Exchange Traded Funds: Where did they come from and where are they going?

By Emma Nelson

The speed of technological development and an anxious market forces the banking system to adapt faster and innovate further, all in the name of pleasing investors who readily take on risk to achieve any return the market will give them. And as they have time and time again, the financial industry delivers.

From the safe and dependable pass-through mortgages, to the rise of securitization in the 1970s, to the intricate technological monstrosities of credit default swaps and collateralized debt obligations that brought the economy to its knees during the financial crash of 2008, technology has a way of completely changing the landscape and rules of the market, leaving investors running to catch up.

This time, a new product is poised to become a household name just as the alphabet soup of ‘asset-backed securities’ and ‘mortgage-backed securities’ have in the past. They are known as exchange-traded funds, which only a short time ago were known only to those who traded them. What exactly are these exchange traded funds or ‘ETFs’? Simply put, ETFs are an offshoot of the typical mutual fund structure. They allow investors to trade a portfolio of securities or index just as they do shares of stock. This hybrid security seeks to mimic a benchmark, say an index like the S&P 500 or a portfolio of a specific sector in equities or bonds, as closely as possible to generate similar returns in an efficient manner. Rather than purchasing every stock of every company in the entire S&P 500 and managing that portfolio themselves, an investor can instead purchase, for example, Vanguard’s S&P 500 ETF, which will closely track the S&P 500’s return. All the investor needs to do is buy one share, which can be bought on an exchange without an exorbitant commission fee from a financial advisor, and instantly become a stakeholder in a fund that is being passively managed by companies like Vanguard and BlackRock.

The convenience of not having to pay for an actively managed fund really lies at the heart of the popularity of ETFs. While only $1 billion was invested in commodity ETFs in 2004, this value had grown to $109 billion in 2016. In fact, ETFs now comprise one-third of the entire market of publicly traded equities. With major tax advantages compared to actively-managed funds that also charge large commission fees for financial advisor input and security selection, ETFs provide portfolio diversification without exorbitant cost. By giving investors access to a vast array of investment opportunities that the average investor would not normally enjoy, such as complex derivative options, ETFs provide instant liquidity and the broad capabilities of the market through diversification of asset classes and financial instruments in a portfolio.

Every innovation comes with risk. This was no more evident than during the flash crash of 2010 when ETFs rapidly crashed after high frequency trading (highly complex and rapid computerized trading programs) sent the algorithmic trading methods utilized by investors around the world into a panic, causing the entire system to fail temporarily and resulting in devastating losses for many investors’ portfolios. Like a genetically-mutated new strain of a disease resistant to traditional cures, new technological instruments of the economy react differently to market conditions than those of the past. In the new market environment, normal relationships between asset classes have completely broken down, in part from disrupters like ETFs that grow even more complex by the day. From Leveraged ETFs that promise to deliver a multiple of the return on a given index, to synthetic ETFs that don’t even hold an underlying asset, but instead use a complex algorithm to try to match the return using derivative trading, ETFs are experiencing relentless pressure to grow more complex from a market in search of ever higher returns.

Security trading and selection in the past used to require an analyst to have a gut feeling about a certain company or the direction of a sector of the market. With the rise of ETFs and other complex investment products, investing requires a new set of skills: a keen knowledge of market fluctuations and advanced computer programming abilities, to name just a few. Meeting this demand has completely transformed the identity of Wall Street. The finance world now employs more and more PhDs with advanced mathematical and engineering degrees, especially in firms like Jane Street that mimic Silicon Valley’s commitment to intellectualism and innovation in how it operates its massive $1 billion investment fund, which specializes in these highly advanced ETF trades. These highly-educated analysts who once were derogatively nicknamed “quants” are now well-respected and integral members of any trading floor. This reversal in sentiment is ample evidence that the Street has had to evolve with advances in technology.

ETFs are the financial tool of the future, which is exactly the reason why they are so popular amongst the Millennial generation. According to one study conducted by Cogent Reports, 40% of the age group reports owning ETFs. In an interesting yet gimmicky twist, at least two investment companies are even building ETFs designed to hold shares of companies that sell to the generation born between the early 1980s and the early 2000s. This union of Millennials and ETFs makes sense: in the smartphone age, the need for a constant stream of information from investments, combined with the ease and cost of investing, make ETFs the Millennial financial tool of choice. Where Generation X and Boomers look for more traditional tools, Millennials are moving away from the wisdom of traditional market relationships and embracing the new.

It is the new, however, that often forgets the old. History has shown the great things that can be achieved with innovation, but it can also demonstrate the huge risk that underlies the foundation of many of these advancements. The changing face of Wall Street is by no means a surprise or a bad thing. Innovation brought about by these talented analysts is inevitable. However, technology outpacing our understanding of the financial world is also inevitable. There is no greater illustration of this simple fact than what we saw in the financial crisis, which was brought about not because of the new complex mortgage products on the market, but from analysts and market participants not fully comprehending how these instruments affected the macroeconomy at a fundamental level. This event was not an anomaly, but rather will continue to be the rule if risk management divisions and federal government regulation do not closely monitor these new financial tools in their introductory stages before they have a chance to wreak havoc on the financial system if something goes awry. So as ETFs grow in popularity and complexity, it is important to keep a mindful eye about the incredible potential – both positive and negative – that they can bring.  

The Reality of Mini-IPOs: A critical look at the new A+ capital-raising rule for small businesses

By Sang Hyun Park

For the unsuspecting entrepreneur, the announcement of an “A+” regulation in the venture capital ecosystem may seem like remarkably good news. A closer examination of the terms, however, will leave many venture heads disappointed.

A new amendment to SEC Regulation A, called Regulation A+, now allows young companies to raise up to $50 million in new capital online through “mini-IPOs.” However, the lack of appetite for such offerings since the revision last June points to an unfortunate reality: the amendment is hardly the sea change in crowdfunding that entrepreneurs had imagined.

The concept of a mini-IPO as a way of raising capital has been in existence for some time, but has largely been ignored. The high costs associated with the complex registration process and the ownership costs of going public have been key reasons why small businesses have preferred alternatives such as equity crowdfunding. The recent Regulation A+ was an effort to jumpstart the old system of small offerings by providing several attractive new features. In particular, it substantially increased the amount that young private companies could raise in the offering through general solicitation. Furthermore, it created registration exemptions that would lay off the burden of following through with state blue sky-law compliance. The new regulation was made in hopes of spurring business startups by making capital formation much easier and simpler.

At first sight, entrepreneurs may see many reasons to be excited about Regulation A+. The tenfold increase in the possible amount of capital that can be raised is likely to delight many young executives with ambitions of making a conspicuous splash in the venture capital community. There is also the matter of the considerable savings that small businesses would enjoy from the registration exemptions. Previously, small companies attempting a mini-IPO were required under blue-sky law to register in each state in which their securities would be sold. Companies pursuing second-tier offerings amounting up to $50 million would no longer need to worry about going through such an exhaustive registration process. Perhaps the most notable feature of the regulation is the flexibility of the solicitation process. Issuers would be allowed to “test the waters” by communicating to investors via social media and measuring possible investment amounts before deciding to formally register. Moreover, even non-accredited investors in the public would be allowed to chip in, no matter how miniscule the amount.

So why haven’t we seen more mini-IPOs this past year? It turns out that, despite the hype, small initial public offerings are still not the ideal funding path for ventures for a number of reasons. Ventures seeking to go public under newly expanded rules may find relief from registration exemptions but will have to stomach the ongoing costs of audits and reports to the SEC. According to a report by the Financial Executives Research Foundation, latest estimates for the average audit fees that public companies pay on a yearly basis is approximately $1.5 million. While such fees will be drastically lower for smaller firms, they will still materialize to a significant slice of their revenues. This has created an incentive to cut corners by turning to unqualified registration consultants for their offerings, oftentimes leading to faulty registrations that would ultimately be rejected by the SEC. Thus, even for ventures with stellar prospects of expanding their businesses, the extra layer of costs to their operations from having to prepare audited statements will be hard to ignore.

This is not to mention the traditional reasons why young ventures hesitate in going public: ownership dilution and mandated transparency. For young companies just beginning to scrape together a viable business model, the dilution in ownership and pressure from venture capitalists could create complications and distract them from their company goals. Moreover, the transparency required from having to publicly disclose financials at a regular basis can hurt any competitive advantage companies may already possess or will develop with additional capital. Especially for young ventures, it is entirely possible to overlook such long-term difficulties in a rush to secure short-term funds.

It’s also worth noting that the costs do not end with simply registering the products. There are considerable costs involved in marketing the products to the public. In a traditional IPO issued by mid- to large-cap companies, the investment banks advising on the deal would easily take care of this by turning to their equity capital markets and sales force teams, taking the issuer on a roadshow to meet with institutional investors and carefully structuring offerings based on an analysis of the issuer’s needs and investor demand. Such a system will be hard to duplicate in the mini-IPO environment; without the same level of expertise that large investment banks can provide, microcap companies will find it more challenging to market their products to the public. More fundamentally, the investors themselves will not only be harder to identify but also be a tougher crowd to convince. As the amendment allows growth companies to raise from unaccredited investors, the sources of funding will be less predictable than when raising from recognized institutions. In addition, while institutional investors will typically examine each investment opportunity through careful analysis of the financial merits, investment decisions by the everyday American will typically be more psychologically-driven. Companies looking to issue a mini-IPO will thus need to spend extra attention to their marketing investors, recognizing that they will address a completely different investor base.

This is hardly to say, however, that Regulation A+ has added no value to the venture capital community. With its flexibility and grander scale, there are still many contexts in which the regulation could make sense for later-stage ventures seeking to raise capital. In particular, venture-backed companies that are either generating or have prospects of generating substantive revenue will most likely be able to sustain the accounting and registration costs that would put small companies without stable revenue-generating ability underwater. In December, real estate crowdfunding company Fundrise raised $38 million through the new regulation. As the world’s first online real estate investment trust, their dominance in the market for real estate crowdfunding fully enabled them to pursue and effectively execute the offering. More recently, Elio Motors raised $16 million in a Regulation A+ offering, topping their $12.6 million hurdle for funding their newest prototype. What was truly impressive about the offering was not the amount of the offering but the time in which it took place. Due to the market volatility caused by record low oil prices, there were very few regular IPOs that took place by February, when the deal was closed.

If this is any indication, mini-IPOs can be successful, and in some cases, wildly so; the only problem is that, in the current environment, they will only work for a very narrow segment of ventures and startups. Both Fundrise and Elio Motors had fully credible business models and ample prospects of growth through the new initiatives they would undertake. They were also well ahead of their competitors. Perhaps most importantly, the executives truly believed in the significance of going public. As CEO of Elio Motors, Paul Elio, put it, “Regulation A+ is how Wall Street was meant to work.”  For a large portion of later-stage ventures, it is hard to see all three conditions in place. At the very least, companies will be ill-advised in pursuing a mini-IPO without seeing revenue streams taking shape and prospects of achieving greater profitability by adding the extra millions on their balance sheets.

With all the hype that had built up over the amendment, most startups will find the offering process still less than satisfactory. The regulation may have given a leg up for small companies looking to raise capital, but it has hardly made it more desirable. Early-stage ventures without a clear business model or a revenue stream in progress will do well to stick with existing crowdfunding methods rather than incurring the costs of going public. Until a more refined offering process emerges, the current system will stand as a test for young entrepreneurs to look past the title of an “A+” offering and look closer at their income statements.