How ETFs Come to Market: From Idea to Ticker (EP.245)

0:29We all need to make smart decisions with our money. behind-the-scenes mechanics make many things possible that simply can't be achieved in mutual funds and other wrappers. Now, in this episode, we're going to start with how an ETF is launched, and what I'm hoping you'll learn is how demand drives new product in the first place, what the seeding process looks like, and how an ETF survives post-launch, as well as what happens if it doesn't survive. In the next episode, we're going to focus on the key plumbing and mechanics of the ETF ecosystem that allow for many of its unique advantages. And then the third episode is the big payoff, where I'll apply what you've learned to thinking through whether or not to seed the launch of a new ETF via a 351 exchange.

1:13As always, if you find this episode useful, please, please, please, please consider rating and reviewing the show. That's what helps others like you find this information. Now, before an ETF ever shows up in your brokerage account, The sponsor, whether that's a Vanguard or iShares, Dimensional, any number of fund companies, the sponsor has to answer a basic question. Is this something investors will actually use? Knowing in advance that there will be demand for a product isn't exactly straightforward, and it typically requires the fund company to gather information from a handful of signals. For starters, the sponsor will typically go out to real-world allocators for ideas.

1:57Now, most ETF ideas are created to do one of a few jobs. There's core exposure, like I need U.S. stocks or international stocks or core bonds at the lowest all-in cost. You'll also hear jobs like portfolio completion, like I'm missing small value or international quality or tips or short-term munis. And then there's the problem-solving angle, like I need income or tax efficiency or inflation protection or downside control. There's convenience, like maybe I want a managed solution, a buffer, a covered call, a targeted outcome, a managed bond ladder. And then finally, there is a narrative, such as I believe in AI or defense or energy transition or whatever.

2:44That job, those five different things, core exposure, portfolio completion, problem solving, convenience narrative, those jobs matter because it helps the sponsor separate a real allocation need from a passing storyline. And if the job is repeatable, something that advisors can use across many clients, then demand tends to be more durable. If it's mostly narrative, demand can show up fast and disappear just as fast. From there, sponsors look for proof that demand is much more than a hunch. So they'll start studying the flows and the holdings across the industry to see whether money is moving into that type of exposure across the category, not just in one headline fund.

3:26And then they'll ask whether the space is dominated by a few incumbents, and if so, whether there's a genuine reason a buyer would switch. And fund sponsors, they also have to get specific about who the buyer is and how the ETF would be distributed. So they'll ask, is this built for RIAs and model portfolios? Or is it for wire house platforms or institutions? Or for retail investors who might find it on a brokerage platform? A great idea with no realistic path to distribution is still a bad business. And then comes the part that looks like normal product viability tests. Like, can this be implemented at scale?

4:03Will it behave in a way that advisors and its clients can live with? And then there are these pre-launch conversations, I'll call them, where they're going to ask allocators, hey, if we launched this product at this price, would you use it in models? Or what would you need to see to get comfortable with it? Or who would actually allocate to this? Now, by the time the sponsor is ready to move forward with the paperwork in the build-out, they usually have a decent sense of two things. One, whether the ETF has a real market, and two, whether it can be priced in a way that makes it viable. Sometimes with the expectation that it may need to wave fevers or have some support from the sponsor early on.

4:40And once that decision is made and the sponsor decides that the ETF is a real market, the work shifts to the legal and regulatory build out. And I'll admit, this is sort of the boring part that you probably don't care about, so I'll keep it brief, but I will mention it for just kind of the comprehensiveness of the conversation. So the fund sponsor, they prepare the fund's disclosure documents, you know, what it will own, how it will be managed, what it will cost, what risks come with it. And they're not really asking regulators for a gold star here. They're simply getting the fund registered and launch ready so they can be listed and offered to the public.

5:14Now, at the same time, they're going to line up the infrastructure that makes the ETF functional. Some of this we're going to cover in the next episode, but that includes the custodian to hold the assets, an administrator to calculate the net asset value and keep the books, and if it's an index ETF, an index provider relationship. They're also going to choose the exchange to list on. They're going to lock in the ticker. They're going to coordinate the launch logistics with the firms that help the ETF trade smoothly on day one. And it's a lot of plumbing. But once you get that infrastructure in place, the fund still does need one more thing before it can open for business.

5:51And that is money. And that is where the seed capital comes in. So on day one, an ETF can't just show up to the market with no assets and hope that people buy its shares in an orderly fashion. There has to be something in the fund when the opening bell rings so that the ETF can publish a meaningful value and investors can actually trade it without the whole thing feeling like a ghost town. And so that's why fund sponsors line up Seed Capital. The seed capital lets the fund buy or receive its initial portfolio, issue its first shares, and begin trading like a real fund. Now, there are two basic ways an ETF gets seeded.

6:33First, it can be seeded with securities. So the seeder delivers a starter portfolio, stocks or bonds that closely match what the ETF is supposed to hold, and it will directly put those into the fund's custody account. And in exchange, they receive ETF shares, typically in institutional-sized blocks, rather than just one share at a time. The second way an ETF can be seeded is with cash. And in that case, the seeder wires the money into the fund and the portfolio gets built through purchases in the market. Now, this cash seeding, it's probably more common when the underlying holdings are harder to deliver as a clean basket.

7:09So examples that come to mind would be like certain bonds or derivative-based exposures or strategies where the launch is easier to execute with cash. Either way, the outcome's the same. The ETF now has assets, holdings, and shares outstanding, and it is enough to open for trading. I think it's worth calling out two misconceptions I often hear when I explain this. The seeding isn't the same thing as demand. It's more like that first brick that lets the building open. the real demand shows up later through the sustained assets and consistent trading, which we'll talk about in a second. The other thing is that a bigger seeding doesn't guarantee tight spreads.

7:46Now, this is kind of getting into the nitty gritty, so I'll just mention that trading quality depends much more on the liquidity of what the ETF owns and how easily the market can make prices in it. So once the ETF is seeded, it can open for business. The question then becomes the final thing we'll tackle, which is whether or not it can survive in the real world long enough to grow. And that's where the post-launch economics start to matter. So after the launch, there's really only one scoreboard and it's assets. If the fund doesn't gather enough assets under management, the economics simply won't work.

8:20And eventually the fund sponsor has to make a decision about whether it's worth keeping alive. And that's because every ETF has a cost base that doesn't shrink just because the fund is small. So think of it like a restaurant with rent and staff. You can have a great menu, but if nobody shows up, you can't cover payroll forever. Now, I have a detailed list of costs in the show notes at the long-term investor.com. Stuff like fund administration, custody, legal, exchange listing, index licensing, ongoing reporting, etc. And there's actually some costs that rise as the fund becomes more active or complex.

8:55But really, the point I'm trying to make is that there is a meaningful fixed cost just to keep the lights on. And the sponsor's revenue is pretty straightforward. It's essentially assets times the fee. So if a fund has$25 million of assets and it's charging 35 basis points, that's roughly$87 ,500 a year in management fee revenue to the sponsor before you even get into any sort of fee waivers or platform costs and the rest of the machinery just required to run and support an ETF. And that's why so many funds eventually get shut down. They just don't gather enough assets to make the math work. Now, why don't assets show up?

9:34In my experience, it usually just comes down to two drivers. The first is just the ETF has to be easy to use. So if the trading is clunky, investors are going to hesitate and advisors are going to avoid building into portfolios. And that just becomes a growth problem. It's not really ever about how good a strategy is. I've actually seen some ETFs that I absolutely loved. But we waited for three years because that's typically when a fund will fail. And if it fails, it's not just because the strategy was bad. Often it's just because it doesn't trade with enough volume or it trades with too much friction to make the underlying exposure really reasonable to manage in real time.

10:11Now, the second driver is probably the bigger one. The ETF has to be distributed at scale. And I think this is the part that most people underestimate because most ETFs don't grow just because a retail investor stumbles across them. They grow because they get adopted by the gatekeepers, the model portfolios, the strategist platforms, the large RIA networks, the brokerage platforms, and the approved list across all of those. And if a fund can't clear those hurdles, it usually won't be able to gather assets fast enough to survive, even if the concept makes perfect sense on paper. But when you do get those forces working together, you get a flywheel and a growing fund attracts more attention.

10:51The trading gets easier. The ETF looks more credible and adoption becomes easier and the assets, they just build on themselves. So an ETF, when it doesn't get off the ground, it can be a problem. You're looking for those ones that can. But when it doesn't, sponsors have a choice. Unfortunately, just none of them are particularly fun for the end investor. And that's why this really matters. That's really why I'm even covering this episode in the first place. So sometimes when things aren't going well, a sponsor will subsidize the fund for a while. So they'll waive part of the fee, or they may absorb some of the fixed costs for a period of time, keeping around longer than the math suggests because they want a broader lineup or they believe the category will eventually catch on.

11:33But if the assets never arrive, the sponsor has to do one of two things. They have to liquidate the ETF or merge it into another fund. Now, liquidation is the cleanest operationally, but it is definitely the most disruptive for investors. So the sponsor, what happens in these situations, they'll announce a closing date in the last day the ETF will trade. And then after that, the fund sells everything it owns, it pays down its remaining expenses, and then it distributes the cash proceeds to the shareholders. Now, if this is in a retirement account, it's mostly an inconvenience. You're just forced to choose a replacement, but in a taxable account, it could be more than an inconvenience because the liquidation creates a taxable gain, and it forces you to realize that outcome on a timeline that you didn't necessarily choose.

12:18The other outcome that doesn't necessarily result in taxes can feel smoother because you don't receive the cash, but you do end up in a different surviving fund. So you may wind up with a different exposure than you originally chose, different fees, different performance profile, and while many mergers are designed to be tax efficient, the tax result really depends on how it's structured and what happens inside the funds during the transition. So here's one last subtle point that I think a lot of people miss because when funds that struggle to gather assets don't end up closing, they often have a tougher trading environment along the way.

12:57So wider spreads, less depth, more friction. So even if a closure never happens, owning an ETF that never really finds its footing can be an unnecessarily expensive way to get an otherwise simple exposure. And all of this is why it's important to think carefully when you're considering a newer ETF. There is some research that I'm going to link to in the show notes in the longterminvestor.com that shows that most ETFs fail in the first three years. And as a result, it's common for allocators to wait to even begin due diligence until that three years of live history for a fund exists. Another common hurdle investment teams will consider is assets under management.

13:37And that can be as low as$100 million or as high as a billion dollars, really just depending on the strategy and the fund sponsor themselves. But if you are seeding an ETF as part of a 351 exchange, and that is the topic of the third episode in this series, you don't get to have that usual comfort of the three-year track record or being able to say, hey, this thing already has scale. And so you have to personally underwrite the reasons it will survive and function well. So we're going to do exactly that in episode 247. I'm going to share some of the questions that I ask fund sponsors when considering a newer ETF or seeding an ETF via a 351 exchange.

14:17But in the next episode, we are first going to be covering the plumbing and mechanics that make ETF management different than mutual funds or any other vehicle for that matter. And this is important because understanding this makes it clear when ETF will be more tax efficient than a mutual fund. And I realize a lot of people think that ETFs are always more tax efficient than mutual funds, but a lot of new ETFs are coming to market where that is not going to be the case. So I think this is a really important episode. I also think understand the mechanics will also make it clear why something like a 351 exchange using ETFs is possible.

14:52Again, if you're finding these episodes helpful, please leave a review in your podcast app because that helps more people like you find the show. As always, thanks for listening. And until next time to long-term investing.

15:25and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.