Is ETF Performance Enough To Survive?

September 08, 2010

My zombie ETF list elicited a howl of protest from investors, sponsors and supporters of many of the funds I said were at risk of closing.

(In case you missed my original blog, I suggested more than 40 ETFs need to be closed here.)

Many of the protests centered around a legitimate question: How can you recommend closing a fund that is delivering solid results to investors?

Consider the First Trust IPO Index Fund (NYSEArca: FPX). It was first on my list, since at the time I wrote that blog, it was the longest-lived fund with less than $10 million in assets. The fund has had more than three years to build an audience, and has yet to hit critical mass. I think there’s a legitimate chance it will be closed.

All that said, the fund has delivered solid performance. For the three years ending July 2010, FPX has lost 5.06 percent per year—not bad considering the Russell 3000 has dropped 6.34 percent per year over that same time frame. For the past year, the fund’s 17.93 percent performance has topped the Russell 3000 by more than 3 percent.

 

FPX vs. SPX, trailing 3 years

 

I’ve spoken with a number of ETF sponsors about the ETF closure process, and they agree that relative performance is a factor in closure decisions. After all, a high-performing fund is more likely to eventually gain traction with investors than one that performs poorly.

But top performance is not a get-out-of-jail-free card. Fund sponsors have closed high-performing funds before. Recently, for instance, Grail Advisors closed the RP Technology ETF (NYSEArca: RPQ), despite strong relative performance in the technology space.

One twist for FPX is that it’s not being fully rewarded for its strong performance. One of the key reasons performance matters is that it is a leading driver of the rating a fund receives from Morningstar; a good rating can help drive assets. Unfortunately, Morningstar classifies FPX as a “Large Growth” fund, as its current makeup is dominated by large-cap growth companies. And as a large-cap growth fund, FPX’s performance has been just slightly better than average over the past three years. As a result, Morningstar rates FPX as a three-star fund, or “average.”

I think Morningstar’s in error here. While the fund’s construction methodology tilts toward large caps, its current tilt toward growth is an accident of recent corporate IPO and spinoff activity. A broad-based large-cap index would be a fairer benchmark for the portfolio. And for the record, FPX has crushed the S&P 500 since inception. If Morningstar followed the prospectus of the fund rather than its current portfolio (which could change), FPX would have a higher star rating and would be more likely to attract assets.

Where does all that leave FPX? I’m not sure. Certainly its strong performance is a feather in its cap and a legitimate thing for First Trust to consider when evaluating the portfolio. Perhaps it should spend more effort marketing the fund in an attempt to help it attain critical mass.

But I don’t think the performance advantage eliminates the risk that the fund will be closed entirely. I suppose we’ll see how it plays out in the months and years to come.

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