For nearly three years, investors in exchange-traded funds have found brokerage companies increasingly willing to offer big deals on some highly in-demand products. Millions of investors now have access to a variety of commission-free ETFs, helping them cut their trading costs dramatically.
Recently, however, the commission-free ETF movement got its first bad news in a long time. With a recent spate of ETF closures, the episode shows how important it is for investors to focus on ETFs that will survive and thrive over the years.
Earlier this month, ETF provider FocusShares announced that it would liquidate all 15 of its exchange-traded funds at the end of August. The ETFs stopped trading on the open market last Friday, and anyone who didn't sell their shares on the open market should receive liquidation proceeds in the near future.
The reason for the closure is simple economics. The 15 ETFs attracted assets of about $100 million, which at the ETFs' extremely low expense ratios apparently produced far too little revenue to keep the ETFs afloat.
Obviously, FocusShares, which is wholly owned by broker Scottrade, had hoped to attract more assets. The fees the ETFs charged were lower even than some of the cheapest ETF offerings from Vanguard and Schwab (NYSE: SCHW ) .
Yet even though the ETFs offered low fees, they didn't offer much in the way of novelty. The FocusShares-based style of ETFs largely mirrored what Vanguard already had available, while its sector-specific index ETFs matched State Street's (NYSE: STT ) SPDR line very closely.
The FocusShares ETFs weren't the only ones to give up the ghost recently. Russell Investments, which is well known for its stock indexes, decided to close 25 of its 26 ETFs, choosing to keep only its actively managed stock ETF.
But the big difference is that Russell didn't have an affiliation with a broker for its ETFs. By contrast, the major question this leaves for Scottrade is how it will respond to no longer having commission-free ETFs available.
Never getting left out in the cold
In hindsight, Scottrade's experience seems to validate the moves that E*TRADE Financial (Nasdaq: ETFC ) , Fidelity, and TD AMERITRADE (NYSE: AMTD ) made in making partnerships with established third-party ETF providers. Although they had to give up the opportunity to keep assets in-house, the decision reduced the pressure on them to make sure the ETFs they did offer would become viable. Fidelity's partnership with industry leader BlackRock (NYSE: BLK ) had no risk of abandonment whatsoever, while TD AMERITRADE's decision to embrace a wide variety of different providers left it equally well diversified against any fund closures.
Of course, Schwab's experience shows that a brokerage company can build a successful commission-free ETF lineup from scratch. But Schwab benefited greatly from being a first-mover with its program. Vanguard, on the other hand, had already established its proprietary ETFs as a major force in the ETF industry before it entered the commission-free battle.
Scottrade has some tough decisions to make. On one hand, it has made a commitment to its customers to provide ETFs that will now be gone. Granted, the lack of success from those ETFs suggests that customers didn't really get on board and so won't necessarily miss them that much. But with competitors still going strong with their offerings, the failure puts Scottrade at a competitive disadvantage unless it takes action to replace the closed funds with others.
For other brokerage players, Scottrade's experience only stresses the highly competitive nature of the ETF industry right now. With the strongest players seeing further gains, those that played catch-up by latching onto more speculative ETF providers could end up feeling the same pain that Scottrade is going through now.
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