The nuts and bolts of ETF fund administration

Victoria Hartley lifts the lid on the processess that take place behind the scenes of ETF investm...

Victoria Hartley lifts the lid on the processess that take place behind the scenes of ETF investment and the different players involved

Behind the scenes of any performance - including an ETF's - there is a huge supporting cast. From investment managers and the legal team to the board of directors and the audit team, all interact and service their areas to keep the fund above reproach by the regulator.

ETF Securities launched the first gold ETF in 2003 and its head of UK sales, William Rhind, says the registration work for any new launch in partnership with the regulators creates a huge amount of work behind the scenes.

Once the fund proposal is submitted, alerting regulators to the intended launch, the regulator responds with comments and suggested changes, which can be very onerous. "This is one of the biggest barriers to entry for fund issuers as the regulator provides the hoops for you to jump through," says Rhind.

The next step pre-launch is for the fund sponsor or issuer to appoint a fund manager, a custodian to look after the underlying investment, be it gold bullion, investment equity or swap notes for the underlying assets, and a fund administrator to process the fund in and out-flows and net asset value (NAV) on a daily basis. Plenty of banks, including Wells Fargo, HSBC and Bank of Ireland offer both custodian and administration services.

Next, the fund issuer also appoints an audit firm to report back yearly on the fund and a board of directors and a separate board of trustees. Often, the asset managers and fund sponsors put together and constitute the fund's board of directors.

Perhaps unsurprisingly, the process of creating and administering an ETF is principally about teamwork, with plenty of overlapping responsibilities among that team.

However, the board of trustees is responsible for the day-to-day running of a fund, looking after the investor's interests and making sure a fund is priced correctly. Each other player or firm is legally required to report into the board. However, the board of directors, investment manager, issuer and legal advisers act as the linchpins, coordinating and managing operations, while the other players follow closely behind, as masters in their own specialist areas.

Investment manager
In the investment firmament, the investment manager is usually the star of the show. However, ETF fund managers have a more earth-bound democratic position, working closely with the fund administrator and the custodians who look after the fund's assets.

Fund managers are responsible for secondary registrations, or registering the fund for further distribution in international locations and depending on whether the ETF model replicates an index synthetically, in the case of swap notes, or buys the underlying assets, as with i-shares, the brief differs.

Michael Huber, sales analyst and retail sales with investment manager Assenagon, says unlike the stock-picking manager, the swap-based ETF manager does not demand an investment specialist.
"The swap contracts are unsurprisingly the focus of a swap-based approach," he says. "So, if the money market the ETF is tracking has big inflows, the manager needs to set up swap contracts to track that in the portfolio, keeping it both in line with the index and inside the limits of counterparty exposure."

He adds: "An ETF swap-model fund manager does need to be a swap-contract specialist, but can also oversee several ETF s at the same time. This is because the underlying assets are already being managed by, for example, the Dow Jones Index Management team, who keep their index in line with regulation."

In the case of the buying model used by i-shares, the manager oversees the instruction, then also the settlement and movement of the cash as well.

Db x-trackers, which also follows the synthetic model, says that as well as overseeing the compliance process, db x-tracker fund managers get an overview of the swap prices provided by parent group Deutsche Bank.

Manooj Mistry, head of UK for db x-trackers, which enlists State Street as administrators, custodians and investment managers for its two equity and fixed income ETF streams, says db x-trackers is the promoter and sponsor of the funds, and ultimately responsible for building the asset portfolio.
"Our experience is in structuring, distributing and marketing the ETF funds and we outsource the day-to-day operation to specialists like State Street, says Mistry.

"But we are the specialists when it comes to launching new products and innovation, for example, as the first providers to launch money-market ETF funds," he adds.

Legal firms
The legal adviser both structures the fund and ensures it complies with the Ucits directive, enabling it to be cleanly distributed into all other jurisdictions. The legal advisers also coordinate and manage communications between many of the players involved, from the investment manager to the trustees and auditors, for example.

The legal team also creates and finalises the prospectus of pre-launch fund information, which is offered to the regulator. It is also responsible for working through the regulator's objections until the watchdog is satisfied.

The ultimate legal liability for the fund is with the board of directors, which hires the trustees, but responsibility for the Irish registration, the exchange listing and compliant distribution to other jurisdictions lies with the legal team.

The Dublin office of international law firm Maples and Calder lists Barclays Capital, Credit Suisse and Source UK Services (an open-architecture platform created by Bank of America Merrill Lynch, Goldman Sachs and Morgan Stanley) among its clients. Maples advised Source on its first transaction, which involved launching 13 ETFs and 22 exchange traded certificate platforms of up to €90bn at the end of April.

Barry McGrath, partner and head of the funds group at Maples, says: "The legal team's key role is to project manage the deal to ensure the ETF platform is established in full compliance with relevant Irish law and the local legal and listing requirements of the foreign jurisdictions where the platforms is to be registered and listed. Making this project work by coordinating each piece of the puzzle means the team needs to be very focused and carefully managed."

"The legal team continues to advise Source on an ongoing basis as EU listing coordinator on the ETC platforms", says Nollaig Murphy, partner and head of the Finance Group.

Administrators and custodians
Administrators and custodians take care of the integrity of the fund, by setting pricing, monitoring asset in and out-flows and raising any problems with the fund manager.

However, from incomplete trading instructions to chasing down bits of security after trades have been settled or have been on loan, it is the administrator's job to keep the fund in line with the index it tracks.

Paul Ellis, head of product and compliance strategy at HSBC Security Services, says: "Under the custody banner, the core responsibility is the safekeeping of the assets. HSBC Security Services has some of the larger ETF assets under custody, such as FTSE trackers, which globally amount to $3.6trn."
Ellis adds: "The problem we solve for the client and our differentiator is that we allow fund managers to concentrate on their strengths and have confidence in the back office."

Bank of Ireland Security Services offers both fully outsourced administration and custody and, through The Governor and Company of the Bank of Ireland, fiduciary or trust-related services.
Again, depending on the ETF model, whether it is a swap or portfolio model, the custodian's role is different. With a portfolio model, the custodian and administrator takes the instruction to buy a basket of equities from the fund manager, puts the instruction to the market and, ultimately, delivers the cash to the fund after the sale.

The swap-model custodian is responsible for buying the swap at the right price or 'reconciling' the swap, which means checking the valuation is accurate against the level of the index. It also includes checking against a counterparty price, analysis of corporate actions that might affect the price or dividend implications.

Ferghal Woods, director of business development with Bank of Ireland Security Services, says: "It's always about the subtle differences in the fund models. What we try to do as custodians is understand those models and create a service structure that accentuates and benefits the goals of that model. No two ETF s are the same."

The auditor
"Our principal role is to audit the fund's annual financial statement," says Andrew O'Callaghan, partner and investment manager at PricewaterhouseCoopers.

The year-end for most ETF funds is 31 December and most fund reports are prepared by the administrators, and then examined in detail by the auditors, who submit a full report by the end of April each year. The board of directors signs off the report and the investment manager and regulator each get a copy, says O'Callaghan.

However, O'Callaghan outlines the three phases to this, which include the set up of the fund and any taxation consulting needed, the controls testing and interim phase, which involves a few weeks on site with the administrator/custodian each year and finally, the completion stage when the audit team agree a fund as 'materially correct' and sign it off.

"Often, ETF providers are dealing with multiple exchanges, currencies and varying accounting standards between one jurisdiction and another. The value we add to the process is resolving complex accounting and valuation issues," he says. "We fulfil a very important duty in attesting to the fund performance and financial statements that the manager has communicated to the regulator. We offer the background to the accuracy of all the figures."