Hundreds of exchange traded funds may not see the light of day, because seed capital for such funds is drying up.
"Seed capital has virtually run out, and no one has refilled the granary," said James Lowell, Needham, Mass.-based editor of Forbes ETF Advisor, a monthly newsletter, who was recently forced to pull the plug on his own line of ETFs because of the dearth of seed capital.
Unlike traditional stocks, which raise money through initial public offerings, ETFs have long relied on stock exchange trading floor specialist firms to provide cash to get off the ground.
But the flood of new ETFs coming to market, coupled with the rise of automated trading, is forcing many specialists to cut back on the seed capital they have historically made available.
As a result, the spreads for ETFs could widen, according to industry experts.
"It's a very big issue," said Michael Rosella, the New York-based chairman of the investment management practice at Paul Hastings Janofsky & Walker LLP of Los Angeles. "It is an issue that can, over time, retard the growth of ETFs."
The situation is particularly dire for smaller ETFs, said Mr. Lowell, who is also co-founder of The Rankings Service in Needham, Mass.
That's because established players such as Barclays Global Investors of San Francisco, State Street Global Advisors of Boston and PowerShares Capital Management LLC of Wheaton, Ill., are less dependent on the specialists' seed capital.
Even so, it's the well-established sponsors that stand the best chance of getting what little seed capital there is to go around, industry experts said.
For example, the first-ever municipal bond ETF, the iShares S&P National Municipal Bond ETF (MUB), from Barclays, made its debut on the American Stock Exchange on Sept. 10 and was able to raise $294 million in seed capital.
It's likely that the specialist firm tapped to bring the ETF to market — specialists are firms that make sure ETFs trade smoothly — didn't provide all of the seed capital, said one ETF insider, who asked not to be identified.
But even if that's the case, it appears that the muni ETF was able to attract a significant amount of seed capital — an impressive feat at a time when many ETFs are having trouble raising any more than $5 million to $10 million in seed capital, industry experts said.
What precipitated the problem, and how best to address it, is a matter of much debate.
Without a doubt, the rapid growth of the ETF industry is partly to blame.
At the end of August, there were a total of 546 ETFs in existence, up from 270 a year earlier, according to the Investment Company Institute in Washington.
ETF assets totaled $507.1 billion at the end of August, up nearly 46% from $348 billion a year earlier, the ICI reported.
What's more, hundreds of ETFs are currently in registration.
As more ETFs hit the market, specialists are being pickier about ones they supply with seed money. ETFs based on obscure indexes are least likely to get the specialists' backing.
"It's survival of the fittest," said Mel Herman, chief executive of XTF Global Asset Management LLC, a New York-based firm specializing in actively managed asset allocation portfolios comprising ETFs.
Not everyone blames the problem on the growth of the ETF industry, however.
By going to a more electronic system of trading, the exchanges themselves are reducing the incentive for specialists to offer seed money, several industry experts said.
Automated trading creates a level playing field, thereby eliminating the trading privileges that specialists have enjoyed for seeding ETFs and insuring a market for them, said Joseph F. Keenan, managing director of BNY Mellon Asset Servicing, a division of The Bank of New York Mellon Corp.
Out of the 10 specialists still in existence, only a handful can be counted on to provide seed capital to ETFs, said one Wall Street insider, who asked not to be identified.
Among those "stepping to the plate" is The Goldman Sachs Group Inc., Kellogg Group LLC and Bear Hunter Specialists LLC, all of New York, Mr. Keenan said.
The exchanges, however, are skeptical about their culpability in the problem.
"Even if you had no changes, [ETFs] would be facing the same issues," said Lisa Dalmer, vice president of ETFs and indexes at NYSE Arca Inc. of New York.
NYSE Arca is currently in the process of moving all of its ETFs from its traditional platform onto the Arca electronic platform.
Of course, there are actions the exchanges can take to make the transition easier, said John Jacobs, chief executive of Nasdaq Global Funds Inc. and an executive vice president for The Nasdaq Stock Market Inc.
For example, Nasdaq of New York this month announced the launch of The Nasdaq ETF Market.
It features "designated liquidity providers" that will receive incentives to support ETFs in their early phases of trading, Mr. Jacobs said.
One particular initiative of the market allows ETFs to select multiple liquidity providers — something that had not been done in the past, he said.
Even Mr. Jacobs, however, admitted that The Nasdaq ETF Market is not a "panacea" to the problems facing ETFs looking for seed capital.
David Hoffman can be reached at [email protected].
