At The Money: Building an ETF

Have you ever had a great investment strategy and thought to yourself, “Hey, this is really good! It should be an ETF!” It is much easier than it used to be to create a strategy and put it into an ETF wrapper. Wes Gray is founder and CEO of ETF architect. He helps managers turn strategies into ETFs by providing turnkey, white label platforms to handle all of the complex and expensive office operations. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

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• 3:10Barry Ritholtz?

  Mutual 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

• 3:52Barry Ritholtz?

  that handle legal, compliance, operations, portfolio management.

• 3:58Barry Ritholtz?

  Allowing sponsors to focus on the idea and distribution and 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?

• 4:34Speaker 04

  Well, I think it's going to come down to low fees, capital, and passion. In ETF market, as you know, you gotta 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. And 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.

• 5:09Barry Ritholtz?

  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?

• 5:22Speaker 04

  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. Obviously, 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.

• 5:48Barry Ritholtz?

  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?

• 6:05Speaker 04

  Sure. So this is a moving target. And let's say four or five years ago, we would have said, "Hey, 5 million minimum." Now 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 cost of the ETF, it's to convey credibility to the marketplace. We need, like, people just, everyone kind of knows, like, "Hey, where's your break even?" You know, 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

• 6:46Speaker 04

  account, and click the button, and, you know, pay cash to buy your ETF. Or you can seed it with property, where it's a little bit convoluted, but there's a thing called Section 351, where you can actually contribute property tax-free to seed the ETF. So basically, cash or property is the two methods you can use.

• 7:04Barry Ritholtz?

  And I'm assuming property is usually individual stocks or bonds, is that right?

• 7:08Speaker 04

  Yep, you got it. So if you have a portfolio of securities, public securities that naturally fit in this ETF, you can contribute those tax-free. And then that property serves as initial seed for essentially the launch of the ETF.

• 7:22Barry Ritholtz?

  So you mentioned break even. Take me into the minutia of what the backend of this looks like. Legal, 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?

• 7:45Speaker 04

  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 ETF, again, I'll sandbag for a generic ETF, just with easy numbers. You're looking at a 50K startup, soup the 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.

• 8:29Speaker 04

  And you know, it's plus or minus, but you're looking at around 200K a year. So what the heck does that mean as a business, uh, setup? Well, it, you know, if you charge 1%, your break even is 20 million. If you charge 20 basis points, which is a much, you know, much more marketable. Your break even is 100 million and then everything in between. So, so obviously your break even depends on your fee, but you're looking at 200K burn a year on average.

• 8:55Barry Ritholtz?

  Let'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?

• 9:12Speaker 04

  So in the, this, this advice has also changed over time. Where, where 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 cost. I don't have to pay for a third party index agent. I don't gotta pay for third party service providers. And, and I also have a little bit more flexibility at the margin. So 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.

• 9:57Speaker 04

  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. Uh, on like little minutia decisions like this. So we recommend active at the margin.

• 10:13Barry Ritholtz?

  So you must see a ton of different strategies. What do you see that really shouldn't be put into an ETF? What, what kind of strategy, even if a manager is passionate and excited about the idea? What, what are the sort of red flags that, hey, you don't want this in an ETF?

• 10:30Speaker 04

  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 levered, triple levered whatevers, a lot of these gimmicky products that are extremely expensive and they have tons of embedded costs via like swaps and a lot of other things that aren't transparent. I 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.

• 11:13Barry Ritholtz?

  So you're not a big fan of the inverse 3X levered Bitcoin ETF?

• 11:19Speaker 04

  I, 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, you know, low fees, transparent, tax efficient, things that people can understand that presumably add value in the long game.

• 11:36Barry Ritholtz?

  So let's talk about some of the block and tackling once an ETF is created and launched. How 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 than average?

• 12:04Speaker 04

  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. That'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 ask spread.

• 12:46Speaker 04

  So the vast majority of that bid ask spread is is simple to understand. What would it cost you as a trader to acquire or dispose of that basket of securities? So and so, for example, if I'm trading the triple levered Zimbabwe Bitcoin swaps, well, my bid ask spread might be 10% wide. Where if I'm trading a basket that's S and 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. So it just depends on the underlying basket liquidity.

• 13:22Barry Ritholtz?

  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?

• 13:50Speaker 04

  Another great question. So ETFs, unfortunately, we run ETF architects, so everything should be at an ETF, of course, right? But, you know, let's be honest here. The big disadvantages of the ETF structure are transparency and you cannot close an ETF. So if we have a strategy where transparency is just not, you know, 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 constraint. So let's say we're trading the micro cap strategy in 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 the whole concept up.

• 14:35Speaker 04

  You cannot stop or close an ETF, whereas in SMA or mutual fund, obviously they have tools in which you can actually capacity constrain the capital you take on.

• 14:46Barry Ritholtz?

  So 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?

• 15:32Speaker 04

  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? So 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 anytime you have a strategy 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

• 16:13Speaker 04

  just not massive scalability, that's where you'd want to focus. If you can put a trillion dollars in your strategy without any breaks, it's probably not going to work because Vanguard's already doing it and we don't want to compete with the monopoly.

• 16:29Barry Ritholtz?

  So 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.

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