Small, Illiquid ETFs Under Fire

by on August 26, 2009 | ETFs Mentioned:

The Wall Street Journal ran a piece this morning seeking to shed some light on the true cost of ETF trading, speculating that many investors may be paying a lot more in expenses than they believe. While ETFs have become tremendously popular in part because of their low cost structure relative to traditional actively-managed mutual funds, they may ding investors in other, less obvious ways. Of primary concern to most investors is the bid-ask spread, or the amount between the asking price for buyers and sellers. While this metric is negligible for many of the largest ETFs, it can represent a material cost (i.e., up to 1%) for smaller, less liquid funds.

A few interesting statistics from the Journal article:

  • Are ETFs Hiding Costs to Investors?The average ETF charges an expense ratio of 0.56%, compared to 0.40% in 2005
  • The ten largest ETFs account for approximately 40% of ETF assets and two-thirds of trading volume
  • Most ETFs are now launching with $5 million to $10 million in seed money, compared to about $20 million two years ago
  • Nearly 200 ETFs have bid-ask spreads over 0.5%

What’s The “Big” Deal?

The fact that there are illiquid ETFs on the market should come as no surprise to investors. As the number of ETFs has increased, some have struggled more than others to gain traction, resulting in wider spreads and potentially higher costs to investors. But these illiquid ETFs are no different than many small- and micro-cap equities that can go days without trading a single share. And they may not even pose a problem for investors who are willing and able to place limit orders. Investors who are forced to complete a trade immediately through market orders are much more likely to get burned by high bid-ask spreads.

In her article, Eleanor Laise makes the contention that “though many funds don’t attract much cash, they are relatively cheap to launch so fund companies will continue to throw products at the wall to see what sticks,” noting that there are currently more than 500 ETFs in registration that have not yet made it to an increasingly crowded market.

Based on my discussions with representatives of several ETF issuers, this simply isn’t true. While the last few years have seen a fair amount of “launch the fund first, worry about the demand later” approaches to the ETF market (our ETF Hall of Shame is proof of that), most issuers are becoming increasingly methodical, developing and introducing only funds for which there will be sufficient investor demand.

Several new fund launches in recent months highlight this trend:

  • ETF Securities, the London-based European ETF giant, launched its first U.S.-listed ETF (the ETF Securities Silver Trust, SIVR) just over a month ago. The fund recently topped the $100 million in assets mark, a tremendous accomplishment for such a short time period.
  • iShares launched the MSCI All Peru Capped Index Fund (EPU) just over two months ago, and the fund currently has a market capitalization of nearly $70 million.
  • In late July, Direxion launched two new ETFs, the Daily Real Estate Bull 3x Shares (DRN) and Daily Real Estate Bear 3x Shares (DRV). Just over a month later, these ETFs have an average daily volume of more than 65,000 shares, indicating that liquidity shouldn’t be an issue for most traders

While many other funds have been much slower to establish a meaningful market capitalization and reasonable trading volumes, the presence of so many “success stories” surely indicates that issuers are not simply “throw[ing] products at the wall to see what sticks.” We will continue to see new product introductions and innovation in the ETF space, but future funds are likely to be based on significant research and investor demand, not simply whims of ETF executives.

For more information on ETF liquidity, read:

Disclosure: No positions at time of writing.