and has signaled a willingness to reconsider the idea.” Regulatory considerations aside, the conversion to an ETF structure raises a number of tax, operational, and distribution issues. Perhaps the biggest operational challenge is with the transfer agent, which tracks and maintains the records of a mutual fund’s investors. When retail investors buy ETFs they purchase them on the secondary market, typically through brokerage accounts. “A traditional fund can have thousands of investors recorded as shareholders. ETFs are held electronically in the name of the depository,” Peggy Vena, Director, ETF Product Development at Citi explains. “To convert a mutual fund to an ETF, managers would have to transfer the investors into brokerage accounts “The biggest organizational change when entering the ETF market is the need to establish a capital markets team.” Joe Rappa Director of ETF Product Development, Citi “There is a general misconception that if you are offering a strategy in an ETF wrapper, the management fee needs to be lower. Managers should focus on ensuring that the management fee is the same between wrappers and that operational cost savings result in better returns for investors.” Stuart Thomas Founding Principal Precidian Investments