DRAMATIC SHIFT: "Unlike mutual funds, the structure of ETFs require sponsors to report holdings on a daily basis," notes John Alshefski of SEI.

In the last two decades, ETFs have grown from a tactical investment tool to a product that is firmly entrenched in the asset management landscape. By the end of 2014, U.S. ETF assets reached $2 trillion, nearly triple what they were just five years ago. Industry analysts expect this growth to continue with some projecting $5 trillion in total assets by 2020.

But growth is only part of the story. ETFs are also evolving with new product types and marketing approaches. This combination of growth and innovation is driving a whole new era in the ETF market which can best be described as ETF 2.0.

There are a number of trends driving this shift including the materialization of the active ETF market, increasing acceptance of ETFs both by investment managers and investors, new distribution channels, and a more receptive global environment.

While these trends indicate an attractive environment for new entrants in the ETF space, fund managers need to make sure they are prepared from an operational standpoint. Entering the world of ETF 2.0 will not be without a number of stumbling blocks and obstacles. Below are three of the key challenges for managers looking to get into the ETF space and suggestions for dealing with them.

MISINFORMED INVESTORS

While sophisticated and institutional investors are very familiar with ETFs and how they should be used, expansion of the market means that investors with less experience will increasingly have access to esoteric or less common ETF strategies.

Products such as leveraged and inverse ETFs, which were initially designed for institutional investors, are now widely available, leading to a potential for misuse with those without a proper understanding of how they work. Additionally, there are a number of misconceptions that exist among certain segments of the investing population that could potentially lead to problems for managers.

For instance, some investors consider failed trades and tracking error as an area of great concern. However, neither poses a significant risk and the former is based on a misunderstanding of how ETFs operate.

The onus is on fund sponsors to ensure that investors are properly educated on how to use evolving ETF products. Marketing efforts should place a heavy emphasis on providing educational information to investors and intermediaries. This is especially true if sponsors plan to expand into new international markets that do not have well-established channels of retail distribution.

DATA DELUGE

Unlike mutual funds, which only have to report holdings quarterly, the structure of ETFs require sponsors to report holdings on a daily basis.

This is a dramatic shift for most managers. As an additional challenge, when authorized participants want to create or redeem units of an ETF, they are typically delivering or receiving securities in-kind. In-kind purchases and redemptions are rare in traditional mutual funds and may take weeks to process.

For ETFs, these transactions are a daily occurrence. Inaccurate daily reporting of holdings is not only problematic from a compliance perspective, it will also frustrate market makers and authorized participants. If that were to happen, it can lead to cascading effects including widening spreads and higher transaction costs.

For sponsors entering the ETF market coming from mutual fund backgrounds, it is essential that they have an operating platform that can support the significant changes that come with the new structure. They need to be able to aggregate and distribute data that meets the needs of portfolio managers, risk officers and compliance professionals.

ETFs also present unique distribution challenges, and new entrants need to adapt to the presence of market makers and authorized participants. To succeed in the long-term, managers need an operating infrastructure tailored to ETFs' complex daily operational demands.

MORE PRODUCTS

Having an operational platform that can handle the current challenges is not enough. ETF 3.0 is right around the corner and managers must be ready for the operational complexities of the next generation of products and innovations. As the ETF market rapidly evolves with new products such as active ETFs, it's critical to have an operating platform that can smoothly handle the order-taking, daily accounting and basket data capabilities.

Managers need an adaptable and scalable operating platform that is nimble enough to handle new products as they are introduced to the market. This can best be achieved by having an open architecture operational infrastructure.

In the coming years, the ETF market will continue to evolve. Sponsors who are operationally adept and can identify and address the challenges that come with the ETF 2.0 landscape will be in much better position to succeed as the industry progresses into the world of ETF 3.0.

John Alshefski is senior vice president and managing director of SEI's Investment Management Services Division.

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