Conventional wisdom has it that millennials have an affinity for exchange-traded funds and will be a growth driver for this product class as they attain more investible assets. But two millennials who basically don’t have enough money to invest in ETFs are taking this to another level by trying to create an actual ETF.
Stephen Benvenuto, Jr. and Mark Harkin, 20-year-old students at New York University, have created a concept they believe can be a hit with investors. This isn’t a class project for academic credit; rather, it’s a bona fide idea that has caught the attention of people within the ETF industry who have offered encouragement and the research muscle needed to potentially bring their concept to market.
That concept is a fund that tracks the entire ETF ecosystem. Their proposed Exchange-Traded Financial System (ETFS) product currently is in the hands of Indxx, an index provider that’s putting its best minds to work on the idea to see if it can devise an investible index that can underpin a tradable ETF.
When they first kicked around the idea for ETFS in April 2016, there wasn’t a product like it on the market or in registration with the Securities and Exchange Commission. So Benvenuto and Harkin thought they were on to something truly unique as they toiled away last summer to create the fund’s methodology.
But a similar product was filed with the SEC last November that was based on an index created by Toroso Investments LLC, a New York City-based asset manager. And that product, the ETF Industry Exposure & Financial Services ETF (TETF), began trading in April on the NYSE Arca exchange as the first ETF dedicated to the various sectors and companies behind the ETF industry.
Even though the TETF fund got there first, Benvenuto and Harkin aren’t deterred.
“Once we heard about TETF we were initially worried,” says Benvenuto, a junior from Allenwood, N.J., who’s studying finance and management. “However, that soon passed. We read the filing, and we noticed some key differences that substantiated our idea.”
TETF currently holds 37 companies that play a role in the process of taking ETFs from initial idea to investible product, and is organized into four tiers designed to overweight companies with the most exposure to the growth of the ETF industry. Fifty percent of the index contains ETF sponsors and the rest is composed of what Toroso calls the other four parts of the ETF ecosystem: liquidity providers; index providers; back office support and the exchanges.
As Benvenuto and Harkin are quick to point out, TETF is domestic-focused while their concept is globally focused.
“We feel that a global approach is more appropriate as one-third of the assets in ETFs are held internationally,” says Harkin, a sophomore from Ridgewood, N.J., who’s studying management and global finance. “As of April, this [industry] is $4 trillion dollars. By our math, they are missing out on $1.3 trillion in the value of the ETF ecosystem.”
But Mike Venuto, chief investment officer of Toroso Investments, notes that while the TETF fund currently is domestic-focused, it can go global and he says there are a couple of overseas companies on their radar they are considering for possible inclusion down the road.
An Involved Process
The duo’s quest is fueled by a youthful idealism born in the spirit of, "What the hey?" But it’s also a pragmatic endeavor that just might fly, as evidenced by the assistance they’ve received from established ETF players
“We heard about the growth of the ETF industry and I began working in professional settings where ETFs are prevalent, so we started kicking around some ideas on how we could get involved in the action,” says Harkin, who’s interning at ETF provider WisdomTree Asset Management. “We both kind of said, ‘Why not?’ We both work in finance, so we both should know how to do that.”
But they quickly learned it’s a little bit more complicated than that.
“We had no idea what we were getting into,” Benvenuto says. “Google is what we had for research.”
Their quest seemed quixotic, if not naive. Yet they were determined and proceeded with their idea. They have a mutual friend who was being mentored by Ivy McLemore, managing director of communications at Guggenheim Partners, which oversees a large suite of ETFs. Their friend suggested that they contact McLemore.
“So we reached out to him [McLemore] and he thought it was a good idea, if not ambitious,” Benvenuto says. “We arranged a meeting with him and he suggested we meet with Tom Lydon.”
Lydon, who is president of Global Trends Investments and editor of ETF Trends.com, agreed to meet them in Manhattan last May.
“We brought to him a one-sheet concept page, and he said the things we needed were an investible methodology and universe,” Benvenuto recalls. “At that point we just had the broad constructs of what those concepts were and what those specific terms really meant and what the process of building these would be.”
Lydon couldn’t be reached for comment.
Despite the raw state of the duo’s ETF idea, they say Lydon offered encouraging words and recommended they see Rahul Sen Sharma, a partner at Indxx, which has created indexes that underpin roughly $1 billion in ETF assets under management at providers such as Global X, First Trust, Columbia Threadneedle and VanEck. But they didn’t think the time was right.
“At that point we didn’t feel we were ready to pursue an indexer without grounds for either a methodology or a universe,” Benvenuto says. “Plus, the concept wasn’t entirely firmed up at that point. But we had an idea of where we wanted to go.”
Much to their surprise, they were able to gain the rights to the ETFS ticker symbol thanks to assistance from McLemore, who enlisted the help of a Guggenheim colleague who found out the symbol was available on the NYSE.
“When we heard back, they went above and beyond, and reserved ETFS from the NYSE,” Benvenuto says. “As far as we know, it's reserved indefinitely. However, if someone else requests it, we have 30 days to file something or give up the ticker.”
Meanwhile, they took a few shots at developing a methodology and constructing an investible universe of ETF-related companies.
“It was the summer, so we had time and we took it at our own pace while we were working summer jobs,” Harkin explains. “We wanted to get more meat on the bones before we took it to anybody else.”
The trouble they had was determining what companies actually should or shouldn’t be in their index because with the exception of WisdomTree—the only publicly traded pure-play ETF company—it’s difficult to parse exactly how much ETF-related revenue comprises the total revenue of companies involved in the ETF space, or ecosystem.
Based on existing research sources, Benvenuto and Harkin identified roughly 250 companies in the global ETF universe and divided them into eight categories, or sleeves. According to their sleeve weighting system, each category would be equal weight (12.5 percent of the index). And each sleeve of holdings would be weighted by their own respective index methodology rules, based on factors related to how revenue is generated within that category, or by the individual characteristics of the companies within each sleeve.
“This is our recommendation, but is by no means definitive or binding, just a possibility from how we view the ecosystem,” Benvenuto says.
Benvenuto and Harkin eventually felt confident enough to present their idea to Indxx, and in late February they met Rahul Sen Sharma at Indxx’s New York City office.
“I was pretty impressed with their effort,” says Sen Sharma. "We get ideas pitched to us ranging from big-name firms to people who have ideas but who haven’t done a lot of the legwork. I was really impressed that Stephen and Mark had done a lot of the legwork and put a lot of research into the concept before they approached us. They looked at the concept and fleshed out a good number of potential constituents.”
Sen Sharma says his company is currently in the process of deconstructing the duo’s formula in hopes of constructing a workable index.
“We looked through all of the materials they sent and we’re scoping it out to see if we can develop a solid methodology that we think makes sense and is potentially marketable as a fund,” he says.
Challenging Index
Indxx isn’t the first company—and that includes both index providers and ETF providers—to take a stab at Benvenuto and Harkin’s ETFS idea. “The bottom line is we couldn’t get a methodology to systematically select the companies,” says McLemore from Guggenheim.
Benvenuto and Harkin say index provider S Networks Global Indexes came to a similar conclusion. Harkin says he took the idea to his bosses at WisdomTree, but to no avail.
“They told me they didn’t think it could work for them but that we should take it to an indexer and keep going,” he notes.
Adds Benvenuto, “The bigger companies want very strong backtesting with quantitative-based results. This is a thematic concept where the results won’t be there for maybe a max of five years. It’s a forward-facing concept, so backtesting might not be the best way to test its investing merit.”
Sen Sharma sees room for another ETF industry-focused ETF on the market. “I think TETF is a great idea and a great product,” he says. “In a growing space—and the ETF industry is certainly a growing space—there’s enough potential room out there for more than one product."
Nonetheless, he adds, there’s no guarantee his team at Indxx will be able to develop a marketable index for ETFS. “I’d say that for every one product that we built that goes out on the market, there are probably 10 that don’t make the cut.”
Given that there’s an ETF for just about everything under the sun, it seems surprising that there wasn’t an ETF focused on the ETF ecosystem before the TETF fund launched in April. Venuto from Toroso says the big reason for that is simple—namely, it’s difficult to construct a viable index that tracks the industry.
“If you just do a back-of-the-envelope calculation of the U.S. ETF sponsors, take their AUM and cross reference that versus their expense ratios, the revenue generated from that is only about $6 billion,” Venuto explains. “Capturing a $6 billion part of the industry isn’t the primary objective—it’s all of the other things. We’re told that trading the ETF costs a lot more than the stated expense ratio. You have to look at spreads. Those spreads are being captured by the exchanges, the trading companies, and the custodians and platforms.
“The research and thought process behind building an index isn’t cheap,” he continues. “I have to bring in a team of researchers to figure this out. It just can’t be a team of researchers looking at data. It has to be industry insiders who understand how the industry works; who understand why Schwab is now the fifth-largest ETF issuer but the bulk of their ETF revenue isn’t from the expense ratio . . . it’s from custodial fees on its OneSource platform.”
Oh, and there’s one more potential roadblock on the road to making ETFS a viable product: Benvenuto and Harkin don’t have any money for product development.
“We have been going off the notion that the indexer or firm who was interested would develop the idea further,” Benvenuto says.
In the case of the TETF fund, Venuto says it cost six figures to develop the index and six figures to launch the product.
Next Stage
For now, Benvenuto and Harkin are content to let Indxx handle the ins and outs of their baby. But if that fails it won’t end their efforts to turn their idea into reality.
“If no one thinks they know how to do it, we’re learning how to code—the required coding language in order to provide your own indexing is called Python,” Harkin says.
Neither student enrolled at NYU to become an ETF meister—there are no classes for that. Nor do they know what it would mean for them if ETFS does become a U.S.-listed product.
“We’re not entirely sure what our involvement would be,” Benvenuto says. “I’m sure it’d be different depending on who would go with it. But we’ve been told we could possibly expect royalties or media exposure.”
At the very least, they say, the entire effort makes for good résumé fodder that’s probably far more valuable than any classroom experience.