Fleeting ETF Seed Money Could Be Healthy Sign

Growing number of 'zombie ETFs' may slow ETF launches.

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Editor-in-Chief
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Reviewed by: Drew Voros
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Edited by: Drew Voros

Last week, Trevor Hunnicutt of Reuters wrote an interesting story, “New ETFs face more skepticism from financiers,” that examined something new going on in the ETF industry: fleeting seed money for new ETFs.

For small ETF issuers, in particular, this should be a reason for pause.

Hunnicutt writes, “While they have not turned off the tap just yet, ETF capital providers, such as Cantor Fitzgerald LP and Esposito Securities LLC, say that after a bout of ETF launches—some that have failed to attract active trading—they are more insistent on proof of a marketing strategy before they say yes. Fund issuers like Guggenheim Investments and Summit Global Management are working harder and waiting longer for the backing of sponsors that will enable them to go to market.”

Part of the reason seed capital is drying up is that new ETFs are having a harder time attracting enough assets to become trade-worthy vehicles as the industry matures.

‘Zombie ETFs’

“Twenty-eight percent of U.S.-listed exchange-traded products traded fewer than 5,000 shares a day on average over the last six months,” Hunnicutt reports. He goes on to describe these little-traded, nonleveraged/inverse funds as “zombie ETFs.” Two years ago, that figure stood at 20%.

In 2015, there were 284 ETF launches, and so far this year through June 13, there were 101 launches—a blistering pace for an industry of 1,900-plus funds in total. So we could easily be looking at roughly 500 launches in the space of two years, each vying for seed money and investor dollars in order to survive.

Last year, we also saw more than 20 new ETF issuers come into the industry, in a trend that many say is just the tip of the iceberg as some of the biggest wealth managers, such as Franklin Templeton, adopt a better investment vehicle than mutual funds.

But wealth managers like Franklin have a built-in client base, and usually have distribution networks that will keep their new ETFs healthy enough to trade with reasonable spreads. But for smaller ETF issuers that do not manage money for clients, the hill to success may be about to get a lot steeper.

As Lee Kranefuss, the man best known as the founder of iShares, recently told ETF.com, “The barriers to entry in the ETF market are relatively low. You can get an ETF up and running for a few hundred thousand dollars. But the barriers to success are getting quite high.”

Innovation Or Degeneration?

Perhaps compounding the problem is that more and more new ETFs cover thinner slices of the market, with everything from funds that focus on drones or video games to millennial spending habits. While it may better to buy a group of drone companies in one fund rather than try to select which company or companies will be successful, it is more akin to stock picking than broad passive index investing.

The further away a new ETF gets from broad passive index investing, the higher the probability it might underperform, which will not help it attract assets. Many simply see this as innovation, while others see it as degeneration of plain-vanilla index investing that has been beating active investing for decades.

As the industry approaches 2,000 funds—which will likely happen later this year—the ETF industry is maturing to the point that more and more choices may not necessarily be healthy. With more than 500 funds not trading at all or very little, more pockets of potential trouble for investors are forming.

With capital providers starting to withhold seed money for new launches, we could soon start to see a slowdown in ETF launches, which may be a healthy sign in the long run.

Drew Voros can be reached at [email protected].

 

Drew Voros has nearly 30 years' experience in financial journalism. He was a longtime business editor for the Oakland Tribune and sister papers of the Bay Area News Group, and finance writer for the Hollywood trade publication Variety. Voros' past roles have also included editor-in-chief at etf.com and ETF Report.