by Maz Jadallah
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Over the past few months I’ve been talking to potential strategic partners about launching a new family of sentiment-weighted indices. After a decade and a half at this, I’ve got a lot of useful scar tissue around product design, market fit and go-to-market strategy. I’ve never been more certain that 13F intelligence can help investors make better decisions. There’s never been a better time than now to build tools and services for the individual investor.
I’m proud of our accomplishments. In 2008 we were amongst the first to offer a cloud based research service for 13F analysis. In 2012 we were the first to launch an ETF that utilized 13F data. By 2015, the fund had earned a five star rating from Morningstar and accumulated over $200 million in assets before performance stumbled badly due to a dynamic hedge feature. The fund never recovered.
I’ve learned some very hard lessons about building a business around ETFs. I’m sharing them here so that they can help other ETF innovators. Here we go.
ETF buyers hate black boxes
Despite the recent uptick in new active ETFs, my experience has been that most ETF buyers will avoid ETFs with an opaque investment methodology. Here’s why. Without radical transparency around your process, it will be very hard to retain your investors at times when your strategy underperforms – and it will underperform at some point. Transparency helps you minimize the turnover in your fund which is a critical component of asset growth (that is often overlooked). A good rule of thumb is that you should ask yourself whether you can explain your index design to your mother in a way that she could describe it back to you.
The methodology to construct our new sentiment-weighted indices will be fully transparent. I’ll share more in the future but for now, Figure 1 summarizes the theoretical performance of high sentiment strategies organized by market capitalization.
In the above analysis, sentiment is defined as the number of times a stock appears within the largest ten holdings amongst funds in our universe. Portfolios are rebalanced quarterly and constituents weighted by sentiment. Market caps are recalculated quarterly and the effects of delisted securities are included.
How funds are rated should inform your design
Most advisors/investors use a “style box” approach when building portfolios for their clients. The style box framework gives them a way to categorize the “tools” they used to build a portfolio. Morningstar and others has developed rating methodologies that give investors a way to compare funds in the same category. Like it or not, an ETFs “rating” is one of the first things investors look at to evaluate a fund, so it matters a great deal.
Here’s the thing, you don’t get to choose the category to which your ETF is assigned. Instead, regardless of what your investment mandate may be, your ETF will be assigned a category based on the characteristics of its current portfolio. If your mandate is all-cap but your current portfolio is 60% by weight invested in large cap growth stocks, then that’s the category to which your fund will be assigned.
This is important because if your fund’s holdings are “partially mismatched” relative to other funds in your category it will usually work against you, not for you. For example, if you happen to be assigned to a category that is outperforming other categories (e.g., large growth) – then you’re being compared against funds and a benchmark who’s portfolio holdings are often 100% exposed to that “factor” while your portfolio is only 60% exposed. On the other hand, if you’re assigned to a category that is underperforming relative to other categories (e.g., value) you might be doing better than the average fund in that category but often you won’t get the credit as most allocators will tell you that the reason you’re doing better is because your portfolio is “underweight” the underperforming factor while the other funds and the reference benchmark in that category are 100% exposed.
The important take away is that if you’re going to bring a product to market you need to be intimately aware of how its quality will be evaluated. Hope and novelty are not product strategies.
Know when to quit
If your horse breaks a leg after leading the race, it’s time to find a new horse. I can not tell you how difficult a decision that is for a startup business. Like in any startup, your initial product is your “baby” to which there is is a lot of emotional attachment. It’s incredibly difficult to decide to liquidate a fund. Deciding to liquidate your only fund is excruciating.
I should have liquidated our fund back in 2016/17. The fund’s dynamic hedge kicked in for the first time in Q4 2015 and hurt performance badly. The hedge triggered again in Q1 2016 and in both quarters the market rallied hard while the fund was hedged neutral, causing the fund to miss both rallies. In months, we went from +20 percentage points of outperformance (total return) and a five star rating to dramatically underperforming with one star. The funds assets went from over $200 million to $50 million. Ouch. Had the fund achieved $500 million or more prior to its stumble I believe it would have been survivable.
Instead of liquidating, I stuck it out, changed the fund’s underlying index with one that was not hedged so that we avoid another “whipsaw” event. Performance recovered some but assets never did.
You can’t control the markets. Sometimes that means you need to liquidate a fund. Build that thinking into your product plan.
The ETF business is hit-driven
I worked in the entertainment industry for a decade. Like the movie or music businesses, ETFs are hit-driven. That means that success is directly proportionate to the number of bets. ETF issuers look to their hits to pay for their flops. On average, for every three new funds launched, one fund is liquidated/merged. From 2013 to 2022, 2763 new ETFs were launched while 946 were liquidated/merged (Investment Company Institute). Keep the winners, shoot the losers. Rinse-repeat.
For smaller “startup” issuers that poses quite a challenge as launching multiple funds requires much more investment capital than launching one fund. Yet, the business risk of running a one horse race is much higher than the risk of running a multi-horse race. That’s why large asset managers entering the ETF segment always deploy a “family” of funds. Any horse can stumble in any given market environment but it’s unlikely that all of them will.
Ignore retail investors at your peril
Retail investors are often ignored as a segment by most ETF issuers, especially new entrants. You can’t blame them – unlike a mutual fund or a private fund, where the fund knows the identity of the shareholder when they buy/sell shares, ETF managers are often blind to who their individual shareholders are because individual investors buy/sell shares through their brokers instead of directly through the fund. Imagine, trying to market to an audience without the ability to know your customers! It’s crazy.
No wonder most ETF issuers focus mainly on advisors as their target audience. There are way fewer of them, they are easier to reach/track, and they can “write bigger checks”! Right? Wrong.
To my knowledge, in the entire history of ETFs, there has never been an advisor that has been fired for NOT putting their client into your ETF. Think about it; advisors have a ton of choice for any given portfolio exposure. They view their skill at asset allocation as the “alpha” they are delivering to clients. So, the cheaper the ingredients they use to deliver that “alpha”, the better for them and their clients. Like sushi chefs at the fish market, most advisors are looking for good quality fish (beta/theme) at low prices, they’re not looking for the latest sushi roll.
The reality is that for ETFs at the higher end of the fee spectrum (most new funds are), retail investors tend to make up a majority of their shareholder base, not advisors. Figure 3 below highlights a few ETFs across different expense ratios showing how total shares outstanding is split between “asset owners” and “asset allocators” investors. Note how for higher fee funds, “asset owners” make up a majority of shareholders, while cheap beta funds are mostly owned by “asset allocators”.
The lesson here is that a retail-minded marketing/distribution strategy is absolutely key. Don’t get me wrong, advisors are great but their participation in your fund will lag its market adoption (the first $25-50m in AUM). Not only that, and perhaps more importantly, advisor allocated assets tend to be a lot less sticky.
Build digital platforms (not brochures)
Luckily, in today’s digital world, building a retail-minded distribution strategy is possible for even small entrants. Unfortunately, most issuers still tend to build “brochure-like” websites and then run digital ad campaigns to drive traffic.
A better approach is to build a digital platform from the ground up that is designed to connect with and build relationships with your target audience. A platform that adds real value. For example, if your funds are ESG focused, you should build tools that allow users to leverage your expertise (e.g. rubric/tool for ESG assessment, ability to customize emphasis for specific “E” or “S” or “G” attributes, ways to “live” and “apply” ESG values, automatic donations to ESG causes, ESG for kids, the only limit is your imagination).
Our initial cloud-based 13F research platform would have been perfect to build direct relationships with investors interested in 13F investing. Instead, shortly after I deployed our first fund, we stopped offering our research service. I mistakenly believed that the advisor was the main target audience for our funds and that the research service would have been a distraction. I’m still kicking myself!
The good news is that our platform is very much still operational (I use it daily) and in a re-launch – we’ll make it the center of our marketing/distribution strategy. It doesn’t take much to imagine how, in a M/L-AI world, our platform would evolve to become an indispensable tool for retail investors.
The biggest win in pursuing this kind of “platform strategy” is that it allows you to build direct, real time relationships with your target audience and customers … that is marketing gold.
The people you meet
While lessons are important, what you remember the most are the people you meet along the way. Even as the journey continues, I wanted to take the time to recognize the people that helped me come this far.
The support I’ve received from my parents, my sisters/brother and my kids can only be described as heroic. Their support was and is unconditional and I assure you I would not be here were it not for their love and strength. Make sure you have people around you that love you.
I’m extremely indebted to all my clients and the people that invested in me and my vision early; Mike Buchanan, Tad Buchanan, Jim Chiddix, Glenn Duval, Richard Fullerton, Cesare Alessandrini, Jeffrey Parker, Roy Block, Michael Carrier, John Rigsby and Operative Capital all of whom have been amazing.
Advisors/Partners: Brad Bredemann (awesome as head of sales but even better when he’s got your back in a foxhole), Peter Spinelli and Fernando Sepulveda (for being believers), Meb Faber and Jason Jones (for support during the early days).
Developers: Gary Blessington and Robby Russell at Planet Argon (hiring them early was one of my best decisions).
ETF service provider: Garrett Stevens at Exchange Traded Concepts (straightest shooter in the business, entrepreneur at heart), Mike Castino, Michael Barolsky and all the folks at U.S. Bank Fund Services (for finding ways to help even when it was hard); Tom Lydon at ETF Trends (for being an early innovator in ETF marketing); Joe Anthony at Gregory FCA (for owning the PR game and always being generous in sharing his talent); Kris Monaco, Molly McGregor, Mark Abssy, Corey Villani and Lauren Latuso at International Securities Exchange (for helping me launch our first fund).
Legal/Tax: David J. Morandi (for being terrific as company counsel and for being a dear friend), Paul Bleeg and Hiren Modi (for tax counsel and support).
New sentiment-weighted indices
We’re actively talking to potential strategic partners about deploying a new family of sentiment-weighted strategies. We have all the ingredients:
- proven methodology and a strong track record
- redesigned indices to avoid key pitfalls
- go-to-market strategy leveraging our existing research platform as a lead generation engine to lower customer acquisition costs
- ability to evolve and enhance features (e.g. mobile app, ML/AI-powered investing/trading, etc)
If you think you’re a good fit, please reach out.