ETFs (Exchange Traded Funds)


How to Start an ETF

What is an ETF?

An exchange traded fund (“ETF”) is a form of mutual fund that is traded on a stock exchange.

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How are ETFs and mutual funds similar?

Both exchange traded funds and traditional open-end mutual funds are regulated under the Investment Company of Act of 1940. The 1940 Act allows a fund to hold a portfolio of securities and allocate that fund among its investors in the form of shares. Portfolios of ETFs and mutual funds can be managed in the same manner by their portfolio managers.

How are ETFs and mutual funds different?

ETFs can be purchased on the stock exchange on which it is listed any time during the trading day, between 0930 and 1600 Eastern Time. Mutual funds can only be purchased or sold as of the closing price at the end of the trading day, at 1600 Eastern Time.

Mutual funds can either be purchased through an investment account held by a broker dealer or can be purchased directly with the mutual fund without going through a broker dealer. ETFs must be purchased through a broker dealer since the shares are traded on a stock exchange.

Mutual fund transactions are settled in cash. ETF transactions are settled by the AP either delivering a basket of securities in exchange for shares for new investor purchases or receiving a basket of securities from the ETF in exchange for shares that are being redeemed by investors.

How does an ETF operate?

Exchange traded fund purchases and redemptions are handled between the ETF and authorized participants (“APs”).

ETF shares are issued or redeemed in exchange for securities rather than cash. An authorized participant or AP sells shares to investors through the investor’s broker dealer, or purchases shares from those investors on the open market of the stock exchange on which the ETF is listed. A lead market maker typically guarantees a continuous market, and APs usually make a market in those same ETFs but may choose at particular times not to offer a bid/ask market for the ETF.

What is an AP?

An authorized participant or AP is a critical part of the ETF process. An AP is a broker dealer that may provide bid/ask market for an ETF on the stock exchange on which the ETF trades. The authorized participant is important to the creation of new shares in an ETF, or redemption of shares from the ETF.

What is an ETF basket?

An ETF basket is comprised of the same securities that are in the exchange traded fund. These securities are delivered to the ETF much like cash is delivered to a mutual fund, in exchange for shares in the ETF. For redemptions the ETF will deliver a basket of securities to the AP to redeem shares the AP has repurchased on the stock exchange from ETF shareholders.

What is a special basket?

In certain circumstances the ETF portfolio manager may wish to ask for a slight variation in the basket so that it is different than the ETF portfolio. The portfolio manager may wish to rebalance the portfolio and does not want to receive additional shares in a particular security, so may ask the AP to deliver an equal value of a different security.

Special baskets are even more important in the recently approved non-transparent and semi-transparent ETF structures, where the baskets are intentionally slightly different than the actual ETF portfolio, with a goal of not disclosing to the investing public a small portfolio of the ETF in order to preserve the portfolio manager’s strategy and proprietary processes.

Are ETFs and mutual funds subject to tax?

If the fund distributes its net income and realized capital gains to shareholders during the year, the fund itself is not subject to any state or federal income or capital gains tax.

Why are ETFs considered tax efficient?

A key difference between mutual funds and ETFs is the tax efficiency of an ETF. A portfolio manager to a mutual fund may choose to sell securities in the fund portfolio in which the fund has an unrealized capital gain. Once sold, the unrealized gain becomes a realized gain, and must be distributed to shareholders prior to year-end in the form of a taxable dividend.

An ETF portfolio manager that wishes to liquidate or reduce a position in the ETF can  either overweight that security in a redemption basket or create a special basket by agreement with an AP to deliver that security to the AP as a special redemption basket.

Handled in this manner, the ETF does not recognize the capital gain within the ETF and does not have a resulting capital gain distribution.

How are ETFs purchased and held by shareholders?

ETFs are traded on stock exchanges; hence the name exchange traded funds. In order to buy and hold ETFs, an investor must have an investment account with a broker dealer and place the order to buy, or sell, through that broker dealer.

How do you start an ETF?

The process of starting an ETF is the same as starting an open-end mutual fund. A new fund can either be added as an additional series ETF in a series trust or start a new trust and file as the first ETF in that new trust.

How much does it cost to start an ETF?

To start a new trust and file an initial ETF in that new series trust, expect a budget of $100,000+ and approximately six months. To add a new series in an existing series trust, expect a budget of $50-60,000 and a timeframe of 90-120 days.

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How much does it cost to operate an ETF?

ETFs are slightly less expensive to operate than open end mutual funds because blue sky fees are not necessary for ETFs. The total operating cost not including investment advisor or subadvisor fees is a little less than $200,000.

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What is the break-even level for an ETF?

The break-even level for any investment fund can be calculated by taking the estimated expenses and dividing by the expense ratio. Most funds cap the expense ratio to help make a fund attractive and predictable for the investing public. If you assume, for instance, $200,000 in operating expenses and plan to cap the expense ratio at 1% or less, $200,000 is divided by 1% for a break-even of  $20 million.

How are ETFs traded?

ETFs are traded just like common stocks on a stock exchange. One or more market makers will offer a bid and an ask price, a price at which the market maker is willing to purchase from the ETF (bid) and the price at which the market maker is willing to sell the ETF (ask).

What is a non-transparent ETF?

ETFs publish their portfolio every night so that the investing public can know what is in the portfolio they are buying, and so the market makers can make an accurate market in the ETF. This transparency has been a point of concern for active portfolio managers, as publishing the portfolio “gives away” the manager’s intellectual property and investment process.

To help with this paradox, several non-transparent or semi-transparent ETF structures have been approved by the SEC. These structures show some, but not all, of the investments within the ETF, disclosing enough of the portfolio that the investor and market makers knows how to value the portfolio, but enough of the portfolio is non-transparent to preserve the portfolio manager’s proprietary information.

What is a passive ETF or index ETF?

Index or passive ETFs have a static portfolio that either is a duplicate of or representative of an index of securities. The Dow Jones Industrial Average and S&P 500, for instance, are indices comprised of stocks that change infrequently.  The index ETF either holds the same stocks to track the index or holds a representative sampling of the stocks in the index to mimic its performance.

What is an actively managed ETF?

An actively managed ETF can change its portfolio as often as the portfolio manager determines it is appropriate. Each day on which the markets are open the portfolio manager can make investment decisions to buy and sell securities within the ETF portfolio.

Key Takeaways

  • Launching an ETF: Requires significant capital and financial expertise. Launching an exchange-traded fund (ETF) necessitates substantial initial capital and a deep understanding of financial markets. This venture is not just about having a good idea but also about having the resources and knowledge to bring it to fruition.
  • Professional Help: Advisable to hire a firm for creation, marketing, and management. It’s possible and often advisable to engage a specialized firm for assistance in creating, marketing, and managing your ETF. These firms bring expertise in navigating the complex landscape of ETF formation and can help ensure compliance with regulatory requirements.
  • Startup Costs: About $2.5 million needed to acquire assets for the fund. The initial investment to kickstart an ETF for acquiring the underlying assets is very high. This significant amount is necessary to establish a solid foundation for the fund and to comply with regulatory requirements for asset backing.
  • Starting Small: Create a personal ETF with fractional shares for a lower-cost experience. For those not ready to launch a full-scale ETF, it’s feasible to start on a smaller scale by creating a personal ETF. This approach allows for experimentation with fractional shares to simulate the experience of managing an ETF, providing valuable insights into the process with a lower financial barrier.
  • For Beginners: Investing in existing ETFs is simpler and less costly. For novice investors, the complexity and costs associated with creating and managing an ETF might be daunting. As an alternative, investing in existing ETFs offers a way to gain diversified exposure to the markets without the need to manage the fund directly.