Rationalizing ETF Growth

Exchange-traded funds continue to gain steam in the investment world, reaching nearly $4 trillion toward the end of 2017 . This growth has happened remarkably fast, with ETF assets increasing tenfold over the past thirteen years and projected to reach more than $7 trillion by 2020. As investors continue to favor ETFs, investment management firms have an opportunity to broaden distribution of their investment strategies, increase assets, and effectively join in coopetition with emerging robo-advisors. ETF opportunities are plentiful, yet ETF operational challenges can be substantial.

Before expanding an ETF product set– or initially offering ETFs – investment managers are urged to reflect on their operational readiness for the nuances of the ETF product.

Mutual Funds and ETFs are similar, but different. ETFs and mutual funds are structurally similar, so investment managers already offering mutual funds are best prepared for the ETF market. Distribution relationships are likely in place, hedge-related margin maintenance is familiar, and participation of additional parties to the investment management process, such as the fund accountant, is routine.

However, even the most experienced mutual fund managers can be challenged by the ETF share creation and redemption process in which unsettled positions and cash-in-lieu transactions significantly increase IBOR complexity. ETFs generate, in essence, an IBOR-in-motion, as settled and unsettled trades across global markets conflict with the manager’s need for a fully reconciled portfolio in advance of the US market open. In mutual funds, investment managers are in full control of obtaining underlying portfolio shares. In ETFs however, authorized participants’ delivery of share baskets with cash-in-lieu complicate the processes of maintaining a tradeable IBOR record and reconciling across multiple parties. While authorized participant arbitrage keeps costs low for the ETF investor, it tends to initially complicate operations for the asset manager. So while investment management firms familiar with mutual fund structure are ahead of the curve when it comes to offering ETFs, even they are likely to have operational hurdles to conquer.

Distribution matters. ETFs have the potential to provide new channels of growth. While model distribution outlets such as sponsor platforms are more familiar to retail asset managers and the supermarket channel better known by mutual fund managers, all investment firms that want to operate ETFs will likely require an expanded distribution effort to excel in the ETF space. As KPMG advisory director Jim Penman noted, distribution through a particular channel “doesn’t necessarily mean that the same channel has the appropriate technology platform and expertise to distribute your ETF.”

Aggregators of ETF offerings are emerging, including robo-advisors. And while the ETF market continues to grow briskly, strategy culling is already underway. Fixed income, non-US and alternative strategies are sought by investors, and distributors have begun to cull the perceived overcrowding in strategies such as US multi-asset.

Investment managers seeking growth through ETF offerings need to know their current distributors’ ETF-related capabilities and new product needs, and will likely need to expand distributor relationships.

Processing agility is needed. Investment management firms can make thousands of transactions during a trading day, and most transactions are fairly straightforward. In the ETF world, however, increased transaction volume and multiple data flows complicate transaction processing and reconciliation. Add international and emerging market strategies into the mix and unsettled in-kind and in-lieu transactions increase the need for precise timeliness and intricate detail in data flows.

Extreme discipline and technology-assisted efficiency are paramount to the timely processing and reconciliation of ETF transactions. This is particularly true in the case of indexed ETFs, where otherwise inconsequential cash drag can have devastating effects during even the most subtle intraday index moves.

These operational readiness points may not be exhaustive but they are a good starting point for any manager looking to get into ETF space for the first time, or expand their presence in the market. Either way, expertise matters. Providers experienced in ETF-related processing on both the buy and the sell side, and with broadly connected platforms and distributor relationships, can help asset managers efficiently launch – and scale – their ETF product suite.