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Mazzilli: More ETF Closings Likely Without Greater Innovation

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(Editor's Note: The following is ex-Morgan Stanley analyst Paul Mazzilli's first research note for IndexIQ. It begins what is intended as a regular series from Mazzilli as part of the firm's new monthly ETF Insight newsletter. )

Following on the heels of a tumultuous 2008, the markets in January continued to suffer from a lack of confidence and more bad economic news.

In January, we welcomed our first African-American president, who promised significant change and an infusion of capital to our ailing banking system. In Davos, Chinese and Russian leaders blamed the global recession on the U.S. The Fed and Treasury are considering adopting a "good bank/bad bank" model.

Financial advisors and investors are seeking strategies that will perform well during this historic time period.

  • Leveraged and inverse ETFs have experienced significant growth. These products have raised concerns about ETFs in general, and specifically with regards to tracking error and tax efficiency.
  • The vast majority of ETFs continue to closely track their underlying indices and rarely make capital gains distributions. However, at a recent ETF conference, there were great concerns discussed about newer products.
  • Most commodity ETFs use futures and introduce tracking risks between the futures and cash markets as well as lower tax efficiency due to mark-to-market requirements. Most are designed to track daily performance of an underlying index, and period returns can vary from expectations.
  • There has been even greater perceived tracking error on the double leveraged and inverse ETFs. Most investors do not realize that they are designed to get double long or short exposure on a daily basis and that compounding effects can make returns over longer periods vary widely from expectations unless an investor rebalances their positions. The introduction of the triple long and triple short ETFs further exacerbates this issue.
  • Disruptions in the fixed income markets in late 2008 caused concerns about fixed income ETF pricing. Extreme volatility and lack of liquidity in certain fixed income markets made it difficult to get accurate asset values. Coupled with intraday liquidity requirements, this led to wide differences between the indicative intraday value and the ETF price.
  • In 2008, 48 ETFs closed due to either poor support or lack of product differentiation. This trend will likely continue unless issuers bring new and innovative products to the market.
  • Northern Trust recently announced the closing of 17 Northern Exchange Traded Shares (NETS). Launched in mid-2008, NETS raised around $33 million in total assets as of December 31, 2008.
  • There is still room for growth for unique and differentiated products. There are few choices for non-traditional investments, and currently no way to achieve hedge fund-like exposure in an ETF structure.
 

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