How an ETF is born

Each trading day at about 7 p.m. Eastern, Sphere Investments, an ETF firm in Toronto, receives a data file from its index provider, FTSE Russell. Delivered through a secure server, the portfolio composition file informs Sphere about portfolio weights and any changes that need to be made to its positions.

As the link between the index provider and Sphere, the file is necessary for the firm’s ETFs to track their respective indexes. An updated file is checked again in the morning—to ensure there were no market-moving events through the night—before any orders are filled.

“All we receive from FTSE, actually, is a data file that says these are the stocks you’re supposed to own,” says Keith McLean, Sphere’s president and chief investment officer. “It’s up to them to maintain their technology back end, and to provide that file.”

Sphere’s five ETFs each track different geographically focused versions of FTSE Russell’s Sustainable Yield 150 indexes, which are comprised of high-quality, dividend-paying equities. Launched in 2015, they were mostly the creation of FTSE, which had developed its sustainable yield methodology in anticipation of demand.

The index boom

If you’ve seen an ETF launch recently and wondered whether the index it tracks existed previously, there’s a good chance it did not. The global ETF business is booming—with assets exceeding US$4 trillion in May on record monthly inflows of US$37.94 billion.

With it, the number of indexes has surged, along with the number of firms providing them. It’s not just MSCI, S&P and Nasdaq anymore—now Barclays, Zacks and WisdomTree are index players. In May, Bloomberg reports, the number of market indexes rose to about 5,000, surpassing the total number of U.S. stocks—which have declined since 1995. Market strategists say it’s just the beginning for the rise of index-tracking ETFs.

“We haven’t even scratched the surface,” says Tim Baker, director of product strategy at portfolio management firm Symmetry Partners, in Hartford, Conn. “There are a lot of asset managers out there who are kind of holding their ground: ‘We’re not going to launch ETFs. We’re not going to do this.’”

ETF gangbusters

US$4 trillion: Assets invested in ETFs and ETPs globally at the end of Q1

6,835: The number of ETFs globally at the end of Q1, with 12,892 listings

$126.2 billion: Canada’s total ETF assets at the end of Q1, up 29.9% YoY

Sources: ETFGI, Canadian ETF Association

Slowly, however, active managers are ceding ground. Baker says he expects more players in active management to move into quantitative and smart beta ETFs, where niche benchmarks are tracked without an active manager. Many active strategies are convertible into smart beta indexes, pushing up growth.

Choosing what to track

For ETF providers, deciding on an index is largely an exercise in finding a product that’s helpful to advisors and investors. Fund managers are looking not just for unique offerings, but for growth areas, product demand and portfolio needs.

Pat Chiefalo tries to cross the country once or twice per year to meet with advisors. Chiefalo, head of iShares Canadian products at BlackRock Asset Management, the country’s largest ETF provider by AUM, has seen the demand rising first hand, estimating 10% to 25% annual growth in ETF assets in Canada over the past eight years. When on the road, he tries to find out advisors’ biggest portfolio challenges and stress points.

“I love hearing about how they’re crafting and constructing their portfolios. More recently, that’s becoming a bigger part of the conversation,” says Chiefalo. “For anyone that’ll have me in their office, I’m more than happy to make an appearance.”

Last year, based on what clients and advisors asked for, his firm launched Canadian-dollar hedged versions of its global minimum volatility products, which track global MSCI indexes. Chiefalo says iShares can launch new ETFs after a few months of work, though a unique idea could take longer.

Creating a universe

The ETF manager will typically work with the index provider to tweak the index as necessary. While the fund manager has input on conditions and exclusions, the index provider creates the universe.

“We’re kind of the Intel inside of a computer, if you will. We are actually defining the universe,” says Ken O’Keeffe, global head of ETFs at FTSE Russell in New York. “They will have input on those types of decisions. But the starting universe for, let’s say, FTSE Canada All Cap—if they want Canada exposure, we’re going to start there. Then, in dialog with them, we might change [it].”

While fund managers meet with advisors for ideas, index providers are also surveying the landscape for new products and building indexes according to their expectations of demand. FTSE, for instance, says it is constantly looking at additional indexes, like equal weight, fundamental weight, factor indexes, dividend weight, and minimum variance indexes, and building them in the event that clients ask.

A ready index

That was the case with Sphere. FTSE Russell, looking to grow its indexing business, had already developed the sustainable yield index methodology. When Lewis Bateman, Sphere’s founder, approached FTSE about launching a new suite of ETFs, a match was found.

McLean, of Sphere, says the sustainable yield indexes were at least 90% FTSE’s creation. “We basically made it a more tradeable instrument, [and] focused a little bit more on high quality,” he says.

Sphere has an agreement to use the indexes exclusively for its ETFs for five years—no other ETF provider will have access to the indexes—with a possible renewal of the exclusivity terms. It’s now working on additional suites of products to serve demand for the long term, McLean says, with different index providers in mind to suit different ETFs. “FTSE is not going to be our only indexing partner. We’re already working with others,” he says.

“We’re developing indexes and algorithms sometimes in advance of a client saying, ‘Hey, I’d like that,’” O’Keeffe says. “In other cases, it’s a very consultative approach. Usually, the ETF provider is trying to achieve a certain exposure or investment outcome for their end investor.”

He provides another example: when Canadian investor Kevin O’Leary approached FTSE in 2015 about launching an equity and dividend ETF (later launched as OUSA on NYSE Arca), FTSE Russell had already been building indexes based on estimated demand, after surveying advisors and retail investors. The index provider had pretty much already developed what O’Leary needed, with some input from him.

Support and fees

McLean says Sphere chose to work with FTSE partly because of the support the index provider was willing to offer—including marketing and institutional relationships—as it sought expansion into Canada. “They get paid off of our assets under management. The bigger we get, the more they get paid,” McLean says.

Index provider support can vary by firm and region, but assistance may be available through marketing and marketplace education, and providing conference speakers and training.

The major indexes (e.g., S&P, FTSE, MSCI, Nasdaq) tend to charge ETF providers by basis points on AUM. Some smaller, newer index providers may charge a flat fee, perhaps $20,000 per year. The fees charged depend on the index’s conditions, complexity and the factors applied. The fewer the inputs, the cheaper the service.

Large, commercially recognizable index providers can charge more, while big ETF providers have negotiating leverage for a better price, says Kevin Gopaul, head of BMO Global Asset Management for Canada and global head of ETFs. ETF providers include the index pricing as part of their management expense ratios, or total fees. There’s an informal industry rule that says 10% to 20% of the total MER goes to the index provider, says Gopaul, who oversees Canada’s second-biggest ETF provider by AUM. “This is what I’m seeing globally,” he says.

But, as the space grows, so does the competitive pressure to drive down ETF expense ratios—and fund managers are increasingly looking at at index providers’ fees. The Financial Times reported in May that some large managers, like State Street, BlackRock and Vanguard, were looking at co-operating to provide a more cost-efficient form of self-indexing.

Competitive space

At the same time, newer index players are emerging with competitive offers, Gopaul says, pointing to Solactive, an index provider based in Frankfurt. “Some of the newer ones like Solactive come in with a very different value proposition. They come in at a very low cost. and it’s ‘Don’t worry about my brand name; I’ll have the strongest German engineering behind this,’” Gopaul says.

BMO launched a preferred share ETF (TSX: ZPR) in 2012, working with Solactive on a unique product and index, Gopaul says. While the bank works with the major providers, including MSCI and FTSE, it couldn’t find another index provider offering the unique combination of stability and yield, Gopaul says.

He talks to advisors regularly, looking for common storylines. The firm is always looking at launching ETFs that “provide more tools for the advisor’s toolbox,” he says, noting that Canadian investors tend to be focused on yield.

Financial advisors should prepare to sift through a lot more options as ETF product launches accelerate. And, ETF providers are no doubt happy to help you figure that out.

“You can slice and dice Canada into, literally, hundreds of industries and sub-industries. Of course, you can do that for every country in the world, and we can do that for any amalgamation of countries around the world,” says O’Keeffe, of FTSE. Slice and dice those indexes again as you input other factors like currency hedges in U.S. dollars, euros or yen, and “you just get this unbelievable amount of indexes,” he says.

Not your everyday benchmarks

ETF	Description	Index	Trading	Annual fee
ForceShares Daily 4× US Market Futures Long Fund	Seeks investment results of about 400% the daily performance of the S&P 500	S&P’s 500 Stock Price Index Futures	Pending approval	N/A
ETF Industry Exposure & Financial Services ETF	Invests in companies directly or indirectly related to the ETF industry	Toroso ETF Industry Index	NYSE: TETF	0.64%
Horizons Medical Marijuana Life Sciences ETF	Provides exposure to a basket of North American companies with activities in the marijuana industry	Solactive’s North American Medical Marijuana Index	TSX: HMMJ	0.75%
Barclays Return on Disability Exchange Traded Notes	Invests in companies with activities for people with disabilities, looking at talent, customers and productivity	Return on Disability US LargeCap ETN Total Return USD Index	NYSE Arca: RODI	0.45%
ProShares VIX Short-Term Futures ETF	Seeks to profit from increases in the expected volatility of the S&P 500, as measured by VIX futures prices	S&P 500 VIX Short-Term Futures Index	NYSE Arca: VIXY	0.85%