Everyone seems to be launching an exchange-traded fund these days. Across more than 4,000 ETFs, US investors can cheaply access thousands of stocks or bonds, lever up a single stock, hold bitcoin, or do almost anything in between. Incumbents Vanguard and BlackRock continue to lead the way in gathering assets, but smaller upstarts are beginning to nip at their heels.
Record ETF inflows and the success of several niche strategies show that it’s possible to develop a strong ETF business outside of the core broad-market index ETFs from the largest firms. But it’s no gold rush. ETFs are a hard business, and a rising tide does not lift all boats.
A 2024 Morningstar study estimated that only 58% of actively managed stock ETFs, excluding rules-based ETFs from Avantis and Dimensional, are profitable for their issuers. That number is likely only a little better across the entire US ETF market.
Despite challenges, more and more firms are entering the ETF arena, or “terrordome‚” each year. There have never been more ETF issuers than there are today, and the growth rate of new launches isn’t slowing down.
ETF investors shouldn’t concern themselves with the minutia of ETF operations. But remembering that an ETF is a product, and understanding the business motivations behind each one, can help investors decipher which ETFs have legitimate merit.
Positioning an ETF for Success
Most successful businesses start with a good idea. ETFs are no different. Selecting a strategy that’s marketable is, maybe, the greatest determinant of commercial success, which is different from investor success. On the business side, a strategy should be attractive to investors, have staying power, and be one that its management team is equipped to operate to its fullest potential.
ETF issuers—the companies providing the ETF, like Vanguard or BlackRock—make numerous important decisions for how an ETF is positioned in the market, how it operates, and how it’s sold. Market positioning is important because it determines what the ETF will compete against.
For smaller firms, selecting a strategy that doesn’t directly compete with low-cost issuers may be prudent because the largest firms can easily undercut fees. There’s a reason why only four S&P 500 ETFs exist and are offered from only the three largest ETF issuers: Vanguard, BlackRock (iShares), and State Street.
Price is another important consideration. A new ETF should be cheap enough to be compelling but not so cheap to risk not covering the issuer’s costs. Low fees breed success for investors and firms alike, but low fees also mean low profit margins. This is the inherent conflict between ETF issuers and ETF investors: investors want low fees, while issuers want high fees.
Newcomers have more resources than ever to help manage costs. Numerous service providers can provide support for administrative functions, trading, sales, and nearly every other aspect of ETF management, which enables faster and cheaper development cycles than ever before.
While service providers encourage the development of new ETFs, smaller firms usually can’t compete with the largest firms on cost, so they tend to gravitate toward categories not already populated with low-cost ETFs from the largest issuers. Some carved a niche in single-stock ETFs, options-based ETFs, and other differentiated strategies like actively managed ETFs. ETFs in any of these groups likely charge higher-than-average fees.
Some of those differentiated strategies have merit and come with low costs. But lately, issuers have introduced increasingly dubious strategies that charge high fees. Investors should use extra caution to select the ETF that’s right for their long-term goals.
Running an ETF
Reality sets in once an ETF issuer decides on a strategy. It’s generally true that anyone with a decent idea can launch an ETF these days, but there’s a lot more to it. Earlier this year, YouTuber Kevin Paffrath, a.k.a. Meet Kevin, learned this lesson the hard way. He shuttered his Meet Kevin Pricing Power ETF a little over two years after launching it. Paffrath said in a video announcing the closure: “All the bankers, the suits, the lawyers, they all get their hands in the cookie jar, and basically you’re left feeding the kitty…I don’t recommend it if you’re trying to make money.”
The ETF held over $25 million in assets when it closed. Paffrath estimates that he lost $1 million running it. I estimate it collected more than $500,000 in fee revenue, putting its lifetime operating cost in the ballpark of $1.5 million. This likely includes general business expenses, which may not be directly related to running the ETF.
Kevin Meets Reality
ETF firms must comply with relevant laws and regulations, and as Paffrath’s example shows, compliance is not cheap. The chart below, from VettaFi and Arro Financial Communications, illustrates the vast array of interested parties. These include trustees, index providers, brokers, market makers, custodians, accountants, and regulators, among others. The ETF issuer compensates many of the parties for their services, too, demonstrating why large providers have a leg up on smaller shops in the business of ETFs.
The ETF Ecosystem
Most ETF issuers don’t handle all of their own ETF-related activities. The largest firms will keep most functions in-house, while smaller firms may outsource several to ETF service providers. Firms like Tidal Financial Group and ETF Architect are considered “white label” ETF service providers. They, along with others, can handle most or all of the boring stuff—suits, lawyers, etc. This allows an issuer to choose which aspects of ETF management they want to focus on. For example, Tidal’s website markets its ability to help with:
- Strategy and product planning
- Trust and board management services
- Fund management and operation
- Regulatory and compliance services
- Active portfolio management and trading execution services
- Marketing and research
- Sales and distribution
Outsourcing isn’t without costs, though. Wes Grey, founder and CEO of ETF Architect, estimates that an ETF founder should expect around $50,000 in start-up costs, with annual expenses of roughly $200,000 per year. This doesn’t include general business costs like payroll, technology systems, office rent, etc. More complicated strategies likely cost more.
The largest ETF firms usually have dedicated internal teams to handle most core functions of ETF operation and management. While more expensive up front, this approach affords issuers greater control over their ETF lineup and can improve risk management. The cost to stand up these internal teams may be too great for smaller or younger ETF issuers, so they’re more likely to outsource at least some operational functions.
The cost of running an ETF can vary, but investors pay for that cost through a fund’s annual fee. The more expensive a strategy is to run, the higher the fee is likely to be. More complicated strategies, like options-based ETFs, cost investors more than comparatively simple index ETFs.
ETF Sales and Distribution
“Asset management is a sales business… Without a dialed in distribution plan, you are bound to fail” – Corey Hoffstein, CEO and CIO of Newfound Research.
Sales and distribution are critical to an ETF’s long-term viability, so it’s important for a firm to get it right. An ETF will not last long without sufficient assets under management. ETF issuers usually give their products at least two years to gather assets before pulling the plug.
Seed capital enables new ETFs to begin trading without major problems, but it doesn’t last forever. The issuing firm, banks, or outside investors typically commit millions of dollars to support an ETF in its infancy. This capital is usually committed for between one and three years. Paffrath’s Meet Kevin Pricing Power ETF started with $500,000. State Street’s new private credit ETF, SPDR SSGA Investment Grade Public and Private Credit ETF PRIV, started with $50 million.
Once seed capital dries up, it’s up to the sales team and the ETF’s own merits to keep it afloat. Strong performance helps, too. Fee revenue is the lifeblood of the ETF business, so rising assets mean rising revenues. Exhibit 1 showed that Paffrath’s ETF realized only a third of the category index’s return over its short life. Absolute returns weren’t bad, but laggards don’t last long in the hypercompetitive technology category.
Some ETFs sell themselves, others are sold over steak dinners and lavish conferences, but most fall somewhere in between. No matter the sales strategy a firm chooses, a compelling narrative is key. Narratives allow salespeople to easily communicate the value of a product. For example, defined outcome, or buffer ETFs, are not marketed as the complicated options-based strategies that they are, but instead the narrative is: “equity returns with guardrails.” This story made selling the funds easy and helped the burgeoning category grow to over $50 billion in just six years.
Narratives can be powerful, but ETF investors shouldn’t be seduced by them. Always check the data to make sure the story you’re told matches the product you’re sold.
ETF Investing Takeaways
ETF investors shouldn’t concern themselves with the nitty-gritty of the ETF business. But they should understand how and why their ETF exists. There’s a vast sea of ETFs out there. With so many choices and competing narratives, it’s smart to take a step back and consider the forces and motivations behind an exchange-traded product. My colleague, Dan Sotiroff, finds that new ETFs with good long-term merit are increasingly rare.
Here are four characteristics to look for that help ETF investors, not just the issuing firm:
- Low, or competitive, fees. Favor those with expense ratios below 0.50%.
- The strategy is backed by research, and there’s a consensus agreement about its merits. A quick Google search should return credible third-party research on an investment strategy’s merit. Be wary of ETFs jumping on trends.
- Simplicity. In ETFs, investors often get the most out of simple strategies.
- Predictable performance. Past performance is not a perfect predictor of future results, but an ETF should do what it says it does. Covered call ETFs should reduce drawdowns and pay a reliable dividend, for example.
