Five Ways to Launch ETFs

Active ETFs are expanding rapidly, and issuers now rely on five distinct methods to bring them to market: building a new strategy, reusing an existing one, converting a mutual fund, adding an ETF share class, or using a nontransparent structure. Each method carries different tradeoffs, from the time and resources needed to build a track record to regulatory uncertainty around mutual fund conversions and share classes. 

In this video, Bryan Armour, Director of ETF and Semiliquid Research, shows how Morningstar Direct traces an ETF’s origin through its inception date and strategy ID. This data shows whether a fund is new or tied to an established mutual fund strategy, helping investors and advisors judge its staying power. 

This video discusses findings from Morningstar's ETF Guide to US Active ETFs Report. You can read the full report for free.

Bryan Armour: 

Hi, my name is Bryan Armour and I'm the Director of Passive Strategies Research for North America Morningstar Research Services. Active ETFs have been rapidly on the rise in recent years, and this has inspired active managers to take a fresh look at their strategies, while investors are seeking smart ways to determine if active ETFs are fit for their portfolios. Whether you're an investor, an advisor, an active manager, we want to share some critical points on how ETFs enter the market. In this video, we'll cover the five key approaches issuers take when launching an ETF and how to figure out for yourself an ETFs origin and the progress that's made by using Morningstar Direct. Morningstar Direct is our investment analysis application that offers access to our latest data and research, analytics, ratings and more. 

When launching an ETF, issuers can develop a new strategy, use an existing strategy, convert a mutual fund into an ETF, add an ETF share class pending regulatory approval, or use a nontransparent structure. 

As ETFs continue their upward trend, Morningstar Direct is a great resource for tracking performance and origin. I’ll show you how I use it to get this information. Let’s look at each approach to understand it better. 

Today, investors can access thousands of strategies, covering dozens of asset classes, developed exclusively for ETFs. Launching a new strategy follows an asset manager’s normal product development playbook, and the benefits of ETFs make this option appealing. However, developing a strategy can take longer than the alternatives, and running the ETF may require new resources. The biggest downside, though, is having to build the ETF’s track record and asset base from scratch. 

Using Morningstar Direct, we can get to this kind of data with a more refined search. An ETF’s inception date is a clear way to see whether the strategy is new. You can also check whether the strategy is unique using its strategy ID. If the date is older, the ETF was likely issued with an existing strategy, which we’ll discuss next. 

A clone ETF can use the same portfolio managers and point to the mutual fund’s track record, lending it instant credibility. Managers run these ETFs in tandem with established mutual funds, hoping their prior success translates to the ETF. This approach keeps mutual fund investors and distributors happy while tapping a new market of ETF investors. 

The biggest tradeoff for ETF clones is that distribution platforms, like online brokerages, could boot the clone’s more expensive mutual fund share classes for regulatory or economic reasons. You can use Morningstar Direct to confirm whether an ETF is a clone by checking its strategy ID. Clones carry the same strategy ID as the mutual funds following that strategy, making them easy to identify. Next, let's see how existing mutual funds can be converted into ETFs. 

This new approach for mutual fund companies to get into ETFs might be coming soon. Vanguard has been the only one allowed to do this so far, and only for passive strategies, but their patent expired last year. Now other firms are trying to get the SEC’S approval to offer active ETF share classes. The SEC’S hesitation is likely related to ETF investors facing higher costs early on, and the potential for capital gains distributions from mutual fund share classes. 

It used to be that all ETFs were required to report holdings daily. That changed with the SEC’s approval of the first nontransparent, or semitransparent, ETFs in 2016. This offered issuers the tax and distribution benefits of ETFs while allowing managers not to disclose holdings daily. For guarded active mutual fund managers, this setup could be ideal. However, these funds have failed to take off because they’re confusing and investors prefer transparent funds. 

While active ETFs are booming, it’s good to know how fund companies are getting creative to get in on the action. By understanding these different approaches, you can make more informed decisions and potentially benefit from the growth of active ETFs. 

Download Morningstar’s Guide to US Active ETFs for everything you need to know. You can also learn more about accessing our data and generating your own reports with Morningstar Direct by starting a free trial below. Thanks for watching, and we’ll see you next time.