Investors have been pouring into exchange-traded funds. But not all ETFs are prospering, says Ron Rowland, president of Capital Cities Asset Management, a registered investment advisor in Austin, Texas. “Too many products have come to market, and not all of them will survive,” says Rowland.
To track small funds with negligible trading volumes, Rowland publishes a list that he calls “ETF Deathwatch,” which appears monthly on investwithanedge.com. The list includes ETFs and exchange-traded notes that have average daily trading values of less than $100,000. In August, Deathwatch listed 146 products, including iShares MSCI Far East Financials Sector (FEFN), which had average daily trading of $533, FaithShares Lutheran Values Fund (FKL), with $5,884, and PowerShares FTSE Nasdaq Small Cap (PQSC), with $17,211.
Rowland says that investors should steer away from the names on his list. Because such small funds are not profitable to operate, they can have short life spans. Investors who hold a terminated fund will be forced to spend time and effort finding a replacement. If a fund liquidates, it can burn through up to 3 percent of its assets to cover costs of selling holdings and returning cash to investors. The expenses are sometimes borne by those investors who are unlucky enough to be holding shares on the termination dates.
Rowland predicts that the attrition rate will be particularly high for actively managed ETFs. Of the 24 active funds that have been open for at least six months, 11 are on the Deathwatch, including Grail RP Growth ETF (RPX), PowerShares Active Alpha Multi-Cap (PQZ), and WisdomTree Dreyfus South African Rand (SZR). Some funds have been boosted by promoters who claim that actively managed ETFs will eventually steal market share from conventional mutual funds. But Rowland says most ETF shareholders prefer low-cost passive choices. “One day the people who buy actively managed mutual funds will try ETFs, but that day has not arrived yet,” he says.
Even when low-volume funds continue operating, they may be poor choices because of high trading costs, says Rowland. To appreciate the costs of using small ETFs, consider SPDR Nuveen S&P VRDO Municipal Bond ETF (VRD), a new fund that is trading around $21,000 worth of shares a day. With an expense ratio of 0.20 percent, the fund appears cheap. But to calculate the total costs, you must include brokerage commissions and the bid-ask spread, the difference between what buyers want to pay and sellers will accept. The bid was recently $29.34, while the ask was $34.64—for a total spread of more than 16.57 percent. When all the expenses are added up, it could cost more than 17 percent to buy the fund and the same amount to sell it.
There are currently about 1,000 ETFs trading, and Rowland says he usually only buys funds that are among the 20 percent with the greatest trading volumes. Such funds typically trade shares worth millions of dollars a day. Recently Rowland searched for a mid-cap blend fund, screening through the 15 choices on the market. He eliminated 10 funds right away because their trading volumes were too low. The list of finalists included iShares Russell Midcap Index (IWR) and SPDR S&P MidCap 400 ETF (MDY), which both trade more than $50 million a day. But he elected to use iShares S&P Midcap 400 (IJH) because of low transaction costs. Rowland can trade the fund for free because he custodies assets at Fidelity, which does not charge commissions on the iShares fund.
The Deathwatch is likely to include a growing number of funds because companies are rushing to introduce new entrants. There are currently 705 ETFs in registration at the SEC, according to Matt Hougan, global head of editorial of indexuniverse.com. “The flow of new ETF issuance has never been higher,” says Hougan.
The increase in fund registrations is partly due to efforts by big money managers to gain a toehold in the booming ETF markets. Well-known names that are introducing ETFs include Goldman Sachs, John Hancock, and T. Rowe Price.
Seeking to carve out new niches, some of the new crop of offerings target narrow specialties. Inevitably plenty of the newcomers will wind up on the Deathwatch. Hougan says that many narrow funds have failed in recent years. One of the biggest blowups involved XShares Group, which introduced 19 funds that divided the healthcare business into 19 sectors, including cardiology, cancer, and orthopedic repair. The funds all shut down.
Hougan says that some of narrow funds make little sense because they fail to target an important market segment. He cites First Trust NASDAQ CEA Smartphone Index (FONE), which recently filed with the SEC. The fund’s benchmark includes such stocks as Google and Apple. But because those companies are involved in a variety of businesses, they don’t offer a pure play on smart phones. “If you want a pure play, then you should buy some individual stocks,” says Hougan. “ETFs are not always the best choice.”