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The Next Five Years In ETFs

The Next Five Years In ETFs

Related ETFs: SLV | SIVR | EEM | VWO | ACWI | SPY | IVV

Daniel Harrison’s blog on the current fervor in the exchange-traded fund marketplace has me thinking about the future of this industry.

If you didn’t read the piece, it’s available here.

Daniel notes a rush in filings. Indeed, we're near peak levels on filings.  According to ETF Watch, there are currently 518 ETFs in registration at the Securities and Exchange Commission. That’s on par with last year’s record levels (526) and way above levels seen in September 2007 (397, according to our records).

There can be no mistake that the rush of major firms filing to enter the ETF market is unprecedented, at least in recent memory. From Charles Schwab to John Hancock, Jefferies, Manulife Financial, Old Mutual and Pax World Funds, the mutual fund industry has definitely woken up to the threat posed by ETFs, and they’re responding.  The mantra appears to be, “If you can’t beat ‘em, join ‘em.”

Let's add another layer of perspective, however. At least in the U.S., we’re on pace for a down year in ETF listings. By my count, we saw 67 ETFs come to market in the U.S. in the first eight months of this year, for an annualized rate of about 100 ETF launches.  That would be down more than 50%  from the 220 ETFs that launched in 2008, and the record 292 that launched in 2007.  It would also fall short of 2006’s 160.

What It All Means

Daniel outlines three major consequences that all this activity will have on the ETF space, and not all of them are good.

First, he worries about the proliferation of narrow, niche ETFs that trade with wide spreads, and that slice and dice the market. It’s a concern I share.  Already, nearly 50% of ETFs trade with average spreads of 0.5% or more, a group I call the “zombie underclass” of the ETF market.

As I scan through the list of new products in registration, I see quite a few that seem destined for this list as well. These funds can hurt investors, as the fees for entering and exiting the funds are enormous.

At the same time, the new and important asset classes that the ETF industry is opening up constantly amaze me.

The world’s first “all-world” ETF didn’t launch until April 2008, but the iShares MSCI ACWI Fund (NYSE Arca: ACWI) now has over $550 million in assets, and someday will have billions.  Just a few weeks ago, Pimco launched a new Treasury Inflation Protected Securities ETF that I think could be a category killer. (See related story here.)

People have been saying there are “too many” ETFs for a decade. So, while many new ETFs are overly narrow, I guarantee there are some future mega-funds amongst the filings as well.

I also think that some of the “me-too” ETFs in registration will slowly, but steadily, steal market share from competitors.  There’s a belief in the ETF industry that the first mover always wins, but recently, investors have been more discriminating.

Investors More Selective

For example, Vanguard’s Emerging Markets ETF (NYSEArca: VWO) is a better fund than the overpriced iShares MSCI Emerging Markets ETF (NYSEArca: EEM), and over the past few years, it has been stealing market share.

Similarly, the ETFS Silver Fund (NYSEArca: SIVR) gained nearly $100 million in assets in August, while the iShares Silver Fund (NYSEArca: SLV) lost $73 million.  SIVR provides the same exposure with a much lower fee.

Examples like these give me hope that the addition of “me-too” funds can actually be a good thing for investors, particularly if they push the envelop on costs.

Daniel’s second worry is that the proliferation of ETFs into “exotic” asset classes will lead to ETFs that trade at high premiums and discounts to net asset value. We’ve certainly seen this in the fixed-income market, where premiums and discounts are endemic, as well as in special situations such as the closed commodity funds.

The thing to understand here is that the primary driver of premiums and discounts is the liquidity of the underlying securities. So, as ETFs move into less liquid markets, Daniel is probably right that premiums and discounts will increase. I think it’s an open question whether or not ETFs are a good mechanism for accessing corporate debt, and the same question will apply in other illiquid categories.

For ETFs tied to liquid markets, such as most segments of the equity space, there’s no reason to be alarmed.




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