A Fair Exchange?
Get More from ETFs with Efficient Operations
By Tony Warren
Exchange traded funds (ETFs) are a big business and
growing bigger, but inefficient processing can easily
erode already slim margins. With major complexities
and looming overheads to consider, ETF operations
deserve investment too.
Tony Warren is EVP and
head of strategy and
solutions management for
the Institutional and
Wholesale business at FIS.
Market opportunities
For more than two decades, ETFs have offered cost-effective exposure to equities and
bonds. With typically higher daily liquidity and lower fees than mutual fund shares, and
delivering both intraday pricing and tax efficiencies, they’ve become an attractive
alternative for individual investors. While the majority are passively managed, and
simply track a specific index, a smaller proportion of actively managed ETFs have also
come to market – promising outperformance for a higher cost.
Today, the ETF market is booming. More than 270 different ETF sponsors are now
managing over 5,700 funds globally1 and a record 43 companies entered the market in
2015.2 Having grown at a rate of 20 percent year on year for the past five years, ETFs
currently account for total assets of around $3 trillion, surpassing the global total for
hedge funds.3 FIS’ fund accounting, administration and reporting solution, InvestOne,
has seen a 22 percent increase in the ETF assets that it manages over the past three
years.
And there is every indication that strong demand for these funds will continue.
According to PwC, 75 percent of asset managers believe that global ETF assets will
1
BlackRock, ETP Landscape, October, 2015
Financial Times, Record Growth for Exchange Traded Funds Despite Regulatory Fears, January 10, 2016
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BlackRock, ETP Landscape, October, 2015
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reach $5 trillion by 20204 – while ETF.com predicts they will eclipse mutual fund assets
by 2024.5
But behind the scenes, ETFs can be difficult to manage and expensive to administer.
Get them wrong, operationally, and overheads could easily outweigh the market
opportunity.
Processing complexities
From the front to the back office, ETF processing covers an intricate set of operational
flows. Much of the complexity of an ETF stems from the way that its shares are created
and redeemed. Although cash can be used in certain circumstances, institutional
investors usually deposit a basket of stocks “in kind” with the fund in exchange for ETF
shares, which can then be sold on to individual investors. Typically mirroring the ETF’s
portfolio, the contents of this “creation basket” are made available publicly on a daily
basis. Likewise, ETF shares can be exchanged for a “redemption basket” of securities
and, sometimes, cash.
Even with no guarantee that a basket will be traded, firms must generate these baskets
day after day. This can represent a significant operational challenge in itself, involving
sophisticated risk analytics as well as specialized front-office systems. To optimize the
basket, portfolio managers may apply replication strategies, manage tax lots and use
derivatives.
Then there’s the accounting side of the operation. As is traditional, the back office will
calculate a net asset value (NAV) for the ETF at the end of each day, but in addition will
calculate a projected NAV for the following day. And as ETF share prices can fluctuate
during the day, the middle office must also generate its own intraday version of the NAV
(iNAV). This in turn will determine the contents and hypothetical value of the next day’s
basket. This means projecting a range of factors onto the end-of-day NAV, including
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5
PwC, ETF 2020: Preparing for a New Horizon, January, 2015
ETF.com, ETFs’ Future: Huge Growth, February, 2014
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accounting adjustments for corporate actions, income and expense accruals. Any
orders for the basket must then be routed via transfer agency back into the accounting
system, and collateral marked to market until settlement.
On top of managing all this complexity, there’s a growing need for speed in the ETF
ecosystem. A new report by Longitude Research shows that only eight percent of fund
administrators are currently expected to provide valuations for ETFs within an hour of
the end of the trading day. But by 2020, a full 20 percent anticipate being expected to
meet this tight deadline.6 It may not be absolutely required to handle this speed, but in a
competitive climate that’s exactly what you need to get ahead of your peers.
Operational solutions
So, given the multiple challenges involved, what can you do to manage ETFs more
efficiently and keep expenditure down?
First, automation is key. A spreadsheet may seem sufficient when you’re running one
small fund, but manual processes quickly increase expenditure, effort and risk – and
won’t stretch to a business of any scale.
And when it comes to choosing automated solutions, you need to be looking at the
more powerful end of the market. You will therefore need best-of-breed solutions in
place for basket creation, basket processing and fund accounting, each of which can be
a challenge. Not all accounting systems have the sophisticated calculation logic to
easily handle iNAV calculations, so a robust, real-time solution with intraday valuation
capabilities will be critical. But even with the individual pieces in place, ETF operations
can suffer hugely from a lack of integration.
For optimal ETF management, in other words, you need each critical stage in the
process to flow seamlessly to the next. That means creating a continuous loop of
processes from portfolio management and risk analytics in the front office, via iNAV
6
Longitude Research, From Coal to Diamonds: 2020 vision – The Future for Fund Administrators, April, 2016
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calculation in the middle office, to NAV production in the back office. With end-of-day
accounting data feeding back into your trading arm, there should also be smooth
integration with transfer agency services and corporate actions management – for a
single flow of data and highly efficient processing from end to end.
Conclusion: Make ETFs worth your while
For passively managed ETFs, whose low costs are key to their appeal, fees are already
under pressure. If your margins are to survive, it’s therefore imperative to run funds
efficiently and, above all, run them at scale. A highly automated, tightly integrated
ecosystem of front-, middle- and back-office solutions will allow you to do just that. And
at the same time, it will help you differentiate your business – by satisfying the market’s
hunger for rapid data and straight-through processing.
In a fast growing sector, it makes sense to want a piece of the ETF pie and a share of
potential profits. Just don’t let inefficient processes eat into your margins – when
automation and integration could serve up both efficiency and scale.
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