Not so long ago there were a handful of ETFs in the market and multiple companies competing to provide “seed capital” to potential new entrants. Now, there are thousands of ETFs in the market with trillions of dollars invested, but a lot fewer firms interested in the seed business. What does this mean to ETF sponsors, and to the advisors and their clients who look to ETFs to provide the building blocks for investment portfolios?
Answering this question first requires an understanding of what seed capital is and how the seed process works. Seed capital is the initial investment that allows an ETF to launch and start trading. It is used to fund the creation units that underlie the ETF so that the shares can then be offered to investors in the open market and traded. While the amount of seed capital needed varies, a general rule of thumb is that a new ETF should launch with a minimum of 100,000 shares and a share price of around $25. That suggests $2.5 million in seed capital.
Banks and broker-dealers historically were the two major third-party providers of seed capital. Many ETFs have been self-seeded as well, sometimes with new money and other times by essentially porting funds from an existing separately managed account or other vehicle into the ETF. On the high end, we have seen new ETFs enter the market with $100 million or more in assets. While more is clearly better than less, size alone doesn’t necessarily define success. Other important metrics include trading volume—100,000 shares a day is good—and performance. The former provides liquidity; the latter tends to attract more assets.
The sources of seed capital haven’t really changed, but, as noted, the number of participants has declined. In part, this reflects the proliferation of ETFs: 275 were launched in 2017 alone. Still, investors also face the risk of losing money (136 ETFs shut down or delisted last year), and the opportunity cost of having capital tied up in a fund that doesn’t grow or trade after its launch.
Seed providers have to make a market, create liquidity and ensure that the market price of the ETF tracks the value of the underlying securities throughout the trading day. This requires an investment of both human and financial capital. There are other costs that accrue to the seed provider as a shareholder, including management fees and other administrative fees. Add all this together and seeding can quickly become an expensive proposition. As a result, many banks are looking elsewhere for places to deploy their money, believing they can earn a higher rate of return than what’s available from seeding.
Seed providers can and do make money, of course. (Why else would they do it?) This can be through many business lines, such as trading, by providing custody of fund assets, writing options and offering margin loans, among other services. All these are helped by a fund that is successful, and by the seed provider establishing a good long-term working relationship with the fund sponsor. Share price appreciation can also give return on capital a boost, though many seed providers prefer to get their money out quickly—often as soon as new investors come in to purchase shares. This reduces risk and allows them to redeploy capital and human assets elsewhere.
There will always be more ideas than there is capital to fund them. There are also some bad ideas that probably shouldn’t make it to market. Consider that on the low end, an ETF will cost something on the order of $250,000 a year to run. Few ETFs are instantly profitable; they need distribution and marketplace awareness to support investor demand, and that costs money too. Persistence is important as well—even the best ideas can take time to find an investor base.
Because there are fewer seed providers today, the influence of those few on the industry has grown, positioning them as gatekeepers, vetting ideas and making a judgment about which ones to fund. For advisors or others looking to bring an ETF to market, finding a good seed capital partner is critical, particularly if their in-house financial resources are limited.
Mark Esposito is a registered principal and CEO of Esposito Securities LLC.