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This is the first installment of a three-episode series on ETFs—and how their behind-the-scenes mechanics make many things possible that can’t be achieved in mutual funds and other wrappers.
In this episode, we are going to start with how an ETF is launched. What I’m hoping you’ll learn is how demand drives new product, what the seeding process looks like, and how an ETF survives post-launch (as well as what happens if it doesn’t survive).
In the next episode we will focus on the key plumbing and mechanics of the ETF ecosystem that allow for many of its unique advantages, and in the third episode is the big payoff where I will apply what you’ve learned to thinking through whether or not to seed the launch of a new ETF via a 351 exchange.
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The Demand Test: What Sponsors Look for Before Launching an ETF
Before an ETF ever shows up in your brokerage account, the sponsor (e.g. Vanguard, iShares, Dimensional, etc) has to answer a basic question: is this something investors will actually use? Knowing in advance that there will be demand for a product isn’t straightforward and typically requires the fund company to gather information on a handful of signals.
For starters, the sponsor will typically go out to real world allocators for ideas. Most ETF ideas are created to do one of a few jobs:
- Core exposure: “I need U.S. stocks / international stocks / core bonds at the lowest all-in cost.”
- Portfolio completion: “I’m missing small value / international quality / TIPS / short-term munis.”
- Problem-solving: “I need income, tax efficiency, inflation protection, or downside control.”
- Convenience: “I want a managed solution—buffer, covered call, target outcome, managed bond ladder.”
- Narrative: “I believe in AI / defense / energy transition / obesity drugs.”
That “job to be done” matters because it helps the sponsor separate a real allocation need from a passing storyline. If the job is repeatable—something advisors can use across many clients—demand tends to be more durable. If it’s mostly narrative, demand can show up fast…and disappear just as fast.
From there, sponsors look for proof that demand is more than a hunch. They’ll study flows and holdings to see whether money is moving into that type of exposure across the category—not just into one headline fund. They’ll ask whether the space is dominated by a few incumbents, and if so, whether there’s a genuine reason a buyer would switch.
They also have to get specific about who the buyer is and how the ETF would be distributed. Is this built for RIAs and model portfolios? For wirehouse platforms? For institutions? Or for retail investors who might find it on a brokerage platform? A great idea with no realistic path to distribution is still a bad business.
Then comes the part that looks like a normal product viability test:
Can this be implemented at scale?
- Is the underlying market liquid enough?
- Or does the strategy force “ugly trading”—high turnover, higher costs, and execution issues that don’t show up in a slide deck?
Will it behave in a way advisors—and clients—can live with?
- Tracking error can be fine if it’s intentional and explainable.
- But weird outcomes, tail events, or confusing performance can kill adoption quickly.
- And if you can’t explain what the fund is trying to do in plain English, it’s going to struggle to earn a place in a real portfolio.
Finally, sponsors have a lot of “pre-launch” conversations. Not binding pre-orders like a traditional IPO, but practical due diligence conversations like:
- “If we launched X at Y basis points, would you use it in models?”
- “What would you need to see to get comfortable with it?”
- “Who would actually allocate to this?”
By the time the sponsor is ready to move forward with the paperwork and buildout, they usually have a decent sense of two things: whether the ETF has a real market and whether it can be priced in a way that makes it viable—sometimes with the expectation that it may need fee waivers or sponsor support early on.
And once that decision is made and the sponsor decides an ETF idea has a real market, the work shifts to legal and regulatory buildout.
This is the boring part that you probably don’t care about, so I’ll keep it brief.
The sponsor prepares the fund’s disclosure documents—what it will own, how it will be managed, what it will cost, and what risks come with it. They’re not asking regulators for a gold star. They’re getting the fund registered and launch-ready so it can be listed and offered to the public.
At the same time, they line up the infrastructure that makes an ETF functional: a custodian to hold the assets, an administrator to calculate NAV and keep the books, and—if it’s an index ETF—an index provider relationship. They also choose an exchange to list on, lock in a ticker, and coordinate the launch logistics with the firms that help the ETF trade smoothly on day one.
It’s a lot of plumbing, but once that infrastructure is in place, the fund still needs one more thing before it can open for business: money. That’s where seed capital comes in.
Seed Capital: The Starter Kit That Gets an ETF Trading
Now, on day one of trading, an ETF can’t just show up with no assets and hope the market buys its shares in an orderly fashion. There has to be something in the fund when the opening bell rings—assets, holdings, shares outstanding—so the ETF can publish a meaningful value and investors can actually trade it without the whole thing feeling like a ghost town.
That’s why sponsors line up seed capital. Seed capital lets the fund buy (or receive) its initial portfolio, issue its first shares, and begin trading like a real fund—not an empty shell.
Seed capital most often comes from one of three places:
- a large institutional trading firm that helps ETFs get off the ground,
- a market maker or liquidity provider, sometimes through an affiliated entity,
Whoever seeds the fund has to be operationally capable and comfortable taking launch risk.
There are two basic ways an ETF gets seeded.
First, it can be seeded with securities. The seeder delivers a starter portfolio—stocks or bonds that closely match what the ETF is supposed to hold—into the fund’s custody account. In exchange, they receive ETF shares, typically in institutional-sized blocks rather than one share at a time.
Second, it can be seeded with cash. In that case, the seeder wires money into the fund, and the portfolio gets built through purchases in the market. Cash seeding is more common when the underlying holdings are harder to deliver as a clean basket—certain bonds, derivatives-based exposures, or strategies where the launch is easier to execute with cash.
Either way, the outcome is the same: the ETF now has assets, holdings, and shares outstanding—enough to open for trading.
And that’s really the point. Seed capital isn’t “raising money” the way a company does in an IPO. It’s about making the ETF functional on day one:
- creating a real portfolio so the fund’s reported value isn’t theoretical,
- putting enough shares into circulation so trading can start out orderly,
- reducing early-day weirdness—huge spreads, jumpy pricing, that sort of thing,
- and signaling that this launch is serious, not just a ticker someone tossed onto an exchange.
Now, seed amounts vary, and there isn’t a magic number. A plain-vanilla equity ETF can launch with relatively modest seed capital because the underlying market is deep and easy to trade. But the less liquid or more complex the exposure—think certain bond strategies, smaller international markets, options-based designs—the more sponsors tend to care about seeding thoughtfully so the fund doesn’t start life trading sloppy.
And it’s worth clearing up two misconceptions here.
First, seeding isn’t the same thing as demand. It’s more like the first brick that lets the building open. Real demand shows up later—through sustained assets and consistent trading.
Second, a bigger seed doesn’t guarantee tight spreads. It can help, but trading quality depends much more on the liquidity of what the ETF owns and how easily the market can make prices in it.
So once the ETF is seeded, it can open for business. The question then becomes whether it can survive in the real world long enough to grow—and that’s where the post-launch economics start to matter.
Survival After Launch: AUM, Liquidity, and the Risk of ETF Closure
Once the ETF is built, listed, and seeded, it finally starts trading. And after the launch, there’s really one scoreboard: assets. If the fund doesn’t gather enough AUM, the economics don’t work—and eventually the sponsor has to make a decision about whether it’s worth keeping alive.
That’s because every ETF has a cost base that doesn’t shrink just because the fund is small. Think of it like a restaurant with rent and staff. You can have a great menu, but if nobody shows up, you still can’t cover payroll forever.
There are costs the sponsor pays no matter what:
- fund administration and accounting
- custody and settlement infrastructure
- audit, legal, compliance, and oversight
- exchange listing and market-data costs
- index licensing, if it’s an index-based fund
- ongoing reporting and filing obligations
Some costs rise as the fund becomes more active or complex—portfolio trading, reconstitutions, operational complexity—but the point is that there’s a meaningful fixed cost just to keep the lights on.
And the sponsor’s revenue is straightforward: it’s essentially assets times the fee. So if a fund has $25 million of assets and charges 35 basis points, that’s roughly $87,500 a year in management-fee revenue to the sponsor before you even get into fee waivers, platform costs, and the rest of the machinery required to run and support an ETF. That’s why so many funds eventually get shut down: they don’t gather enough assets to make the math work.
So why don’t assets show up? In my experience, it usually comes down to two drivers.
First, the ETF has to be easy to use. If trading is clunky—wide bid/ask spreads, thin depth, inconsistent liquidity—investors hesitate and advisors avoid building it into portfolios. That hesitation becomes a growth problem. And importantly, this isn’t always about how “good” the strategy is. Some ETFs trade smoothly even with modest volume because what they own is easy to price and hedge. Others trade with more friction because the underlying exposure is simply harder to manage in real time.
Second, the ETF has to be distributed at scale. This is the part most people underestimate. Most ETFs don’t grow because retail investors stumble across them. They grow because they get adopted by gatekeepers—model portfolios, strategist platforms, large RIA networks, brokerage platforms, and approved lists. If a fund can’t clear those hurdles, it often can’t gather assets fast enough to survive, even if the concept makes perfect sense on paper.
When those forces work together, you get a flywheel. A growing fund attracts more attention. Trading typically gets easier. The ETF looks more credible. Adoption becomes easier. Assets build on themselves. When they don’t, you get the opposite: the fund stays small, trading remains less appealing, gatekeepers stay skeptical, and the ETF never really gets off the ground.
And when an ETF doesn’t get off the ground, sponsors have choices—but none of them are particularly “fun” for the end investor.
Sometimes a sponsor will subsidize a fund for a while. They may waive part of the fee. They may absorb the fixed costs. They might keep it around longer than the math suggests because they want a broader lineup or they believe the category will eventually catch on. But eventually, if the assets never arrive, the sponsor usually does one of two things: liquidates the ETF or merges it into another fund.
Liquidation is the cleanest ending operationally, but it’s often the most disruptive for investors. The sponsor announces a closing date and a last day the ETF will trade. After that, the fund sells what it owns, pays remaining expenses, and distributes cash proceeds to shareholders. In a retirement account, that’s mostly an inconvenience—you’re forced to choose a replacement. In a taxable account, it can be more than an inconvenience because a liquidation can create a taxable gain (or loss), and it forces you to realize that outcome on a timeline you didn’t choose.
A merger can feel smoother because you often don’t receive cash—you end up in the surviving fund. But a merger still means change. You may wind up with a different exposure than you originally chose, different fees, or a different performance profile. And while many mergers are designed to be tax-efficient, the tax result ultimately depends on how it’s structured and what happens inside the funds during the transition.
There’s also a subtle point people miss: the cost isn’t only at the end. Funds that struggle to gather assets often have a tougher trading environment along the way—wider spreads, less depth, more friction. So even if a closure never happens, owning an ETF that never really finds its footing can be an unnecessarily expensive way to get an otherwise simple exposure.
All of this is why it’s important to think carefully when considering a newer ETF. Research (see here and here) shows that most ETFs that fail do so in the first three years. As a result, it’s common for allocators to wait to even begin the due diligence process until there is three years of live history for a fund. Another common hurdle investment teams will consider is an AUM threshold, which can be as low as $100 million or as high as $1 billion depending on the strategy and fund sponsor.
But if you’re seeding an ETF as part of a 351 exchange–the topic of the third episode in this series–you don’t get the usual comfort of a three-year track record or “this thing already has scale,” so you have to underwrite the reasons it will survive and function well.
So in Episode 247, I’m going to share some of the questions I ask fund sponsors when considering a newer ETF or seeding an ETF via a 351 exchange. But in the next episode, we will cover the plumbing and mechanics that make ETF management different than mutual funds.
Resources:
- Record-breaking growth expected as investors lean on ETFs
- Exchange Traded Funds and the likelihood of closure
The Long Term Investor audio is edited by the team at The Podcast Consultant
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