Radio Show – Wes Gray & Patrick Cleary, Alpha Architect – All Things ETFs | #347

Episode Summary

Executive Summary: This episode of the MedFavor Show features Wes Gray and Patrick Cleary from Alpha Architect discussing the ETF landscape, including the hockey-stick growth of the industry, the process and costs of launching an ETF, mutual fund-to-ETF conversions, the role of lead market makers, and the evolving regulatory environment. They emphasize that while launching an ETF is now more accessible, success requires significant capital, a clear distribution plan, and long-term commitment. The conversation covers the distinction between active and index-based ETFs, challenges with the SEC naming rule, and predictions for a Bitcoin ETF, with the hosts expressing optimism about the industry's future as a more equitable space for boutique issuers.

Main Topics: ETF Industry Growth and Landscape (Priority: 5/5): The ETF industry is experiencing a 'hockey stick' phase of rapid growth, with increased demand for new products, a surge in mutual fund-to-ETF conversions, and a flood of registrations overwhelming the SEC. The guests note that costs are coming down and the space is becoming more accessible for boutique issuers. Launching an ETF: Process, Costs, and Pitfalls (Priority: 5/5): Launching an ETF involves a 75-day SEC review, legal filings, compliance setup, and significant upfront costs ($50-60K) with ongoing expenses ($225-250K annually for small funds). The guests stress the importance of having three years' operating capital, a clear path to $50M in assets, and a realistic distribution strategy beyond media appearances. Mutual Fund to ETF Conversions (Priority: 4/5): Conversions are accelerating as a way to launch ETFs with existing assets, avoiding a zero-start. The process requires a 'plan of reorganization' approved by the SEC, with costs around $50-75K. Key criteria include compliance with the 1940 Act and diversification rules. The conversion must be done with reputable legal counsel to avoid post-launch audit issues. Regulatory Challenges: Index Providers vs. Active Funds (Priority: 4/5): The SEC scrutinizes index providers who avoid registration, especially those that indirectly promote their ETFs. The 'naming rule' requires 80% of assets in namesake investments, creating challenges for thematic funds. The hosts advise most issuers to register as active funds for flexibility and compliance. Distribution and Lead Market Maker Relationships (Priority: 4/5): Distribution is the hardest part of an ETF's success; it requires personal passion, thought leadership, and a multi-year grind. Lead Market Makers (LMMs) are critical for liquidity, especially for small funds. Issuers must actively engage with LMMs, structuring portfolios (e.g., using ADRs) to facilitate tight spreads. Crypto and Bitcoin ETF Predictions (Priority: 3/5): The guests doubt a direct Bitcoin ETF will launch soon due to SEC caution and the need for congressional legislation. They predict a futures-based Bitcoin ETF might appear by 2023, but regulatory clarity via Congress is necessary. The hosts highlight the tension between Senator Warren and SEC Chair Gensler as a factor. Future Opportunities and Cultural Shift in Asset Management (Priority: 4/5): The guests are optimistic about the ETF industry becoming more meritocratic, with boutique issuers able to compete via social media and low-cost structures. They see opportunities in converting legacy structures (SMAs, hedge funds) to ETFs and believe the ETF wrapper benefits investors through tax efficiency and lower costs.

Key Arguments: Launching an ETF requires a multi-year commitment with at least three years of operating capital and a clear path to $50M in assets; it's not a short-term venture. The SEC's naming rule (80% investment in namesake assets) creates challenges for thematic ETFs, especially those benefiting from trends but not directly investing in them. Index providers face increasing SEC scrutiny; the safest approach is to register as an active fund to avoid promotion restrictions and gain flexibility. Distribution is the hardest part: media appearances alone won't drive assets; success requires personal hustle, thought leadership, and a strong distribution plan. Lead Market Makers (LMMs) are vital for small ETFs; issuers must work closely with them to ensure liquidity, such as using ADRs for international stocks. Mutual fund-to-ETF conversions are accelerating because they allow issuers to launch with existing assets, but the process requires careful legal work and SEC approval. A direct Bitcoin ETF is unlikely without congressional legislation; a futures-based ETF may appear by 2023. The ETF industry is becoming more meritocratic, offering opportunities for independent issuers with strong brands and distribution strategies. Tax advantages of ETFs over mutual funds are unlikely to be equalized, as tax changes would require Treasury action and face political resistance. The cultural shift towards transparency and collaboration in the ETF industry benefits investors and allows smaller players to thrive.

Data Points: Launch costs for a plain vanilla ETF: $50,000 - $60,000 - Startup costs for a simple ETF, excluding ongoing expenses. Annual operating costs for ETF under $100M: $225,000 - $250,000 - Estimated ongoing expenses for a small ETF, including all services. SEC approval timeline: 75 days - Standard SEC review period for an ETF prospectus, with possible delays. Mutual fund to ETF conversion legal costs: $50,000 - $75,000 - Recommended budget for a proper plan of reorganization with a top securities law firm. Recommended runway for new ETF: 3 years operating capital - Minimum time to subsidize the fund and reach profitability (target $50M AUM). ETF survival rate: 50% - Roughly half of publicly traded ETFs fail within a decade. Number of white-label ETFs managed by Alpha Architect: 15 - Current funds under their ETF Architect platform, with pipeline to 20-25. Assets under management managed by Alpha Architect: $1.1 - $1.2 billion - Current AUM for white-label ETFs, expected to grow to $1.5-2B. SEC naming rule threshold: 80% - Funds with a name indicative of assets must invest at least 80% in those assets. Control person limit for ETFs: 80% - Maximum ownership by a single entity to maintain ETF tax status; 25% triggers disclosure.

Pivotal Quotes: "I tell folks you should go into this with three years operating capital to subsidize, but more importantly, a clear path to 50 million." — Patrick Cleary: Advising on the financial and strategic commitment needed to launch a viable ETF. "What used to be a cost center to us, we've now turned into a business." — Wes Gray: Explaining Alpha Architect's pivot to a white-label ETF platform, leveraging their own infrastructure. "The LMM is the most underappreciated, overlooked aspect of the ETF value chain." — Patrick Cleary: Emphasizing the critical role of Lead Market Makers in providing liquidity, especially for small funds. "As long as you do what Pat said and you follow the guidelines on what the 40 Act requires, and more importantly, what the IRS requires, and you're following the intent of the rules with respect to taxes... there are ways for syndicates of maybe really rich people that have highly appreciated stock to come together to potentially do these ideas." — Wes Gray: Discussing the possibility of family offices or wealthy investors using the ETF structure for tax-efficient diversification, while cautioning about regulatory intent.

Implications: The ETF industry is democratizing asset management, but success requires significant capital, a realistic distribution plan, and regulatory compliance. Boutique issuers with strong content and social media can compete, but must navigate SEC scrutiny on index providers and naming rules. The trend of mutual fund-to-ETF conversions will accelerate, and a Bitcoin ETF remains elusive without congressional action. Investors benefit from lower costs and tax advantages as the ecosystem becomes more competitive.