After a summer slowdown, the product development segment of the ETF industry is back in full swing; close to 40 new ETFs and ETNs began trading in October, pushing the total product lineup past the 1,300 mark. But while new products continue to pop up at an impressive rate, there is activity at the other end of the spectrum as well; exchange-traded products continue to shut down, as issuers shutter funds that have not generated the interest they had hoped.
While there have been a number of closures in 2011, the consensus in the media seems to be that significantly more consolidation is needed. Ron Rowland’s ETF Deathwatch suggests that about 150 ETFs–more than 10% of the industry lineup–are in danger (or perhaps in need) of shutting down. Last week, that notion made its way to the front page of the Wall Street Journal web site, in an article claiming that the refusal of ETFs to close their doors was somehow “to the detriment of investors” (though that detriment was never really explained).
The most common metric for determining the viability of an ETF is assets under management, with rules of thumb applied to gauge the profitability of a fund. The exact breakeven level depends on a number of different factors, but is generally believed to be between $25 million and $50 million. At the end of September, about 540 exchange-traded products had assets of $25 million or less–a staggering total that highlights the “top-heavy” nature of the industry. But the asset totals only tells a part of the story, and the idea that close to 40% of all ETFs should close their doors is way off the mark.
Most of the ETFs that are presumed to be in need of consolidation are young products. Of the 540 or so falling below the $25 million threshold, more than 200 began trading this year. They haven’t built huge bases of assets because they haven’t been around for long. It’s as simple as that; billion dollar ETFs don’t pop up overnight [see the Top 25 ETFs By Assets].
There is ample evidence suggesting that smaller ETFs continue to grow and attract investor assets. Let’s go back to 2010. At the end of last year, there were about 350 ETFs with less than $25 million in AUM. But so far in 2011, those products have, on aggregate, grown very quickly. Through the first eight months of 2011, the “little guys” saw aggregate inflows of about $3.3 billion–close to the $3.7 billion in combined assets they had when the year started. Of course, not all the small ETFs out there are new; there are about 150 that have been around for more than three years that have not yet crossed the $25 million level.
There is also a case to be made for keeping small ETFs open in the event that a certain environment comes along to drive a surge in interest. Such a development certainly wouldn’t be unprecedented; there are a number of products that have struggled to gain significant assets for extended periods of time before expanding rapidly after the underlying asset class came into renewed focus. The Global X Colombia ETF (GXG) is a great example; that fund launched in early 2009, and generated next to nothing in asset growth for its first year or so. Then in 2010, the Colombian economy caught fire and GXG saw a surge in inflows. With about $140 million in assets now, GXG generates close to $1 million in annual revenues for its issuer.
Van Eck’s Egypt ETF (EGPT) is another example; following its debut in early 2010, that fund struggled to gain assets. But when a democratic revolution swept through Egypt, investors flocked to the country; EGPT now has about $45 million in AUM.
It’s not a stretch to argue that the lineup of sub-$25 million ETFs older than three years could contain some more “late bloomers.” The China Real Estate ETF (TAO) could thrive in the right environment; it would be a shame to see that fund disappear even though it has only about $22 million in assets. The same could be said for the WisdomTree Middle East Dividend ETF (GULF), which has about $17 million, or the PowerShares Global Wind Energy Portfolio (PWND).
So What’s The Number?
It seems as if everyone has a prediction for the extent of consolidation in the ETF industry in coming years, with some estimates going as high as 400 or 500 funds. But the truth of the matter is that the actual number will be much, much lower. To get a better estimate, start with the 150 products or so that have less than $25 million in assets and an operating history of more than three years. Close to a third of those are ETNs, which are considerably cheaper to operate and maintain than ETFs. Among the remaining 100 or so, several belong to the “big dogs” of the ETF industry; about 70% of that lineup belongs to the five largest issuers by total assets, meaning that they are backed by firms with the financial stability to operate a few products at a loss for as long as they desire. Several of the larger players in the space, such as iShares and State Street, have avoided shuttering products, perhaps seeking to build a reputation of stability in their product lineups. Others, such as PowerShares, haven’t hesitated to close down products for which investor demand has not materialized [Exchange Traded Duds: ETF Ideas That Are Striking Out].
We’ve already seen a wave of fund closures so far in 2011, as dozens funds have shuttered their doors since the beginning of the year. Yet, with that being said, investors should note that this well below the pace of closures that we have seen over the past few years as close to 50 products have ended their operations each fiscal year. Furthermore, a number of products that were closed were in the volatility ETP space after they hit ‘automatic redemptions’ for falling below certain levels. These products, which count among the fund closure list, were immediately replaced by issuers, suggesting that even the low number of products that have closed their doors this year is much higher than it really should be when taking this into account.
So while a number of funds probably do need to shut down in the months and years ahead, expect issuers to stick it out for a longer amount of time on a number of ETPs. Extremely profitable winners are helping to subsidize the losing products in a company’s lineup and are allowing these funds to truly go through a lengthy incubation stage, allowing buzz and press to build even if assets aren’t increasing. Due to this, investors could see a minimal amount of shutdowns over the next few years, especially if there is even a hint of inflows in the near future [also see ETF Investors Are Embracing Low Cost Options... Or Are They?].
Other Side Of The Coin
We’d be surprised if more than 50 ETPs shut their doors between now and the end of 2012–and we think that’s a very good thing. Much has been made about the “detriment” inflicted upon ETF investors by keeping smaller ETFs open. We suppose that’s a good story, but it simply doesn’t make much sense. The argument is perhaps that if these products were to shut down, issuers could pass along the cost savings in the form of lower expense ratios on other products [also read Here's A Wild Idea: The ETF ETF].
That’s a stretch for several reasons, including the fact that, last time we checked, there are no not-for-profit ETF issuers. Moreover, the losses incurred by any “oughta-be-shut-down” ETFs are dwarfed by the revenues generated by those that have achieved critical mass. The Gold SPDR (GLD) generates about a quarter of a billion dollars in annual revenue–enough to subsidize a handful of funds that are hovering around breakeven.
The irritation caused by the breakneck pace of expansion continues to puzzle us; it is as if some critics of the ETF industry are under the impression that investors must invest in every new product that hits the market. They’re still free to pick as they see appropriate, or to avoid ETFs altogether. But for those looking for precise, targeted exposure, the proliferation in the ETF lineup has been a very positive development. It’s nice to have more tools in the toolkit, even if most of those will never be used by the vast majority of investors. The ETF industry’s growth has been so impressive because of the wide net cast by the product lineup; every conceivable investment strategy or asset class is within reach, allowing investors and advisors to embrace ETFs fully.
The Journal has it wrong. The widespread elimination of smaller ETFs and ETNs would be a detriment to investors; keeping them around for a bit longer would be a very positive development.
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