Exchange Traded Funds (ETFs) have exploded in popularity in recent years, providing fund managers with access to a broad and growing client base. Recent innovations mean that a fund manager’s strategies can now be made available to both listed and unlisted distribution channels within a single actively managed fund.
But where to start? What options are available when it comes to listing on an exchange, registry and market making? How best can fund managers balance compliance obligations with commercial objectives?
We got three industry experts together to discuss the future of distribution for fund managers; Shane Miller from Chi-X, Morgan Potter from Nine Mile Financial, and Richard Harris-Smith from Iress.
Why should fund managers get into this space?
Shane: We’ve had a few things happen over the last few years which have made it really attractive for active managers - starting with distribution. Some of the emerging distribution channels fund managers are seeking to access include full-service brokers, financial advisers and direct investors.
There has also been innovation in how active managers can protect their intellectual property. While previously they may have looked on and seen 30% growth per annum being enjoyed by passive managers, they’re now able to tap into the ETF market without having to disclose portfolio holdings every day.
Richard: managed funds are in many senses playing catch up compared with equities and other sophisticated trading instruments. Across the fund managers we work with, we’re seeing strong demand for digitalisation across all parts of the investment journey.
Through our single registry service we’re able to support fund managers to achieve more sustainable cost-effective investment flows. We’re also able to open the door to multiple distribution channels.
We’re seeing some direct investment growth of 50% in Australia in this low interest rate environment. Investors want digital, cost-effective options to invest - which fund managers should be taking advantage of.
Is this the future of managed funds?
Morgan: We are in such an incredible environment. The regulator has been very proactive in allowing different structures to come to market, as have the exchanges. As a result, there’s much more flexibility for asset managers than previously existed. With respect to investment, we are going through a generational shift in how people want to invest. We live in an instantaneous environment - with consumers expecting easy, 24/7 access to research, trading and products. The shift in investors’ appetite for exchange traded product is evident in the crypto markets, where people from all demographics are utilising technology to access new products. With the growth in investors via new technology, it’s an incredible time to use ETFs to access a much broader range of investors.
There’s no one size fits all and every asset manager is different, with different needs. But the good news is the flexibility exists to suit almost every fund.
What options are available to fund managers seeking to list?
Shane: There are three different types of fund structures
- Feeder fund - where you set up an entirely new fund just for the ETF, which at a minimum holds units in the corresponding managed fund.
- Creating a different unit class - this is similar to how you might create different unit classes for different currencies or wholesale/retail investors, this enables you to set up a unit class for the ETF.
- Dual access / listed-unlisted / hybrid - this is perhaps the most interesting new development, where one unit is simultaneously available as a managed fund and an ETF. The last eight ETFs we’ve listed have used this method - it’s really the future of fund distribution.
What do fund managers need to consider when setting up?
Shane: Some of the main things fund managers need to consider include:
- Liquidity of underlying assets - can your assets meet the listing rules? We can handle a wide range of assets but they will need to be liquid and have independent daily pricing.
- Use of derivatives - Not all funds have them but it does impact the naming and disclosure of the fund. In our experience derivatives haven’t stopped us from listing a fund.
- Market announcements - With an ETF you will need to make announcements to the exchange, including distributions and portfolio disclosures.
It’s also important to think about disclosure. There are three main modes here:
- Full disclosure / transparent - where you will need to disclose the full portfolio every day.
- Non transparent - This can be periodic and on a delayed basis, for example four times a year. This model provides intellectual property protection for asset managers by not having to disclose the full portfolio each day.
- Hybrid model - This is a combination of both approaches - for example delayed disclosure with an INAV and/or a basket or proxy portfolio.
What role does a market maker play?
Morgan: There are two different models of market making—internal and external.
Internal market making exists where the issuer accepts the role and responsibility of the market maker, in addition to the fund management. Such firms manage both investment management and trading capabilities. Through this model, asset managers won’t need to disclose portfolios on a daily basis, though will be required to provide a portfolio look through on a quarterly basis in arrears. The internal market making model means the fund takes the risk on execution and is required to manage strict regulatory compliance obligations such as segregation of duties and managing conflicts of interest, between the investment and dealing teams.
The second model involves an external market maker, such as Nine Mile Financial. Here the market maker takes the risk of providing liquidity to the market. Nine Mile would consume a partial or full portfolio from the asset manager, derive an INAV and then place bids and offers around this, providing liquidity and pricing certainty for investors.
A regulated market making function ensures investors are provided with price and liquidity certainty, enabling investors to invest and divest from ETFs.
How different is the registry service to support dual access funds?
Richard: We feel it’s important that the quoted managed funds channel connects to a single registry system—with all transactions recorded in the same place—which is what we have done at Iress.
The concept of a single unit means just that - without the administrative friction you would see from using two separate registry systems for listed / unlisted.
This provides greater choice for fund managers, including the ability to connect with brokers, platform, advised and direct.
What’s your final piece of advice for fund managers considering this approach?
Morgan: Currently when we speak with new issuers, we spend a disproportionate amount of time working through portfolio disclosure. Quite rightly, fund managers are worried about exposing their portfolios to the market on a daily basis with the IP they’ve generated over many years. While this is potentially concerning for issuers, the new framework provided by Chi-X allows for partial disclosure. This disclosure can be part of the portfolio or a proxy set of instruments that look like the portfolio. This is called the MPI (Material Portfolio Information) structure. Our advice would be to explore the use of proxies, working with the market maker to come to a solution that allows you to ensure IP protection, though at the same time provide enough information for the market maker to provide accurate pricing.
Secondly, it takes time to come to market – we find people generally take three to six months. Domestically we have a number of people that have come to market, alongside exchanges and market makers that can help provide guidance. I recommend utilising the experience from others as much as possible.
Shane: It’s really important to think about your sales strategy for the listed market. Just because your product is on the exchange, doesn’t mean it’s going to sell. Think about putting a product in a supermarket on the bottom shelf - how will anyone know it’s there? The same applies to listing on an exchange. Think about which advisers, brokers or investors you’re seeking to target. A lot of effort may go into the process of listing - make sure you put the same amount of effort into the sales and marketing.
Richard: My advice is to go for it. If you look at what’s happening in the direct market today we’re seeing high growth flowing into retail investment platforms such as Robinhood and Superhero. Retail investors want to be empowered to invest. There are big opportunities for fund managers to meet this demand and give investors a really good experience.
