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Why most RIAs bent on launching in-house ETFs should swallow hard and start a mutual fund

What makes exchange traded funds so great for consumers can cut the other way if you try to compete with BlackRock

Monday, June 23, 2014 – 4:33 PM by Guest Columnist Andrew Rogers
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Andrew Rogers: Unless they team up with a distribution or sales partner, smaller firms will likely find launching ETFs too big of a financial strain.

Brooke’s Note: You can see the appeal of owning an ETF. Not only are there headlines blaring out how they are sponging up assets but ETFs are just so cool. Any RIA would feel proud to say: My firm has its own ETF. But pride cometh before the fall and Andrew Rogers is here to talk down would-be compulsive ETF launchers and suggest a very viable, cool enough, substitute.

Exchange traded funds are a force to be reckoned with, growing assets annually about 30% since their emergence in 1993 and hitting $1.77 trillion in assets under management in U.S.-listed ETFs as of May 16, according to ETF.com’s data. See: Would the intern buy an ETF?.

That’s more than $700 billion of growth in exchange traded fund assets just since 2011.

So it’s hardly surprising that over the past few years many investment advisors that have come to my firm, Gemini Fund Services LLC, want in on the ETF action — not just as investors but as players in the production game right alongside PowerShares and BlackRock.

It’s a natural inclination informed by headlines and intuition. But after consulting with us, those advisors typically realize that they can better realize their dream of selling their investment management expertise to a wider market using mutual funds. See: RIA custodians charge steep new ETF-related fees that can range into the tens of thousands of dollars for big trades and advisors are working to deal with them.

Distribution sand trap

The shift in sentiment comes about when advisors become aware of the potentially dire drawbacks of being in the ETF game with the big boys. The transparency and investor accessibility associated with ETFs aside, this type of fund can be more cumbersome and expensive for many advisors to launch than a mutual fund.

The big issues are related to economies of scale particularly with regard to distribution.

Almost any investor can buy an ETF, but not every manager can sell ETFs. Broker-dealers are experts at using their distribution platforms to identify targeted groups of potential investors for mutual funds, but ETFs require national marketing campaigns due to their broader appeal. See: Schwab makes play for ETF-distribution domination but not without risks.

Too much disclosure?

In general, only larger advisors—which have numerous broker, representative and RIA contacts as well as deep coffers—can successfully mount a national marketing campaign for ETFs. Unless they team up with a distribution or sales partner, smaller firms will likely find launching ETFs too big of a financial strain. See: TD, Schwab and Pershing RIA units embrace mini-option mania to hedge Google, Apple, ETFs.

In addition to differences in distribution and marketing requirements, an advisor’s management style is also crucial in deciding whether to introduce a mutual fund or an ETF. Actively managed strategies, which utilize investment strategies to attempt to outperform a benchmark or the overall market, are more suited to mutual funds. Passively managed strategies that track benchmarks are generally beholden to market direction, and therefore better cut out for ETFs. While there are some actively managed ETFs on the market today, their number remains low due to two factors—greater transparency and lower trading volumes. See: RIAs surpass wirehouses in ETF asset distribution and it’ll mean change.

ETFs are required to disclose their portfolio holdings and asset allocations every day, while mutual funds are only mandated to do so on a quarterly basis. While this is a strong benefit for ETF investors, advisors can be negatively affected because investors might become spooked if an ETF suffers short-term difficulties. Furthermore, advisors with value-investing strategies that seek underpriced securities might not be comfortable disclosing their holdings on a daily basis. Mutual funds are a better fit for advisors that prefer less frequent disclosure, and also provide advisors with time to effectively respond to market developments before investors express concerns. See: A cottage industry of hedge funds-to-RIAs is springing up but so far the mutual fund industry looks like the big winner.

A big chew

The majority of ETFs are much less expensive than mutual funds because they are passively managed and can trade on an exchange during market hours. As a result, actively managed ETFs have higher fees, keeping investors away and resulting in very low trading volumes. These smaller trading volumes lead to wide spreads in bidding and asking prices, which can make ETFs more costly for investors. See: One-Man Think Tank: A method for analyzing and comparing the costs and fees for mutual funds and ETFs.

Advisors should keep in mind that while ETFs generally have lower fees than mutual funds, they can be more expensive to launch and operate. An ETF needs approximately $50 million to $75 million in assets — excluding advertising costs — to cover its operating expenses after it has launched. See: John Bogle tells the Morningstar crowd just why Vanguard Group has a 'problem’ — and it starts with his dogged criticism.

By contrast, excluding sales and marketing costs, a mutual fund usually requires between $15 million and $20 million to meet its operational expenses—far less than an ETF.

Legal costs

While both mutual funds and ETFs are generally registered under the Investment Company Act of 1940, ETFs’ structures conflict with certain parts it. As a result, ETFs require exemptive orders from the SEC in order to operate, which can increase their startup costs. Depending on the flexibility and requirements of the specific SEC exemptive orders they seek, and the legal costs associated with obtaining and adhering to them, ETF startup fees can range from $50,000 to $100,000. See: How Russell is faring since joining the competitive ETF party with an all-star ex-Barclays crew.

Mutual fund startup costs can also vary depending on whether the investment vehicle is created as a stand-alone offering or as part of a fund trust, in which different advisors share the costs of establishment and administration. With this in mind, the cost of launching a mutual fund can run anywhere from $40,000 to $75,000.

While ETFs are generally more expensive to launch and more difficult to distribute for smaller investment advisors, they are by no means the sole factor to consider when bringing a strategy to market. In our opinion, even if ETF startup costs decrease, advisors with actively managed strategies are generally better off launching them as mutual funds. However, every strategy is different, and the advice and guidance of experienced fund startup and distribution partners can help advisors make the most informed decision.

Andrew Rogers is CEO of Gemini Fund Services, LLC (www.geminifund.com), a provider of pooled investment solutions for independent advisors.

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