At The Money: Building an ETF  

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0:47Mutual funds, trusts, and ETFs. Have you ever wondered how these are put together? Are you an analyst, strategist, or fund manager that has a really good idea? Have you thought about launching a fund to employ that idea? I'm Barry Ritholtz, and on today's edition of At The Money, we're going to discuss how to build your own exchange-traded fund, or ETF. To help us unpack all of this and what it means for your portfolio, let's bring in Wes Gray of ETF Architect. He helps managers turn strategies into ETFs by providing turnkey white-label platforms that handle legal, compliance, operations, portfolio management, allowing sponsors to focus on the idea and distribution.

1:40And Wes also runs the Alpha Architect shop as well. Full disclosure, Wes Gray and ETF Architect are helping my firm, Ritholtz Wealth Management, launch a new ETF later this year. So Wes, let's start with the basics. If I'm someone with a novel strategy and a good idea for a ticker, what are the elements that determine whether or not this ETF launches or whether it just dies on the vine? Well, I think it's going to come down to low fees, capital, and passion. In ETF market, as you know, you got to have low fees for the most part, people aren't going to buy your product. And low fees means you also got to have a lot of capital to back this thing because you got to be around for at least three to five years to tell your story.

2:29And then you got to have the passion. You're in a market competing with monopolies like BlackRock and Vanguard. So you got to be someone like a Perth Toll that we talked about previously, where you just have to go knock on doors and tell people why your product and your story is so great. Huh, really interesting. So I'm curious as to the timeline from the original conception to trading day, what's a realistic timeline and where are the common bottlenecks? So we generally tell folks four months. You sign the letter of intent and you're ready to whoop it on. We can get this thing out the door in plus or minus four months.

3:08Obviously, that could go out to four years, depending on your own internal issues. But we've got this thing so checklist and automated at this point. If you want to launch in four months for like a relatively straightforward ETF, that's going to be possible. Four months seems really short, but I guess I'm imagining how long it takes to accumulate enough seed capital launch. How much money under management do you need to launch an ETF? How does that get structured? What's the usual launch dollar amount? Sure. Sure. So this is a moving target. And let's say four or five years ago, we would have said, hey, 5 million minimum.

3:49Now we tell people 25 million and I'm about to probably move it up to 50 million. And really, it's not because of the operating costs of the ETF. It's to convey credibility to the marketplace. Everyone kind of knows like, hey, where's your break even? Because I want you to be in business three to five years from now. And usually that break even in people's minds is 25 to 50 mil. So anyways, high barrier to entry just on that. Now, how do you seed these things? Well, there's basically two methods. You either seed with cash. So you launch the ETF and people go open up their Schwab account and click the button and pay cash to buy your ETF.

4:27Or you can seed it with property where it's a little bit convoluted, but there's this thing called section 351 where you can actually contribute property tax-free to seed the ETF. So basically cash or property as the two methods you can use. And I'm assuming property is usually individual stocks or bonds. Is that right? Yep. You got it. So if you have a portfolio of securities, public securities that naturally fit in the CTF, you can contribute those tax-free and then that property serves as initial seed for essentially the launch of the ETF. So you mentioned breakeven. Take me into the minutia of what the back end of this looks like.

5:06legal, audit, administration, listing, distribution, marketing. What are the big costs that any ETF manager has to run? Where do people kind of make mistakes with these? So, yeah, I'll kind of reverse the question. And let me tell you what we've done, the cost, and what you have to do. Because what you're asking about is a total dumpster fire behind the scenes. But essentially for our platform is like you show up with the spreadsheet, tell us what to do, and you go market and distribute this thing, comma, compliantly because we have oversight responsibilities. That's your two primary jobs. Now, we're going to deal with all the dumpster fire behind the scenes and the generic cost of doing this to launch an ETF.

5:52Again, I'll sandbag for a generic ETF just with easy numbers. you're looking at a 50k startup soup to nuts and then which is not the bad news uh the bad news is the ongoing cost to deal with all the aspects you just talked about and you know it's plus or minus but you're looking around 200k a year so what the heck does that mean as a business uh setup well you know if you charge one percent your break even is 20 million if you charge 20 basis points which is much more marketable, your breakeven is$100 million and then everything in between. So obviously your breakeven depends on your fee, but you're looking at$200K burn a year on average.

6:32Let's say someone comes to you with a systematic strategy. How do they decide whether or not this is based on an index and running it fairly statically versus a more active ETF that's run more dynamically. So this advice has also changed over time. We're in the old days, we would say, hey, index active, there's a bigger trade-off there. Now it's almost always the case, just go active. Even if your strategy is 100 % systematic, why is that? Well, there's just low overhead costs. I don't have to pay for a third-party index agent. I'm going to pay for third-party service providers. And I also have a little bit more flexibility at the margin.

7:15So, for example, let's say I'm on an index versus an active and I'm doing the exact same strategy. But we know this week there's going to be three Fed meetings and, you know, the world's going to blow up. I might not want to rebalance this week. I'll just punt to next week. That's easy in an active strategy. In an index strategy, that's possible. But the paperwork trail and the compliance to be able to facilitate that's essentially a nightmare, which means most index funds just follow the book no matter what. on like little minutiae decisions like this. So we recommend active at the margin. So you must see a ton of different strategies.

7:52What do you see that really shouldn't be put into an ETF? What kind of strategy, even if a manager is passionate and excited about the idea, what are the sort of red flags that, hey, you don't want this in an ETF? I mean, I don't know if I'm weird or just old school or conservative, but if I'm not going to recommend this to my parents or my grandma. Why do we have this in an ETF where anyone with a Schwab account can click the button and have a party, right? So what does that mean? Things like double lever, triple lever, whatever's a lot of these gimmicky products that are extremely expensive and they have tons of embedded costs feel like swaps and a lot of other things that aren't transparent.

8:35I can't stand those products personally. Does that mean that people won't do them? Well, of course not. If you can sell out to people that are going to pay 1 % for your stupid idea, great. But I'm not a big fan of having those products in the ETF marketplace. So you're not a big fan of the inverse 3X levered Bitcoin ETF? No, I'm not a fan. And again, maybe I'm just a funny daddy and I need to move on in the world, but I just kind of old school. I like low fees, transparent, tax efficient things that people can understand that presumably add value in the long game. So let's talk about some of the block and tackling once an ETF is created and launched.

9:20How do you think about what I think about as someone who was on a trading desk as good market behavior, meaning tight spreads, reasonable liquidity, especially if the ETF is holding some assets that are perhaps a little less liquid than average? Yeah, that's a great question. And it creates a lot of confusion in the marketplace. And so what there are, there's basically two types of ETFs. One we'll call liquidity diamonds. These are ETFs that everyone knows, right? Like SPY, Triple Q, where when you go and transact in those ETFs, it's very likely that you're actually trading shares with someone else who actually owns those ETF shares.

10:04That's rare, right? Because it's just such a huge market. The other set of ETFs, which is 99.99 % of them is normal ETFs, where when you go access the marketplace, you're accessing what they call primary liquidity, which means you're asking a market maker to give you a bid ass spread. So the vast majority of that bid ass spread is simple to understand. What would it cost you as a trader to acquire or dispose of that basket of securities? And so, for example, if I'm trading the triple levered Zimbabwe Bitcoin swaps, well, my bid ass spread might be 10 % wide. Or if I'm trading a basket that's S &P 500 stocks, even though the ETF maybe never trade, But once a year, we could trade a billion dollars of that ETF with a couple basis points of impact.

10:56So it just depends on the underlying basket liquidity. You may notice I didn't ask an obvious question. Hey, do you go ETF structure or not? I think we all understand the advantages of this structure, not only intraday liquidity, but no phantom capital gains taxes. but what might send us in a different direction, an SMA, a mutual fund to trust? When is an ETF really not the right structure? Another great question. So ETFs, unfortunately, we're an ETF architect, so everything should be at an ETF, of course, right? But let's be honest here. The big disadvantages of the ETF structure are transparency and you cannot close an ETF.

11:44Yeah. So if we have a strategy where transparency is just not going to play favorably for my shareholders because I don't want to expose this to the world every single day, then obviously you can't do an ETF for all intents and purposes. The other one is capital constraints. So let's say we're trading the micro cap strategy and penny stocks where the maximum amount of capital that can go in there is called 50, 100 mil. Beyond that, I'm going to start blowing the whole concept up. You cannot stop or close an ETF, whereas an SMA or mutual fund, obviously, they have tools in which you can actually capacity constrain the capital you take on.

12:22So the last question, we have noticed just a tremendous amount of flows are going to the big three. They go to BlackRock, they go to Vanguard, they go to State Street, and broad passive indexes have dominated a lot of the flows. The exception has been these kind of new, clever, unusual active funds that occasionally catch people's fancy. If you're thinking about creating an ETF, what sort of space should you really be looking in? What sort of strategy is the best ETF alternative to the core of a lot of people's portfolios, the big indexes? Yeah. So I would basically focus on things that Vanguard or iShares can't do well, which is usually going to be very boutique, very niche strategies where it takes some special expertise to put those portfolios together and or you can't jam a trillion dollars into the strategy, right?

13:27So basically focus as be good at being a boutique because you're never going to beat vanguard at delivering scale trillion dollar market beta that's insanity so so anytime you have a strategy that that vanguard is not offering because it's either really complex really differentiated hard to explain hard to build hard to manufacture or there's just not massive scalability uh that's where you'd want to focus if if you can put a trillion dollars in your strategy without any breaks it's it's probably not going to work uh because vanguard's already doing it. And we don't want to compete with the monopoly.

14:05So to wrap up, if you're an analyst or strategist or even fund manager, and you have a unique idea that you think will do well in the market, as well as well in the marketplace, you think others are willing to pay for it with their capital, consider launching your own ETF. You need about$25 million in assets and a cost of about a quarter million dollars annually, but the upside are potentially hundreds of millions or even billions of dollars in client assets. I'm Barry Ritholtz, and this is Bloomberg's At The Money.