ETFs are a booming industry. Data from LSEG show ETF issuers collected $142.5 billion of inflows in September. The 10 best-selling ETFs captured $48.9 billion of those assets. Given those figures, it’s no surprise that asset managers of all types are considering bringing an ETF to market or, in some cases, converting existing strategies in other structures to an ETF.
While the asset flows might be attractive, new ETFs are entering a very crowded market. Over the summer, the number of ETFs offered surpassed the number of U.S.-listed equities. That means there are more funds tracking stocks than there are stocks. Industry data further show that for an ETF to be viable and get listed on brokerage platforms, the fund has to launch with—or very quickly bring in—several hundred million dollars. If asset managers do not already have funds to bring over, they may look to seeding arrangements that allow them to launch an ETF with a viable level of assets and give distribution teams time to bring in more investors.
“While asset managers have been the most active in launching new ETFs, there is a lot of interest in seeding funds by institutions that are not your typical ETF sponsors,” says Amrita Nandakumar, the president of Vident Asset Management, a firm that helps launch new ETFs. “This often entails pursuing some type of conversion into an ETF. For example, we are being contacted by quite a few family offices and [registered investment advisers], who see the ETF wrapper as offering superior tax management tools as compared to separately managed accounts. Hedge funds have also become increasingly active over time. Their motivation for seeding ETFs is often to allow financial advisers and retail investors easier access to strategies that would normally be limited to high-net-worth individuals.”
Institutional investors are also seeding ETFs. As CIO reported in February, the $925 billion Saudi Public Investment Fund seeded a Saudi Arabia-focused ETF managed by State Street Investment Management with $200 million. The ETF focuses on Saudi Arabian bonds.
The California Public Employees’ Retirement System reported in Form 13F-HR in August that it owned more than 39 million shares of the J.P. Morgan Active High Yield ETF (Ticker JPHY), the firm’s first actively managed junk-bond ETF. CalPERS was reported to be the fund’s anchor investor, and the investment had a reported value of $2.01 billion, as of June 30, according to the filing.
Influence and Liquidity
Zachary Evens, a manager research analyst for Morningstar Research Services, says that institutions may be interested in seeding arrangements because “anchor investors can have a say on things like the direction of the strategy or fund fees.” This is the same strategy the largest institutions have brought to their negotiations with other investment fund managers, so it is not a surprise to see it being revisited now as more of the market moves toward the ETF structure.
However, there are some challenges, such as that the democratized structure of an ETF means that it is harder to set up favorable fee arrangements, compared with the many that can be negotiated with a hedge fund in fund agreements and side letters.
Sebastian Stewart, an institutional business development partner in U.K.-based Pacific Asset Management, says institutions are interested in anchoring differentiated strategies and can be valuable partners in a launch process, but the expectations have to be clear from the beginning.
“The issue is that any kind of concessions you might make for an anchor investor will have to be relatively short lived,” Stewart explains. “It can still be valuable to the institution because they are getting the tax optimization and liquidity benefits of the ETF long term. But institutions do have to think through those realities. They don’t have as much control as they do in a separately managed account or other fund structure.”
Stewart adds that fund strategy plays an important role. Institutions may find it valuable to get lower-risk access to a unique strategy through an actively managed ETF, from which the institution can still retain the ability to exit quickly, rather than agreeing to a long lock-up via a hedge fund or taking on the higher costs of an active mutual fund.
Pacific Asset Management is working with an outsourced CIO provider to seed its Pacific NoS Global Emerging Markets Equity Active ETF (ticker GEME), and Stewart says the OCIO was interested in large part because the firm was able to get access to the strategy without sacrificing liquidity. The same strategy is also offered as a Delaware-registered investment fund, but the liquidity of the ETF structure ended up being a deciding factor.
“The goals driving each investor are going to be different,” Stewart says. “But we are hearing more about liquidity from all types of investors. That does give ETFs an advantage in some cases.”
Conversions on the Rise
Conversions from one fund structure to an ETF are also on the rise. Many large asset managers—including BlackRock, Dimensional Fund Advisors and Lazard—have announced a steady stream of mutual fund-to-ETF conversions. Institutions are not seeding these funds in the most strict sense, but they can end up moving to a lower-cost vehicle without having to realize capital gains. A move which Tim Huver, managing director of the ETF servicing team at Brown Brothers Harriman, says investors tend to like.
“Investors are going to end up with better tax optimization, and the ETF itself starts out at a level of viability because you have the assets coming over from the mutual fund,” he says. Mutual fund conversions also get to retain their investment performance track records, so the ETF launches with a higher level of credibility than a new fund.
So-called 351 conversions, named for the tax code section that allows the transactions, are also on the rise. These allow for the conversion of large SMAs or other direct index accounts into an ETF. Once the conversion is complete, investors can rebalance the underlying investments in line with the ETF prospectus and avoid creating a taxable event. Such conversions are already growing in popularity among family offices and hedge funds.
Cambria, an ETF issuer that will help do the conversion, has launched the Cambria Endowment Style ETF (ENDW), which suggests that there might be some interest among taxable endowment investors to convert their SMAs—provided the strategies still work within the ETF wrapper.
Morningstar’s Evens says these types of conversions are happening more frequently: “I don’t think we’re going to see a big rush; it’s limited to the types of investors that already have large SMAs. But it is a category that we think will continue to grow over time.”
Going forward, BBH’s Huver expects that both new seeding arrangements and conversions will remain in the mix for ETF issuers. Funds that offer a differentiated strategy and a clear path for distribution are going to get attention.
“There is a lot of product out there, but we’re still at the tip of the iceberg in many categories—especially actives,” he says. “Investors like the benefits of the structure, and now that we can do more with share classes and active strategies, there are growth opportunities. Investors have a lot of influence over how the market evolves.”
Tags: CalPERS, ETFs, exchange-traded funds, Public Investment Fund