The tremendous growth of the ETF industry over the last several years has been generally cheered by the media and investors alike, as the introduction of cost-efficient products offering exposure to more and more asset classes has been praised as a positive development for investors both big and small. But many have viewed the surge in the ETF product lineup more skeptically, proposing that product development efforts have far outpaced the market demand for new exchange-traded products.
The evidence for this “oversaturation” of the ETF industry has been both anecdotal and statistical. The fate of hyper-targeted products that flopped with investors–such as the HealthShares suite and the Wal-Mart Suppliers ETF–are still fresh in the minds of many [see ETF Hall Of Shame: Nine Exchange-Traded Debacles]. And in the last several years, the ETF industry has become tremendously top-heavy, as a small handful of funds have accounted for a disproportionately large portion of total assets. At the end of the second quarter of June, there were just over 1,000 U.S.-listed exchange-traded products according to data from the National Stock Exchange. A whopping 470 of those–47% of the product universe–had assets under $50 million–a common “rule of thumb” breakeven point for issuers.
The economics of a business built around low expense ratios can be challenging for those offering the products, and many shared a pessimistic outlook for the smaller issuers that struggled to build assets. The consensus opinion has been that the ETF industry still maintains an incredibly bright outlook, with years of strong cash inflows and increasing market share ahead. But the expectation has also been that a “trimming of the fat” is in order; predictions for a wave of ETF closures have been common over the last year. Heading into 2011, this was expected to be the year of the ETF closure, with opinions for the scope of the reduction ranging from a few dozen to a few hundred.
But we’re now well into the second quarter, and there is no sign of a wave of ETF closures materializing. In fact, not a single U.S-listed ETF has shut its doors this year. That outcome would have come with some pretty long odds just a few months ago [see more from the Closed ETFs news archive].
So what accounts for the lack of ETF closures? It could be that it has simply been delayed, with some issuers holding on longer than expected. There are certainly issuers that are losing money. Grail has accumulated assets of only about $20 million, meaning that annual revenues are in the neighborhood of $140,000. FaithShares’ five faith-based ETFs have about $10 million in aggregate, meaning the company’s annual revenues are about $85,000. These companies are more than likely losing money hand over fist, and the odds of survival still seem very long [see How To Survive An ETF Liquidation].
But there is another explanation for the lack of ETF closures as well. Many of the inflows into exchange-traded products have gone towards smaller products. At the end of June 2010, the 470 smallest ETPs–those with under $50 million in assets–had aggregate AUM of about $7.8 billion. In the nine months since, cash inflows to those fund have totaled nearly $7 billion. This group of funds has seen assets more than double over the last nine months. To put that in perspective: at the mid-point of 2010, the 20 largest ETFs had aggregate assets of almost $390 billion. Inflows into that group over the next nine months totaled less than $11 billion [see ETF Price War Victory: VWO Beats Out EEM].
The ETF industry remains top heavy, but the small guys are gaining ground. In June 2010 the 20 largest ETFs accounted for just under 50% of total assets. That figure has dropped to about 46%, a deceptively large decrease considering the relatively short amount of time elapsed.
At the end of March, 511 exchange-traded products had assets of less than $50 million, or about 44% of the ETP universe. That’s still a significant chunk of the industry, even if the percentage has declined by a few points over the last few quarters. But many of those are new additions to the ETF industry–fresh meat that hasn’t had much of a chance to build a base of assets [see Counting Down The Best New ETFs Of 2010]. More than 10% of he ETFs below the $50 million threshold debuted this year, and more than 30% hit the market last year:
The future probably isn’t too bright for those funds that debuted five years ago and haven’t crossed the $50 million threshold. And it would be foolish to expect that at least a few current ETF issuers aren’t headed for bankruptcy or a sale. But the cash flow trends over the last nine months suggest that investors and advisors are diving deeper into the universe of exchange-traded products, looking beyond the blunt instruments at the top of the totem pole to find tools that allow them to fine tune exposure and more efficiently seek out alpha. That is no doubt a positive development for both issuers and investors: parity (or relative parity at least) in the ETF industry will translate into fewer fund closures, lower expenses, and more granularity in the product lineup. So here’s to hoping that, in this case, past results are indicative of future returns [just in case, make sure to read How To Deal With ETF Closures].
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Disclosure: No positions at time of writing.