ETF Seed Money

The seed money is the dollar amount that an ETF Specialist firm commits to the issuer to create the initial position in the respective ETF. Some call it pay to play but I liken it more to an IPO where the Specialist is the underwriter of the new issue.

The issuer is naturally anxious to get the maximum amount of seed at the start as he is paid a fee for assets under management(AUM). The issuer has had to fund the entire birth and early childhood of the prospective ETF including legal fees for the S 1 plus accounting and a myriad of other fees. The total cost for a single ETF is substantial. Only when the seed is tendered does the issuer start to recoup his upfront expenses.

The Specialist only has the opportunity to turn a profit once the ETF starts trading. While each Specialist has a different capital cost, it is safe to say that with seed always in the millions, the interest expense is sizeable on a daily basis. The goal of the Specialist is to  sell the initial shares of the seed as quickly as possible but hopefully at something better than the Net Asset Value of the underlying securities that make up the ETF.

This situation clearly puts the Specialist and the issuer in a somewhat adversarial relationship.

Some issuers have firm upper limits on the amount of seed money asked for while others seem to go for the largest amount possible. Almost all claim to make their decision on a Specialist on a quality basis and definitely not based solely on the amount of seed offered.

As the number of ETF products has grown to roughly 300 with another 300 slated for issue in 2007, and with only 10 ETF Specialists in the game, the amount of seed money available is becoming problematic. With the proliferation of close to clone like ETFs it has become increasingly difficult for the Specialist to pick the wheat from the chaff. The end result is that there are an increasing number of situations where the Specialist is essentially stuck in a product with large amounts of seed and the consequent interest costs.

Having been brought up in a different(read older) generation, I heed the old adage that one’s word is one’s bond. Unfortunately, there have been occasional instances where some firms have not fulfilled their initial seed commitments.

The skinny is that several to many mutual fund companies are somewhere along the path to issuing their own ETFs. The obvious question is how far can the current pool of available seed be stretched? Will the mutual fund companies seed their own products? What happens to the Specialists incentive to move product if they have no seed committed? Do they jack up the offering effectively widening the gap between NAV and the sale price of the ETF?

With projections of AUM in the range of 1 trillion dollars up from the current $350 million, it seems these are questions that need to be addressed in the near term.

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