ETFs are becoming more popular, yet some in the industry do not yet have the specialised, cost-effective operating models they need.
As exchange-traded funds (ETFs) become more popular, the asset management (AM) firms that offer them need to develop appropriate operating models. Given ETFs’ low investor fees, operating models have to be cost-effective. Both asset managers and their service providers need to adapt accordingly.
Since ETFs require different back-office functions than traditional mutual funds, a new approach is necessary. Simply modifying existing fund servicing capabilities, or supplementing them with ancillary procedures is not enough.
Given the relative immaturity of the ETF industry compared with traditional funds, its levels of standardisation and automation are well below what we would expect in a trillion-dollar industry. Most industry participants have been in the business less than a decade, and many joined when ETF products were predominantly domestic equity, broad-based index funds. Since then, the broad-based equity index ETFs have become commonplace, so product innovation and asset growth has focused on fixed-income securities, commodities, niche indices and derivatives.
Re-examining operating models
The industry’s evolution has forced sponsors and key industry participants including distributors, authorised participants and their service providers (Index Receipt Agents) to re-evaluate and retool their operating models so that they can support ever-growing asset flows in increasingly complex ETF product instruments. In parallel, they have had to evaluate service providers with mature, systematic processes and scalable technology-based solutions that can handle ETFs.
In the traditional fund businesses, mature operating models have been in place for decades for open- and closed-end funds. Well-established industry service providers offer a variety of commercially proven offerings that address: transfer agency, custody, fund accounting and administration functions. Additionally, software and service providers have developed robust solutions supporting large transaction volumes and sophisticated processes.
ETF sponsors need to be positioned to support continued growth by addressing current operating challenges as well as unforeseen new requirements. Similar issues exist across geographies with some notable exceptions – for example European funds must be able to handle the complexity associated with in-kind transactions across multiple exchanges. But whether an asset manager is focused on one country, or creating global offerings, there is a need for a consistent set of capabilities, enabled by a standardised operating model that addresses technology, process and organisational requirements specific to ETFs. Otherwise, the solution won’t be scalable over time.
Economies of scope
As the ETF marketplace grows quickly and evolves, the typical ‘economies of scale’ approach that matters so much in a mature market may be usurped by sponsors and servicers that have an ability to bring ‘economies of scope and economies of specialisation’ to the table. By developing offerings that meet the control requirements of ETF products – as well as addressing the specific stakeholder requirements of authorised participants, market makers and distributors – newer entrants and suppliers that are currently in the process of “re-platforming” may have an advantage over those modifying outdated processes and platforms.
The new ETF operating models address the specific terminology, processes and roles that are unique to ETFs. Systems should be able to handle creation units, baskets and index-tracking errors, as well as supporting rebalancing, index monitoring, in-kind redemptions and cash in lieu. Administering proper tax allocation and lot selection is important for ETFs. Modified fund infrastructures do not perform these operations so easily.
Developing a standard operating model also means creating a set of controls, metrics, governance and reporting capabilities that not only address current needs but also anticipate additional regulatory reform. The current ETF service provider landscape is limited but evolving quickly. Only a handful of players can support the full suite of ETF products including equity, fixed income, international and commodity securities. Fewer still have the ability to do so in an automated fashion with integrated tools and processes, instead of relying upon manual process and ad hoc solutions. They continue to focus on building out the capability to scale as needed, while being price-competitive.
So how do we get to an environment where ETF operating models become more suited to their role? As a first step, ETF sponsors should assess the capabilities they need. For their part, service providers should continue to invest in designing and developing scalable, ETF-specific service offerings. By investing in technology and automation, in the right operating model, well-crafted operations should be able to position themselves as the low-cost, high-value suppliers of these offerings. Asset managers need and expect this from their partners. And their partners need to position themselves to deliver.