Most Endangered ETFs Lists Spark Debate

May 30, 2008

Fallout from the latest fund closings leads analysts to consider which are the most likely to be next on the chopping block.

With 136 exchange-traded funds still on the market with less than $10 million in assets, the closing of five unpopular bond exchange-traded funds by Ameristock this week isn't likely to be the last, say industry observers.

Although economics within the industry can differ greatly between fund shops, the most widely used rule of thumb has been that ETFs with less than $10 million in assets are most exposed to either be swallowed or shuttered. That's viewed as the bare minimum to stay afloat.

Another common yardstick is to look at funds that have been in existence for at least a year. That way, good ideas not well-known have a chance to attract attention.

Using both those factors to weed out potential liquidation suspects from a larger list provided by Morgan Stanley, some 58 underachievers move into the spotlight.

That group, says the firm's veteran ETF analyst Paul Mazzilli, can be labeled as the industry's equivalent to an endangered species list.

Prime examples he points to are the XShares health sector ETFs. Several at this point still only have around $2 million in assets.

"The bigger companies can afford to clean up their messes when they make a mistake in the marketplace," Mazzilli said. "XShares doesn't have the assets or marketing clout to turn a lot of their funds around."

Also on that endangered list are:

  • Four from iShares. All are based on FTSE NAREIT real estate indexes.
  • Five from Claymore, which was the first major ETF shop to take the axe to their own lineup when it shuttered 11 earlier this year.
  • First Trust has 14 such ETFs. The largest is the First Trust Multi Cap Growth AlphaDEX Fund (AMEX: FAD).
  • PowerShares has three. Those are the FTSE RAFI Consumer Services Sector Portfolio (NASDAQ: PRFS), the FTSE RAFI Consumer Goods Sector Portfolio (NASDAQ: PRFG) and the Dynamic Hardware & Consumer Electronics Portfolio (AMEX: PHW).
  • ProShares has five, all of which are leveraged. Each comes with the Ultra label, meaning it provides double the long exposure in the market. Interestingly enough, except for one that's focused on consumer services, the rest are broad-based value funds. The biggest is the Ultra Russell 1000 Value (AMEX: UVG).
  • Rydex also has five. All but one is sector-related. That's the S&P SmallCap 600 Pure Growth ETF (AMEX: RZG). Besides being focused, most are also equal-weighted.
  • Two SPDRs make the list. Those are the DJ Wilshire Large Cap ETF (AMEX: ELR) and the SPDR S&P Pharmaceuticals ETF (AMEX: XPH).
  • WisdomTree has two of its sector-specific international ETFs. Those are the International Technology Sector Fund (NYSE Arca: DBT) and the International Consumer Cyclical Sector Fund (NYSE: DPC).
  • XShares has 16 on the list. All belong to the company's HealthShares stable, which breaks down that sector into everything from dermatology and wound care to respiratory- and pulmonary-related stocks.

Another industry analyst, Morningstar's Jeffrey Ptak, has a smaller list. He also screened by $10 million or less in assets as well as at least one year of operations. But his methodology included taking into account performance, something that left off the five Ameristock/Ryan Treasury bond ETFs that will be closed. (See related story.)

Ptak's "ETF DeathWatch 2008" was created before the most recent closure news. Still, it has sparked debate about how much performance matters in a young ETF's evolution.

"Quite simply, a vast majority of ETFs are nothing more or less than passive vehicles to provide investors exposure to a specific part of the market," said Roger Nusbaum, chief investment officer at Your Source Financial. "Using Morningstar's logic, every S&P 500 index fund should've shut down in 2002."

As such, he considers including performance measures into such screens "ludicrous."

What investors need to focus on, Nusbaum says, is whether an ETF tracks the index it's supposed to follow. "But boiling it down to sheer returns shows me Morningstar doesn't understand what it's analyzing. If you look at everything they're trying to do, they just don't get ETFs," he said.

Ptak defends such criticism on his blog by pointing out that fund companies often use the excuse that assets will come around when performance goes up. He also notes that at least a few of the ETFs on his list employ quasi-active strategies. These are trying to outperform a benchmark.

"If they're performing poorly on that basis, then it's pretty hard to justify one's existence, no?" Ptak noted.

Should investors be worried if they owned one of the ETFs on his list? Probably not, wrote Ptak. "I'd imagine that seed capital [from specialists and market-makers who help finance a fund's launch and ensure there's a sufficiently deep, liquid market out of the gate] soaks up a big chunk of the asset base, meaning that if they're liquidated, it'll be a nonevent for most retail investors," he added.


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