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'Tailored' Exchange Traded Funds

Issuers of new exchange traded funds (ETFs) have a problem: how to attract enough investment to keep the fund alive. ETFs have a relatively high turnover rate, and many of the funds that fail simply never gained significant assets under management. Also, if the fund is not traded frequently, it is likely to have a wide bid-ask spread, further reducing investor interest.

One solution that a few ETF issuers have recently adopted involves building ETFs with a particular customer in mind. Back in April, iShares launched three ETFs that were developed in collaboration with the Arizona State Retirement System -- with each receiving initial investments of $100 million. Those funds were designed to track aspects of an MSCI equity index.

Recently, this idea has been taken even further. Earlier this month, a new nonprofit ETF issuer, Vident Financial, issued its first ETF, the Vident International Equity ETF (VIDI). According to IndexUniverse, both the fund and the issuer were developed in conjunction with investment advisory firm Ronald Blue & Co., who is reportedly responsible for most of the fund's initial assets under management. The fund invests in international equities based on a highly customized, "principles-based" selection strategy. This approach"identifies countries outside the United States that promote human productivity, as measured by dozens of research metrics" and allocates "among developed and emerging markets in countries that exhibit an adherence to these principles."

Investors should perhaps be cautious about ETFs developed in this fashion. If an issuer develops a fund with a particular client in mind, and that client invests an overwhelming majority of initial assets, then that client may have a disproportional influence on the fund either through its relationship with management or through its large trading capacity. For example, if that client were to liquidate its shares, the ETF itself might liquidate or have significantly reduced trading volume.

Also, this approach might not solve the liquidity problem faced by many new ETFs. While having a large client lined up might solve the problem of attracting sufficient assets under management to make the ETF profitable, it does not necessarily ensure that the fund will trade at a small bid-ask spread.

In all, the benefits of securing a large investor are mostly for the issuer, while the potential downsides might fall more on the fund's other investors. It will be interesting to see if more ETF issuers adopt this approach. If so, this might be another risk factor for ETF investors to be aware of.