ETF Capacity Constraints

By Hunter

Earlier this week I was talking with a fund family RM that I have known for a number of years. The firm he works for manages tens of billions of dollars in the public equity/fixed income universe, primarily within ETF wrappers, and is likely a name that you are familiar with. At some point the conversation turned to capacity constraints, especially around small cap value strategies. This particular fund family has a natural competitor, with whom comparisons are common, and with whom they go head-to-head on specific strategy offerings. One specific “selling point” this fund family really harps on for their small cap value product is that they can access smaller “microcaps” for more efficient implementation of their particular strategy whereas their competitor is hamstrung by the amount of assets they manage in their own small-cap strategies. They also claim some technical differences in how they derive their signals & implement the strategy but I think the vast majority of the difference probably lies in the fund size differential, in my opinion.

Anyway, at some point we discussed how they would handle future capacity constraints and this particular ETF sponsor’s intended solution is apparently to “shut down” the create/redeem mechanism for the ETF in question as a means of controlling asset inflow. Apparently their solution is to cease publication of their baskets and refuse negotiated baskets except in the instance of facilitating large trades. Having neither considered nor heard anyone even discuss this novel solution, my ears perked up at hearing this. Given my (admittedly non-expert) understanding of ETF structuring, I was under the impression that publishing your creation/redemption baskets was non-voluntary. For the vast majority of ETF issuers this whole concept is a non-issue because the liquidity and tax-efficiency provided by the create/redeem mechanism is part and parcel to running an ETF in the first place. For many years an oft-cited argument for many active managers with big books of existing traditional mutual fund business was that the ETF vehicle offered no means of stemming flows into the strategy. As far as I knew that was just a widely accepted downside of an otherwise superior investment vehicle structure.  

But this revelation certainly piqued my interest. My questions abound, however: Is that permissible by regulations? What is the lead/lag time for turning the create/redeem mechanism on and off? Does it require additional filings/paperwork/SEC approval to turn it on/off? How would your AP respond to suddenly being denied access to the create/redeem mechanism? 

Obviously, one of the well known downsides of the ETF structure is the truly open-ended nature of the vehicle. Even in traditional 40-Act mutual funds you can close the fund to new assets, if desired. But assuming this “shutting down” of create/redeem was permissible, it would certainly accomplish its intended purpose of restricting new inflows. However, wouldn’t this be effectively transforming your ETF into a closed-end fund? Sure, it’s great that you’ve limited the AUM of the strategy and addressed the capacity constraint of the strategy, but now you’ve opened up the fund to potentially meaningful swings in premium/discounts. As an allocator, the investing part of the game is hard enough already without having to worry about wild swings in entry/exit prices.  Arguably this exact dynamic has contributed to the waning closed-end fund industry for the last few decades. Not to mention you are effectively limiting the liquidity of the ETF to purely secondary markets. If there’s no create/redeem, the only sellers are existing shareholders who happen to need liquidity on a particular day (or vice versa for sellers who need buyers). The whole idea seems ill-conceived and potentially chaotic if the create/redeem function can’t be controlled with extreme fidelity.

Anyway, I posed a number of these questions during our call, but my guy was pretty light on the details so I am due a follow up at some point. I’m eagerly awaiting those details and will post a follow up if I actually get it. But I wanted to put this into the universe and see if readers had any perspective on the viability of this strategy. Have you ever heard of an ETF issuer doing this? Is it legal? Would this actually work? Reach out and let us know if you have any insight.